The British Are Leaving! The British Are Leaving!
The British Are Leaving! The British Are Leaving!

The British Are Leaving! The British Are Leaving!

 

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J. Reed Murphy
J. Reed Murphy
CIMA®

President
Chief Investment Officer

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The British Are Leaving! The British Are Leaving!

The financial implications of the Brexit.

In a twisted play on the famous Paul Revere warning that “The British Are Coming!” the British people voted to leave the European Union (EU). This announcement is reaching far beyond the Massachusetts towns that Paul Revere once road through on his horse in the dark of the night. It has shocked markets, as recent polls, surveys and investors were expecting a remain vote. In fact, the FTSE index of the largest 100 companies trading on the London stock market exchange was up approximately 5.5% from last Friday’s close through Thursday’s close in anticipation that the Brits would vote to remain in the EU. As we write this, the FTSE is down approximately 2.4% after being down nearly 9% earlier in the day. Other European equity markets are worse. The S&P 500 is down approximately 2%, cutting in half the decline that futures markets were predicting.

FTSE Index (Price Performance June 20 through 10:13am CST June 24)

Exhibit #1

Source: Bloomberg
 

What Does This Mean for the UK?

It is hard to comprehend what it means. No country has ever left the EU, but the estimates are extreme. The Organization for Economic Cooperation and Development (OECD) forecasts that the British economy (i.e., GDP) could decline 3.3% by 2020 and a further 2.7% to 7.5% by 2030. Forecasts also suggest that total trade could decline 10-20% (OECD) and that total unemployment could be between 350,000 to 600,000 by 2030 (CBI). The U.K. government had warned that leaving the EU would kill jobs, create currency turbulence and pull the economy into a recession. However, it is important to keep the size of the U.K. in context within the global economy. The U.K. accounts for 2.4% of global GDP. Nonetheless, the contagion effect on the viability of the EU, currencies and global trade is what is weighing most on investors’ minds today.

What Is the EU and the Benefits of Membership?

The EU is a political and economic union of 28 member states primarily in Europe. Benefits include a single market with common laws that control the free movement of people, goods and services. Additionally, 19 members have adopted a common monetary union and currency known as the Euro. The challenge of this union to have its member countries create a common monetary policy, while each still having its own fiscal policies (within some EU guidelines) and individual sovereign rights, is a tall order. Therein lies the root of the British decision to exit the EU.

What Happened?

There is a populist and nationalistic movement afoot globally and the UK was not immune. British elections in 2016 incented the British Prime Minister, David Cameron, to promise an EU referendum on EU membership, which took place this week ending in today’s result. During the winter, the Prime Minister traveled Europe to renegotiate even more favorable arrangements. Nonetheless, voter concerns over a few issues outweighed the benefits of EU membership and the dire warnings of many politicians and economists. What are some of those issues?

  1. Trade – EU membership entails no trade tariffs on imports and exports between member states. While the UK may lose some negotiating power by leaving, they will need to renegotiate trade deals. Other countries have negotiated favorable trade agreements with the EU, however many believe that the EU will make it hard on the British so as to set an example for any other country that may consider leaving the EU.
  2. Sovereignty – Voters for an exit (i.e., Exiters) argue that the UK has given up some internal democratic powers in place of EU mandates, despite the UK having a voice at the table.
  3. Immigration & Jobs – Under EU law, members cannot prevent anyone from another “member state” from coming to live in the country. Exiters argue that others coming into the country take jobs away. These embers of worry grow into flames when terrorism is on the rise, despite the indirect connection. There are shared intelligence and security benefits of membership also. Those who voted to remain (i.e., Inners) argue that British also enjoy the right to travel and live in other EU countries and that the economic benefits to Britain in all circumstances has been favorable. Ironically for Exiters, estimates by the OECD are that net immigration will fall by 56,000 to 116,000 relative to a potential job loss of 350,000 to 600,000 (CBI).

25 Largest Economies by GDP (Purchasing Power Parity - Adjusted to U.S. Dollars) - Peak Levels

Exhibit #2

Source: IMF, Conway Investment Research
 

What’s Next?

There are many events that have already unfolded with many more to come. Being that no country has ever exited the EU before, we are in unchartered waters.

  1. UK Prime Minister – David Cameron, the British Prime Minister, has already announced that he will step down in the near future. There will be a new election, most likely in the upcoming months.
  2. New Referendum – There is a low probability chance that external pressures mount so much that another referendum vote will be called.
  3. Actual Leaving – The UK will implement Article 50 of the Lisbon Treaty (EU governing treaty), which requires the exiting country to notify the European Council of its intentions and framework for future relationships with the EU. That agreement must be approved by the European Council. Being this is the forum for negotiations on terms that will dictate the financial impact of the Brexit (British Exit) and that it is expected to take up to two years, this drama will continue to play out.
  4. Other Elections – There are several other countries that have similar referendums in the upcoming years. Hence, the posturing and negotiations of the EU with the UK has far reaching implications for the EU itself.
  5. Central Banks – Central banks have already communicated plans to step in to provide liquidity and stimulus where needed.

What to Do As an Investor?

  • We need to keep in mind that high drama is a consistent theme in politics and investment markets. The populist movement that was a catalyst for the Brexit vote is also unfolding here in the U.S. So, we are not immune from these issues even in our own country.
  • We need to realize that the U.K. accounts for 2.4% of global GDP (USD adjusted) and 4.4% of global exports. While Brexit could impact other countries, no one expects that global trade will dry up because the UK has to renegotiate trade agreements. Even if other countries end up leaving the EU, global trade will continue, just under new norms.
  • Remember the world is interconnected, so it is still wise to invest internationally. In fact, the U.S. only represents 16% of global GDP and approximately 50% of global equity market capitalization. And of those U.S. companies, they generate significant revenues in foreign countries. Some of the best investment opportunities still reside outside the U.S.
  • The markets always climb a wall of worry. This is another step on that journey.
  • The international funds that we utilize have met our strict due diligence criteria, have managed through other turbulent times, while generating very respectful peer group rankings and overall returns for investors.
  • Several asset classes are doing well today. While many risk-on assets like equities are down, many others like U.S. bonds are doing well. Other asset classes like currencies are moving significantly. We have investments that can benefit from these trends as well. In summary, we have been overweight domestic equities and generally have broadly diversified portfolios that are built to sustain major moves in any one asset class.

We will keep you posted as events dictate. Feel free to contact your Trust Company financial advisor with any questions.


Tags:  Brexit, EU, Global Economy, Global Trade, Investing, Investing and Emotions, Investment Decisions, Market Risk, Market Volatility, Politics and Economics, Risk, Stock Market, Unemployment, US Economy, Volatility

Note:  The content of this article is for guidance and information purposes only and is not intended to be construed as advice. Information provided is not intended to provide investment, tax, or legal advice.