The Fallout from Brexit

June 27, 2016 10:50 am
Betsey

Betsey A. Purinton, CFP®

Managing Partner & CIO

The British vote to leave the European Union (Brexit) was a local shock—a political event. In and of itself, it was not an economic event, although it could have major financial repercussions. In an immediate response, markets reacted forcefully responding to concerns that the ultimate economic and political outcomes are indeterminate and ambiguous. As is often the case, markets sell before they think. That does not mean the sell-off is over; rather, the first reaction is often bloody. The follow-through can be more calculated, whether up or down from here.

What bothers most investors is that the exit story may not end for a number of years, and along the way the political tensions, posturing and tough negotiations could dampen what could otherwise be a slow and uneventful global recovery. The good news for those of us in the US is that the largest impact should fall on the United Kingdom and Europe.  The US may suffer a more indirect and moderate fallout. However, it won’t be immune from the emotions and tumult of the actual exiting experience.

United Kingdom

Let’s start with the impact on the U.K. and the complexity of the exit process, which could last a long or a short time:

  1. Britain can’t withdraw from the EU until it formally invokes “Article 50 of the Lisbon Treaty,” which starts a two year clock on negotiating the exit. David Cameron, the current Prime Minister of the UK, who resigned effective October 2016, is allowing his successor to start the process. This buys more time for Britain to create a calmer environment for the two sides to sort things out. It also allows room for a compromise more favorable to the U.K. Although leaders of the European Union would like a quick divorce (lest a lengthy process encourages more Eurosceptic sentiment), this past weekend they recognized the need for the political dust to settle in the U.K. first.
  2. Beyond the exit agreement, there are hundreds of specific free trade agreements (FTAs) and arrangements that will need to be re-negotiated. In addition, companies in the UK will potentially lose access to the EU Single Market which could cause workers and corporations to move overseas. And large foreign investors may hold back on direct capital investment, all of which could cause disruptions in the local U.K. economy, unless favorable terms are worked out. Whatever the timeline for the exit, renegotiations on trade deals and special rights could draw resources away from the operation of the UK economy for years to come, stifling its growth.
  3. In addition, Scotland and Northern Ireland (both currently part of the United Kingdom) may opt to sever their ties from Britain in order to remain in the EU or try to block the exit itself, since they benefit from special transfers and subsidies from the EU. That could be another distraction for Britain.

While the voter’s anti-establishment/anti-immigration sentiment and anger were very clear and real, it is uncertain whether the U.K. electorate is truly prepared for the economic consequences of their decision.  Frustration and renewed anger could reappear if the process of negotiation is drawn out for too long.

Europe

The market’s biggest worry appears to be the contagion effect – additional countries breaking away from the EU. BCA Research published a report “The Coming EXITentialist Crisis” on June 24, 2016 analyzing this threat. The results are somewhat reassuring, although not completely so. A couple of notes from the report:

  1. With the exception of the U.K. and Italy, the major members of the EU do not think that their country could better face the future outside of the EU.
  2. Support for staying in the EU is quite strong amongst those who share the euro as currency, again with the exception of Italy.
  3. Most Europeans support the EU for political, not economic, reasons pointing to peace and the power to negotiate as a union. Thus while there may be bitter complaints about austerity measures and other economic sanctions, in the end an exit strategy is not an option for most members of the Eurozone.
  4. It is far easier for the U.K. to leave the EU than other countries, because the U.K. already has its own central bank, currency, is the fifth largest global economy and is physically isolated from the rest of Europe.

For those of us who took “Western Civilization” in high school or college, our textbooks covered centuries of wars between European states including the last century’s two world wars. The EU was designed in part for “peace” and a “stronger say in the world. “ The benefits of a unified economy have helped support political and economic stability for the last half century. However, as the horrors of wars recede from memory, the re-emergence of isolationism and nationalism could become appealing once again and play an increasing role in major upcoming European elections.  The sanctity of the European Union can no longer be taken for granted, although it is way too early to predict its demise.

The United States

A number of analysts feel the implications for the US are far less severe than in the U.K. or Europe, leading to the belief that Brexit, while promoting market volatility, is unlikely to derail our recovery. This is likely to be true on a trade basis, as the U.K. is not a large trading partner and is not going out of business – just suffering a possible economic slowdown. In addition, a fall in the pound sterling makes British imports cheaper for Americans to buy, which helps the US consumer and contributes to lower inflation.

In addition, in the US, our banks have steadily increased in stability since 2008, as evidenced by stress test results released last week. As noted in the June 23rd issue of the WSJ, “The largest U.S. banks have significantly bolstered their defenses against an economic downturn, and could continue lending even during a deep recession, the Federal Reserve said.” The view on European banks is not as sanguine, with several big banks deemed to be vulnerable to a slowdown in growth. Still, the systemic risk that existed in 2008 is no longer pervasive.

But the dollar could be a problem, if it becomes too much of a safe haven or if it rises dramatically against more than the pound sterling. The Chinese have already voiced concern over the potential for destabilizing depreciation in their currency, the yuan; similar to what was experienced last summer.  Back home, a rising dollar could reverse the bounce in energy prices and the outperformance of the cyclical sectors witnessed earlier this year.  If that reflation trade ends, stocks could pull back further and profit margins could continue to struggle.

As for the Federal Reserve, it is likely to  hold off on raising rates for the remainder of the year, providing predictability that both stocks and bonds usually like. In addition, the Fed has pledged a coordinated response with other central banks to provide liquidity in the currency markets. The ability to create a mood of calm will be extremely important, as global leaders attempt to make Brexit a one-off event.

Two Year Window: Brexit’s Best Case and the Worst Case Scenario

Best Case Scenario

The British have it right – they can live without the EU in the long run.  In spite of short term tension, angst and economic disruption, the UK (or what remains of it after Scottish and Irish votes) negotiates agreements that are not too onerous to their economy and beneficial enough to allow Britain to remain a world leader in their own right.  The EU strengthens its core membership and the recovery and markets move ahead.

Worst Case Scenario

Negotiations between the U.K and the EU break down and the disagreements become public. The U.K. electorate develops impatience and restlessness contributing to the turmoil. On the continent, Italy (or some other country) threatens its own exit as the EU and Eurozone struggle to maintain stability and unity. Overall, political chaos undermines the economy, which leaves global markets to struggle with deflation, uncertainty and volatility.

Of course neither the Best Case nor Worst Case is likely to happen, but until the markets feel comfortable with Brexit and are reassured against instability, they are likely to be held captive by a the  political environment. And that means a bumpy ride.

 

Betsey A. Purinton, CFP® is Managing Partner  and Chief Investment Officer at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at bpurinton@strategicpoint.com.

The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.