In the wake of Brexit, challenging market dynamics
June 27, 2016
The British public rendered its verdict on June 23, voting to leave the European Union (EU). The ramifications will likely affect Britain politically and economically, including the considerable pressure they could put on its financial sector, but there are also questions of wider implications of the vote, in the rest of the EU as well as globally.
A prevalent uncertainty
As with most aspects of the Brexit question, the things we know are overshadowed by the things we don’t. Many moving parts must be accounted for, which complicate views of potential outcomes. Still, Britain’s departure from the EU raises several broad concerns and sources of friction that we believe investors ought to think about.
A precedent for other populist movements
Britain’s departure is more than a mere ballot initiative. It is rich with symbolism, and it could fuel an undercurrent of populist sentiment that appears to be growing across Europe. Already, there is speculation that this vote could prompt countries like Greece, Denmark, or the Netherlands to reconsider their Union membership. Scotland, which two years ago voted to stay with the United Kingdom, is also in the mix, and another referendum on independence appears more likely considering that two-thirds of its voters wanted to stay in the EU. Prior to the Brexit vote, the Netherlands government indicated that it may hold its own EU referendum if the U.K. voted to leave. Meanwhile, other countries such as Germany and France have elections scheduled.
Whatever ultimately happens, it is becoming more apparent that the Union’s political orientation is shifting further to the right. Should Britain’s departure play out reasonably well in the years ahead, it could further embolden member states who are inclined to seek a similar path.
Rifts in currency markets
Across asset markets, foreign exchange is among the biggest areas of concern as investors contend with currency volatility. Again, uncertainty is the biggest pain point, and the British pound is feeling the pressure. At first glance, a weaker pound might seem like a plus for British exporters, but we think the global nature of the supply chain would probably temper any positive effects.
Of equal concern, the related strengthening of the U.S. dollar could have implications that stretch beyond the confines of the EU, setting off a series of consequences that travels around the world. For instance, a strong dollar could weigh on emerging markets that hold dollar-denominated debt, perhaps restraining the nascent recovery in commodity prices, and furthering tightening financial conditions at a time when the Federal Reserve had been looking for signals to finally continue raising rates.
A jolt to the British economy
Overall, economic forecasts look bleak for an independent Britain. Amid much uncertainty about the fundamental underpinnings of Britain’s economy, the negative effects of independence could be felt for years.
London, one of the world’s leading financial centers, could be facing strong headwinds as U.K.-based banks and financial firms lose automatic access to services across Europe. London’s role as a financial hub could be in question, particularly if major banks choose to relocate, taking jobs along with them and generally compromising the city’s once-robust financial industry. There’s another important linkage at play here as well; a diminished financial center would result in weaker financial channels than Europe has become accustomed to, which in turn could hamper the performance of trading partners across the Union.
Additionally, the U.K.’s financial sector could face pressure from multiple sources, beginning with this overarching reality: In order to regain access to the Union’s single market, London may have to adhere to EU regulations without having much say in their shaping. At the same time, Britain will have to continue making significant contributions to the Union’s coffers in Brussels, and continue to allow free movement across its borders (as Norway and Switzerland do under current programs). Then there’s the ever-present issue of uncertainty: Investors could be likely to postpone big projects until they feel more confident, resulting in lower loan growth and reduced real estate investments.
Some generalizations as we consider what comes next
The EU experiment has suffered its biggest shock since World War II, leaving investors to wrestle with questions about how disruptive Britain’s disentanglement from the Union could be. Markets will also be challenged to make sense of what the U.K. will truly look like going forward, and just how much animosity it could encounter from the EU
As noted above, there is a high probability that inertia will spread throughout the economic landscape. This may inhibit decision making across the board, leading to slowdowns in consumer spending, business spending, and capital expenditures. Even before ballots were cast, businesses were feeling the results of uncertainty as customers delayed orders and waited for better clarity about what the future might hold.
As active investors, one thing we can do in the wake of Britain’s exit is to keep in mind that market volatility often yields significant investment opportunities for managers who emphasize diligence, patience, risk management, and a commitment to research. In the coming days, watch this space for additional insight into the benefits of active portfolio management in light of Britain’s departure from the Union.
The views expressed represent the Manager's assessment of the market environment as of June 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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