Brexit: Follow Up Commentary
June 28th, 2016
British voters shocked the world last week with their historic vote to leave the European Union. Political and market pundits, polling data and even the bookmakers were caught off guard with the 52%-48% “leave” vote. The immediate aftermath was virtual chaos. European equities traded off nearly 10% in a day, the Pound sold off to 30 year lows and US Equities sold off dramatically as well. Meanwhile, U.S. Treasuries rallied, pushing the yield on the 10 Year Treasury as low as 1.41% at one point, and gold rallied. These are typical trading patterns for financial markets when unexpected negative news hits and are indicative of the level of uncertainty created by Brexit. As you have heard me say before, the markets hate nothing more than they hate uncertainty. The long-term consequences of this move are unclear, resulting in as many questions as we have answers at this point.
At its core, this was not an economic or fiscal vote by the British people, but a vote driven by a growing sense of populism / nationalism / anti-globalization that appears to be spreading throughout the developed world. Support for Brexit was strong within the middle class, many of whom feel that the British economic recovery has benefited the elite rather than the broader population. Border security also played a key role in winning support, with much focus being centered on the cost of immigration serving as a drain on the National Health Service.
Technically, the referendum represents a non-binding vote that must be approved by parliament before Great Britain can officially notify the E.U. of their intent to leave under article 50 of the Lisbon treaty. Already we have seen a petition for a second referendum gain 2 million signatures, and have heard some pundits predicting that Parliament simply won’t approve the referendum. PM David Cameron resigned (effective in October), but has clearly stated that the results of the referendum must be honored and approved, a task he will leave to his successor. We must move forward under the assumption that the referendum vote will be honored by Parliament, and already the EU is pushing British officials to move swiftly in order to limit the period of uncertainty surrounding the issue. However, it is most beneficial for Great Britain to drag out negotiations, as they did not develop a plan for handling Brexit ahead of the vote. The task of negotiating favorable trade agreements with the remaining 27 members of the European Union will undoubtedly be a long, drawn out and politically charged process.
At the risk of sounding redundant, uncertainty is the key factor here. Approximately 44% of British exports go the EU, making it an extremely important trading partner. With no blueprint for what British trade looks like outside of the EU, business fixed investment and capital spending within Great Britain will certainly slow, leading to significantly lower growth, possibly pushing the British economy into recession. Further, the falling Pound will likely boost inflation. The Bank of England has already expressed that they are prepared to inject up to 250 billion pounds ($345 Billion) of liquidity into the system, and still has some room to cut rates to further ease monetary policy.
The direct impact of Brexit on the US economy is small. The U.K. accounts for less than 4% of US exports and less than 3% of US imports. The likelihood of Brexit directly derailing US economic growth is very low. However, many of our US firms have substantial operations in Britain and the drag on growth will be a headwind, especially in light of the generally sluggish global growth forecasts. Slower global growth and a stronger dollar (which could create a drag on energy prices) will not help to stimulate the earnings growth US firms need to fuel the equity markets higher, but overall the US economy should continue to grow. Additionally, the likelihood of a Fed rate hike in the next few months has dropped virtually to zero, and currently the likelihood of a December rate hike has dropped to 11%. Lower rates for longer has certainly been solidified in the last few days.
While the British economy is relatively small on the global stage (less than 4% of GDP), it is the world’s 5th largest economy. Therefore, contagion issues become a key concern. While the EU economies would be best served by a swift and orderly British exit, members such as Germany and France may want to make the divorce painful enough to dissuade other countries from following the same path.
Some commentators have suggested that Brexit could lead to systematic or global financial crisis, such as the Lehman collapse in 2008. We question the logic and likelihood of these statements. When Lehman collapsed and defaulted on its obligations it called into question the financial stability of other institutions with exposure to Lehman. Counterparty trading and liquidity seized up and the solvency entire financial system was called into question. We do not project Brexit leading to defaults. Additionally, financial institutions are better capitalized today than they were eight years ago. Finally, Brexit was a known risk, allowing central banks to draw up contingency plans ahead of time. As previously mentioned, several, including the Bank of England, stand ready to step in should a systematic threat emerge.
Today, equity markets are rallying around the world, while gold and Treasury yields are down modestly. While we are pleased to see markets firming after the initial shock of the Brexit vote, we are not convinced that the lows are in. We anticipate volatility to remain heightened for some time to come as the details behind Brexit emerge. At this time, we are choosing not to adjust our portfolio allocations in response to recent events. Our preference heading into the year was an overweight to the US within equities, a stance that we will maintain for the foreseeable future. Fixed income has been performing well this year, and with interest rates likely to remain low, we are maintaining our allocations there as well. We believe that financial asset returns will be heavily influenced by the direction and spirit of the upcoming negotiations. As these negotiations unfold, we will stand ready to make any adjustments we deem prudent and advisable.
As always, please feel free to reach out to me directly with questions or concerns.
Josh L. Galatzan, CIMA®
Meridian Wealth Advisors
Managing Director & Founder
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