Brexit and Market Implications
Background On June 23, 2016, U.K. voters took to the polls to decide whether to remain in the European Union (EU). The European Union agreement allows free movement of capital, goods, people and services within and between the member countries. The EU has a population of over 500 million with a GDP exceeding €14 trillion (US$15.4 trillion). It traces its origins to post-war agreements that re-established trade and border movements. Although an EU constitution was never implemented following the vote in 2005, the EU government continued to extend its oversight of member nations. Following the U.S. housing bubble and the ensuing financial crisis, German and French leaders began to exert a stronger influence over the EU’s direction, pushing for expanded control. The U.K.’s centuries-old independent rule was chipped away year-by-year as regulatory oversight was ceded to the EU in the interest of trade and cultural integration.
Analysis With the planned U.K. exit, uncertainty rises over the continuation of free movement. The referendum result sets in motion a two-year process for the U.K. to plan its exit from the EU. It is expected that the U.K. will begin negotiations to continue free movement of capital and goods with EU member countries, albeit there may be negative sentiment that demands some return to tariffs or other trade restrictions. Like the U.S., the U.K. economy has increased its services component to the detriment of its manufacturing base. The EU sets environmental and product standards covering safety, health and pollution, and a new trade agreement with the U.K. likely will continue to impose these standards on U.K. manufacturers. The U.K.’s exit from the EU will not free it from EU regulations. Many product regulations still will be followed, but the U.K. government will direct these to fit whatever trade agreements are crafted.
Free movement of people in the EU is believed to be a strong reason that voters favored the EU exit. Recent refugee arrivals from Syria and other countries engulfed in growing violence sparked fear and resentment among many. With EU governance, countries are restricted from imposing immigration curbs or other measures to limit the movement of people- within the EU. U.K. voters were influenced by events in Germany and France attributable to small segments of recent migrants, and felt that their government was unresponsive to their growing fears. Years of slow growth and stagnant employment in many countries are fueling a backlash against establishment governments whose policies pushed economies toward crises, then issued massive debts to stabilize the turmoil. Voters feel disconnected as they see financial structures unable to deliver all the future promises of retirement and health security. As a result, there is heightened uncertainty over other potential exits from the EU, although none are at the same stage as the U.K. There also is the potential that Scotland could reassess its decision to remain part of the U.K., as Scotland voted to remain in the EU.
The effects on financial systems and banks include uncertainty on multi-country transactions. EU governance over financial transactions in the EU will need to be altered to regulate transactions between the U.K. and the EU. Establishing rules for jurisdiction of counterparty agreements and clearinghouse operations will be part of the negotiations over the next two years. London has grown into a global financial hub, and its banking operations are expected to be impacted negatively because of rising costs and regulations. U.K.-based banks may be more restricted in selling products and services to EU countries, leading to a reversal of the concentration of banks based in London. London as a financial center could lose some standing. Increasingly, EU regulations have become prevalent in the region’s financial industry, and the U.K.’s exit may lead Britain to adapt financial regulations closer to U.S. versions. The Bank of England will maintain its independent standing, which will make the EU exit a less traumatic event than if the U.K. had used the euro.
Market Implications. The full implications of England’s exit from the EU are unclear as there is little historical context to assess the situation. We anticipate that most of the direct impact will be in Europe as it sorts out regulations. Trade agreements with the U.S. do not change and the U.K. accounts for only about 3% of U.S. trade. Nonetheless, this is a big sorting-out process and Brexit will weigh on business and consumer confidence with negative implications for economic growth, especially in the U.K. and Europe. Estimates suggest that U.K. economic growth will be 5% to 10% lower, long term, as a result of lower productivity growth, trade and population growth. Our thoughts on the market impacts are as follows:
Interest rates will remain low for longer. Expectations are that the Bank of England and European Central Bank may announce further policy easing to offset the economic drag from a fall in business confidence. The Bank of Japan likely will have to ease further to fight the Yen’s continued appreciation. With economic growth more uncertain in Europe, we see the Federal Reserve holding off on any rate increases in 2016.
Equity markets generally are fully priced from a historical context. Market uncertainty and volatility are expected to remain high for the remainder of the year over concerns about Brexit, outcomes of European elections, EU-exit contagion, and the U.S. presidential election. This does not bode well for equity markets. We recommend maintaining current allocations but do not recommend rebalancing toward equities at this time. Events like this typically create buying opportunities. We just do not believe it is now. Moreover, in a risk-off environment, we expect U.S. equities to outperform other markets.
Commodities will be influenced on the upside by further easing and on the downside by more negative growth forecasts, with the downside risks likely to outweigh any benefits of easing as demand uncertainty rises.
Currencies are expected to show wider swings as central banks shift policies further to counteract slower economic growth.
By Susan McDermott, CFA
Chief Investment Officer
Pavilion Advisory Group Inc.
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