TSP

Expect continued flat and choppy I Fund performance until Brexit resolves and the fallout becomes clear, but with low equity valuations outside of the US it still makes sense to invest there and rebalance into dips.

Lyn Alden

While the United States deals with the uncertainty of a presidential impeachment inquiry and the ongoing China/U.S. trade war, the United Kingdom arguably has even more political headline risk. The stock market of the United Kingdom is the second largest component of the I Fund after Japan, and accounts for about 16% of the index value. More broadly, Europe as a whole (including the United Kingdom) constitutes nearly two thirds of the I Fund, with Japan, Australia, Singapore, and Hong Kong collectively making up the other third.

Europe has many uncertainties at the moment, but the most acute one is the potential for Brexit, or the exit of the United Kingdom from the European Union. After being delayed earlier this year, it is currently scheduled to occur in one month on October 31st.

The previous United Kingdom prime minster, Theresa May, was unable to secure a deal that both the European Union and United Kingdom’s parliament could agree on after multiple failed attempts, and was replaced by Boris Johnson who is more adamant about leaving in time for the deadline without another delay.

There are several risks involved. If they continue to delay, it undermines the 2016 public vote in the United Kingdom to leave the European Union. On the other hand, if they leave without a new trade/customs/regulatory deal in place, which is termed the “hard Brexit”, it is feared to cause chaos and potentially a recession.

For example, suddenly all shipments between the United Kingdom and the European Union would become international shipments requiring inspection, which could cause huge delays on roads, rails, and ports, and the open border between Northern Ireland (part of the United Kingdom) and the Republic of Ireland (a separate nation within the European Union) would become a closed border but without any significant way to control that border. Additionally, financial regulations between the regions would become unclear. They’ve already had three years to sort this out with limited success.

The current prime minster, Boris Johnson, attempted to shut down Parliament for weeks leading up to the Brexit deadline using the technicality of a Queen’s Speech. This would have sharply reduced the remaining time for debate and increased the odds of a hard Brexit occurring. However, the Supreme Court of the United Kingdom ruled this as being illegal, which allowed Parliament to reconvene.

We’re now back to a period of uncertainty, with a few options. Another extension could push the Brexit deadline back to January 2020, which may leave time for another UK election to sort out this gridlock. It’s unlikely but possible that the European Union won’t allow another extension, resulting in a hard Brexit still occurring next month.

What concerns me about the United Kingdom in particular is their large twin deficits. Currently, the United States and United Kingdom have the largest combined government deficit and current account deficit as a percentage of GDP out of all major developed nations. A nation’s current account measures its trade surplus/deficit in addition to net income from abroad.

Data Source: Trading Economics

The European Union as a whole is actually in pretty good shape as far as its twin deficit is concerned, despite various other troubles that they have. While the details vary by country, averaged together the European Union has a current account surplus and a relatively balanced fiscal budget at the moment. Germany has a budget surplus and a current account surplus. Italy has a mild budget deficit (and a large amount of existing sovereign debt) but a current account surplus. France has a mild budget deficit but a relatively balanced current account.

Of the two portions of the United Kingdom’s twin deficit, the current account deficit portion is a larger issue:

Chart Source: Trading Economics

Usually, current account deficits of this magnitude resolve with a weaker currency, meaning a weaker pound sterling in this case. On the other hand, the current account surplus for the European Union implies that the euro may strengthen compared to the dollar and the pound:

Chart Source: Trading Economics

We’re likely to see continued flat and choppy I Fund performance until we see more resolution on this matter and see what fallout, if any, may arise. However, with low equity valuations outside of the United States, it does make sense to include global equity allocation within a truly diversified portfolio, and to rebalance into various dips that come and go.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.

See also, Is the I Fund Cheap Enough Yet?