Britain may be on its way to once more becoming an island all on its own. On Thursday, June 23, 2016 the United Kingdom’s (U.K.) referendum vote on continued membership in the European Union (EU) resulted in a 52% majority decision to leave the EU. Brexit (British Exit), as it is commonly referred to, came as a surprise to most, although the polls in the period leading up to the vote showed the gap between “leave” and “stay” voters narrowing.
Choppy waters ahead
To date, there have only been two other withdrawals from the EU, both with somewhat different and extenuating circumstances. Algeria, left the EU in 1962 when it gained its independence from France. In 1985, Greenland, an autonomous territory of Denmark and an EU member country, voted to leave (although Denmark remains a member). The U.K. is the first to vote to leave the EU through the formal withdrawal process. This unexpected and without precedent event immediately generated global uncertainty and market volatility, particularly in the U.K. and the rest of Europe.
Following the vote, then British Prime Minister David Cameron, a staunch supporter of remaining in the EU, tendered his resignation to the Queen. On July 13, 2016, Theresa May, the Home Secretary, became the head of the Conservative Party and took over as the Prime Minister following the withdrawal of her only rival for leadership of the party.
Leaving takes time
To start the official withdrawal process, the U.K. must invoke Article 50 of the Lisbon Treaty. From the time it is invoked, the withdrawing country has a period of two years to negotiate withdrawal terms, during which time it is still subject to EU treaties and laws. In addition, Parliament must vote to repeal the 1972 European Communities Act, which paved the way for the initial entrée into the EU. This could also take time to initiate, stretching out the withdrawal process even further.
Britain bears the brunt
Britain felt the most severe effects, although much of the immediate impact has already been reversed. After a 600 plus drop after the Brexit decision, the FTSE 100, the U.K.’s major market index, has more than regained any losses and now hovers near the 6800 mark. Other markets performed similarly post-vote. U.K. debt was downgraded by Standard and Poor’s 500 (S&P), but we feel that reactions will be similar to when U.S. sovereign debt was downgraded, with minimal market impact. The British pound weakened sharply, against the dollar and the yen, and remains weak. Other currencies also weakened versus the two major safe haven currencies, with yields moving lower.
We believe that Brexit is likely to have a dampening effect on the U.K. productivity and there is some potential for a recession in the second half of 2016. The EU is a major export market for Britain, making up about 25% of the country’s GDP. If higher trade barriers are put into place, this could negatively affect the British economy. In order to spur lending and consumer spending, we anticipate that the Bank of England will reduce rates in 2016 and possibly resume quantitative easing.
Effects elsewhere will be muted
It is likely that the EU will feel a similar impact, but to a lesser degree, with growth projections lower than previously forecast. There is a strong probability that the European Central Bank (ECB) will extend its program of quantitative easing. There is even the possibility that the ECB will cut its policy rate to an even more negative level than the current -0.40% bank deposit rate in order to stimulate lending. In Japan, the strengthening of the yen could negatively affect growth prospects, and we believe it is possible that the Bank of Japan may cut rates later this year or step up quantitative easing.
We do not believe that the direct effect on the U.S. will be significant, as U.S. exports to Britain exposure represent only a very small percentage (less than 1%) of total exports. We anticipate increased volatility in the U.S., although we do not believe this disruption truly changes the long-term value of companies. Extended uncertainty regarding the timing of Brexit and its overall impact on Europe could reduce corporate hiring, investments, and consumer confidence in the U.S. In addition, a stronger dollar makes export goods more expensive, which could negatively affect the sales of companies with significant exports.
We have changed our forecast for rate hikes post-Brexit. We expect that interest rates in the short to intermediate term, are likely to be lower for longer than previously anticipated in order to maintain economic growth in the U.S. The 10-year Treasury rate is near an all-time low. We now believe that the next rate increase is unlikely to occur until the end of the year, as the Federal Reserve assesses the fallout from Brexit. A positive of the extended low rate environment is lower borrowing rates in general. Mortgage rates are also down substantially which is a boost for the housing market.
Other European Union countries are unlikely to exit
We do not believe there will be a Brexit domino effect. In general, EU countries appear to believe that they are better off being in the EU from a security and economic point of view. An additional barrier to leaving is the need EU countries would have to replace the Euro, a potentially costly and administratively time-consuming venture. One country that may have greater potential for an exit is Italy, which might consider leaving if the vote for structural reform does not pass. Another possibility is that EU countries could move to a more protectionist stance, potentially undoing years of increased globalization and free trade; negatively affecting future global economic growth.
In summary, there is a high level of uncertainty ahead, and volatility is likely to go on for some time. We will continue to keep a close eye on developments and their potential impact on our clients’ portfolios.
Developing and executing an investment strategy that encompasses every aspect of your financial life
The material presented in this article is of a general nature and does not constitute the provision by PNC of investment, legal, tax, or accounting advice to any person, or a recommendation to buy or sell any security or adopt any investment strategy. Opinions expressed herein are subject to change without notice. The information was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy. You should seek the advice of an investment professional to tailor a financial plan to your particular needs. For more information, please contact PNC at 1-888-762-6226.
The PNC Financial Services Group, Inc. (“PNC”) uses the marketing names PNC Wealth Management® and Hawthorn, PNC Family Wealth® to provide investment, wealth management, and fiduciary services through its subsidiary, PNC Bank, National Association (“PNC Bank”), which is a Member FDIC, and to provide specific fiduciary and agency services through its subsidiary, PNC Delaware Trust Company or PNC Ohio Trust Company. PNC also uses the marketing names PNC Institutional Asset ManagementSM, PNC Retirement SolutionsSM, Vested Interest®, and PNC Institutional Advisory SolutionsSM for the various discretionary and non-discretionary institutional investment activities conducted through PNC Bank and through PNC’s subsidiary PNC Capital Advisors, LLC, a registered investment adviser (“PNC Capital Advisors”). Standalone custody, escrow, and directed trustee services; FDIC-insured banking products and services; and lending of funds are also provided through PNC Bank. Securities products, brokerage services, and managed account advisory services are offered by PNC Investments LLC, a registered broker-dealer and a registered investment adviser and member of FINRA and SIPC. Insurance products may be provided through PNC Insurance Services, LLC, a licensed insurance agency affiliate of PNC, or through licensed insurance agencies that are not affiliated with PNC; in either case a licensed insurance affiliate may receive compensation if you choose to purchase insurance through these programs. A decision to purchase insurance will not affect the cost or availability of other products or services from PNC or its affiliates. PNC does not provide legal, tax, or accounting advice unless, with respect to tax advice, PNC Bank has entered into a written tax services agreement. PNC does not provide services in any jurisdiction in which it is not authorized to conduct business. PNC Bank is not registered as a municipal advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act”). Investment management and related products and services provided to a “municipal entity” or “obligated person” regarding “proceeds of municipal securities” (as such terms are defined in the Act) will be provided by PNC Capital Advisors.
“PNC Wealth Management,” “Hawthorn, PNC Family Wealth,” and “Vested Interest” are registered service marks and “PNC Institutional Asset Management,” “PNC Retirement Solutions,” and “PNC Institutional Advisory Solutions” are service marks of The PNC Financial Services Group, Inc.
Investments: Not FDIC Insured. No Bank Guarantee. May Lose Value.
Insurance: Not FDIC Insured. No Bank or Federal Government Guarantee. Not a Deposit. May Lose Value.