Last week, the United Kingdom (UK) voted to leave the European Union (EU). This decision caught the markets by surprise, as many believed the vote would be close but not favor a leave. The markets reacted negatively – stocks in Europe fell over seven percent with greater losses coming from the UK. US stocks did better, but saw a drop of more than 3.5 percent in one single day. Investors flocked to higher quality and defensive asset categories. The US dollar, Japanese Yen and Swiss Franc all appreciated against the British Pound. The British Pound fell eight percent to a 31-year low against the dollar. The 10-year US Treasury Yield fell 30 basis points to under 1.5 percent, while 10-year German Bunds and Japanese Bonds fell further into negative territory.
This is an unprecedented event that has produced a lot of uncertainty, which has led to more volatility. Last week’s event was simply a vote; British lawmakers will soon formally inform the EU of their intent to leave by invoking Article 50 of the Lisbon treaty, which sets a two-year deadline before which the other countries of the EU decide the terms of Britain’s exit from the EU (without any input from Britain). We believe both sides would prefer to get this done as soon as possible but there is some concern that some EU members may prefer to play hardball during the new trade negotiations. Over half of the UK’s exports go to members of the EU, while only 10 percent of the EU’s exports go to the UK.
This decision to leave will have the biggest impact on the UK’s economy. Corporations and individuals will cut spending, at least temporarily. The UK economy was slowing prior to the vote, so the probability of a British recession has gone up significantly. Many multinational companies with operations in Britain will be forced to make changes; this may include job losses for UK employees and dampening effects on the profits of the corporations. We expect the pound to drop relative to other currencies which should help UK exporters.
The impact outside of the UK is mixed. Members of the European Union may see a short-term impact to economic growth, but may benefit if British companies move operations inside EU borders. Japan will be among the hardest hit from the UK’s departure. Japan’s central bank has been attempting to keep the Yen cheap to help the nation’s export-driven economy, but the global flight to safe assets like the Yen following Brexit is causing a significant rally in the currency and undoing years of work by the Bank of Japan.
We believe there will be little impact to the US economy. The Federal Reserve will likely slow the pace of rate hikes over the short-term. With rates moving lower, consumers can benefit from lower borrowing costs. This should help the housing market and other markets that involve big ticket purchases like automobiles. Banks could benefit from an uptick in refinancing and lending but will continue to be hurt by lower rates. Utilities, telecoms and REITs should benefit from the lower rates. Large multinational companies with strong exporting operations will be among the hardest hit, as the stronger dollar will make goods more expensive for foreign buyers.
Undoubtedly, this is a major financial and political event, but events like these are sensationalized by the media and result in more concern than the situation warrants. When, as in this situation, it is impossible to predict the ultimate impact of an event, the media likes to discuss every conceivable worst case scenario as if they were likelihoods. One legitimate concern is that other countries in the EU may now see leaving as a more realistic option. Approval ratings for the EU in France, for example, are even lower than they are in Britain. Such an event would be even more complex than Brexit because of the use of Euros as a currency and would ultimately call into question the sustainability of the European Union. The EU has a tough task ahead in determining the terms on which Britain will leave: EU lawmakers will want to send a signal that there are consequences for quitting the club, but at the same time they must be careful not to impose terms so difficult that it triggers a British recession that could cause financial contagion elsewhere.
How does this relate to you as an investor? It should have very little impact on your investment decisions. Surprise events like this is the reason you should be diversified. Fixed income investments are holding well, higher quality bonds have actually increased in value, and lower quality investments only fell marginally. If you have a large allocation to equities then you should expect more volatility in the short-term, but there is no reason to change your strategy unless something has changed that would impact your time horizon.