After Brexit, New Breginnings?

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.

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