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Brexit Accelerated, But Didn’t Start, Flight to Quality

Russel Kinnel
Christine Benz

Christine Benz: Hi, I'm Christine Benz for The Brexit vote shook financial markets and many mutual funds. Joining me to discuss fund performance during this turbulent period as well as for the year to date is director of manager research Russ Kinnel.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, you wrote a blog post in the wake of the Brexit vote, taking a look at how various fund categories had performed and also sort of taking a little longer-term view looking at year-to-date performance. But let's start with this period, we had a couple of days there where stocks fell very sharply. Maybe you can talk about the categories that performed especially poorly during this short period following the Brexit vote.

Kinnel: Sure. Well, naturally, European equities and foreign equity categories because it's mostly European stocks, they were among the biggest losers because you had both the equities selling off and you had the pound and the euro and other currencies selling off as well. We saw some of the shakier European countries like Spain and Italy sell off ever harder than the U.K. So, there was damage across Europe really.

Benz: And the financials sector within Europe was a particularly hard hit place. We had seen some of the diversified funds, some of the funds we like, had been invested pretty heavily there and those funds saw some aftereffects as well?

Kinnel: That's right. Funds like Oakmark International were some of the hardest hit because European bank stocks naturally are really under threat in a number of ways because if Europe does pull apart then sorting out all of those obligations is difficult and of course, sorting out the regulation, and it's a serious negative for the economies across Europe, which of course is bad news for the banks.

Benz: And was there also the expectation that rates could stay down, which would apply pressure on all banks?

Kinnel: That's right. This indicates slower economic growth, and slower economic growth means lower interest rates and more accommodative central banks presumably as well. So, a number of challenges for banks out there.

Benz: How about when you look at the U.S. equity fund market? What sorts of trends do you see?

Kinnel: Yeah. So, U.S. equities also got hit and again, it was financials that were among the hardest hit areas. We've also seen health and tech have been having a rough go of it, but financials have been hit harder. But again, it's not nearly as bad in the U.S. The U.S. has already rebounded and recouped some of those losses. So, from a U.S. perspective, it's a little painful but really not that big a sell-off in the big picture.

Benz: At the other side of the ledger, let's talk about some categories that really held their ground pretty well during this short and turbulent period.

Kinnel: Right. When you have a scare like this and you have lots of uncertainty, you often hear the phrase "flight to quality" and that's what happened. So, "flight to quality" means rushing into safer investment areas like Treasuries and other high-quality bonds. So, we saw higher-quality bond funds do well, longer-term bond funds do well because again with falling interest rates, the longer-duration funds are going to look good. We also saw defensive equity areas do well; utilities, communications, others where you're essentially saying, I'll take more yield in exchange for less growth, and when we're ratcheting growth forecast down, that sounds pretty good.

Benz: We also saw municipal bonds hold in pretty well.

Kinnel: Municipal bonds did really well, even the higher-yield municipal bonds. So, again, yeah, I think people are embracing muni bonds, and they have been very strong performers in the recent week as well as year to date.

Benz: And I guess, investors are sort of rationally saying, well, these municipalities will not be affected by what's going on overseas.

Kinnel: That's right. If the U.S. economy is hurt slightly by all this then munis might be hurt slightly, but slight damages, and what causes problems for munis is huge damage and that's not likely. So, munis look pretty well insulated. Obviously, much more insulated from Europe's problems than say your typical multinational U.S. company.

Benz: In a blog post on your Morningstar FundInvestor site you dialed it back a little bit which I thought was a helpful perspective that even though markets were really turbulent during the days immediately after Brexit, you looked at year-to-date performance. And let's discuss some of the themes, some of the same categories that performed well during this brief post-Brexit period have also preformed pretty well for the year to date. But let's discuss some of the big winners so far for the year to date.

Kinnel: Yeah. So, various forms of defense have been great. Precious metals, which have been really hit hard by talk of slowing growth and just general natural resource glut, have had a tremendous year. So, precious metals equities are up over 80% as we speak, both because of defense and because of a shift in economics. Utilities, I mentioned, have done very well because of that appeal of yield and in general, I think we are seeing a shift. Growth is performing worse than value because we had a great rally in growth in tech in recent years and now we're kind of shifting the other way. People are saying, those boring value sectors are looking pretty good right now. And then also the high-quality bonds that we mentioned, they don't have as big a gains, but they have a nice, positive return which I think illustrates that diversification often works in these times and it seems to have once again.

Benz: In terms of categories that haven't performed as well, again, with some of the foreign stock funds there have been losses across some of these funds not just for the year to date but really over the trailing one-year period, some of the losses are pretty significant.

Kinnel: That's right. We do have some sort of high single-digit losses overall for the categories for the year to date but there are a lot of individual funds that have lost much more than that. So, if you're a Europe-heavy fund, if you've got a lot of financials, you're probably doing much worse. The only foreign funds that have held up well are those that hedge their currency. But generally, it's been a tough run. Healthcare is another area that's done even worse than a lot of Europe and that's partly because healthcare had a nice run, partly because we've had scandals like Valeant and some of the others that have really shone an ugly light on healthcare.

Benz: The healthcare, I think, piece might be a little bit counterintuitive to people because I think some people think of it as being a defensive sector but was it simply that valuations, at least in some parts of the healthcare sector, were a little bit stretched coming into 2016?

Kinnel: For sure. We had biotech, which is obviously the least defensive portion of healthcare, had an amazing run and is now giving that back. But then some other areas too, I think, yeah, it's generally right. It is kind of defensive because of course even in a recession we're going to keep on paying for medicine and other healthcare, but these stocks did have a really big run and you combine that with a scandal and of course, it really changes the dynamics.

Benz: Russ, I'd like to get your counsel for investors who have been a little bit shaken up over the past week or so in the post-Brexit period. What's your counsel about how they should be thinking about their portfolios? Are there any adjustments that you would recommend that they make at this time?

Kinnel: Probably not. I think generally you want to stick to your plan unless you really have a good reason to do something else, and I think that's what gets you through these difficult periods. The markets have sold off but you can't really disagree with what they have done. I mean, we do have some serious disruptions going on. So, I'm not sure that that means stocks are any cheaper today than they were two weeks ago because there really are some impacts on the markets and we have a lot of uncertainty going forward. Who knows where Brexit is going to go. There's obviously other political developments on the forefront as well. So, I think it's much more about--stay diversified, stick to your plan. I wouldn't assume that stocks are any cheaper today. It doesn't feel like March '09 when stuff got so cheap that you really couldn't fail to get some good bargains in that period. I don't think we are there yet. I think this maybe a rather reasonable sell-off.

Benz: I think you raise a good point in that valuations arguably weren't all that low coming into this and that maybe the markets have been kind of trolling around for something to go down about for arguably for a couple of years now.

Kinnel: Yeah. If you go back to the '08-'09 bear market that first leg down was not a buying opportunity. Eventually, people really overreacted. But I don't think we are there yet. And it really is hard to say what's going to happen and therefore, it's hard to say that if we're down 5% across the board, maybe that's where we should be.

Benz: Russ, always great to hear your insights. Thank you for being here.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for