Following the Brexit Signs

Yesterday the United Kingdom made history by delivering a surprise vote to leave the European Union. Though the odds were close, market pricing was tilted towards a “Bremain” vote — so “Brexit” was an unexpected outcome.   Markets reacted commensurately today,  European equity markets were down more than 7% and the Sterling down more than 8%.  Other than usual safe-havens like Treasuries, precious metals, and the US dollar, risk assets across the board ended in the red.  It was a long day, but what should we expect in the days ahead?

Uncertainty for Europe

Clearly, the areas most affected will be Europe in general and the UK in particular.  For the EU, Brexit creates a dangerous precedent for the union.   The reality is all countries in the union are bound to be unhappy with one EU policy or another.  Prior to Brexit leaving the EU was considered unrealistic, but Brexit lays a foundation for actually doing it. Other member countries now have a new bargaining chip  (an EU exit) when trying to influence EU policy — that can cause increased divergence within the union which is detrimental to its cohesion and success.  And if the next dissenter is also a Euro Zone member (the UK was not), that creates even more problems for Europe by calling the Euro into question.  Ultimately these events increase uncertainty about the region’s future, its economic conditions, and of course its financial markets.

The UK itself faces the most uncertainty of all.   As of now, it faces a long and drawn out process of separation from the EU — one that is likely to be very costly.  Many global companies with offices in the UK will likely relocate their resources and investments to countries still within the EU.  The UK will need to renegotiate terms with other countries for everything from trade to immigration — but this time it will not have the bargaining power of the larger union.  Even the UK’s very existence is uncertain as Scotland voted solidly for Bremain, and is calling again for independence from the Kingdom.  All Brexit signs point to mounting challenges that will create economic stress and increased financial market volatility for the UK and the areas closely tied to its well-being.

What about US?

So how does this all affect US-based investors?  It certainly got our attention, US equity markets closed down more than 3% on the day.  It was a big move, but also not as big as many feared.  Both European and Emerging markets were down more than twice that amount — so in a way the US was the “least bad.”  That sets the tone for what to expect, the UK’s woes may spillover to the US, but the magnitude will be subdued because the UK simply isn’t big enough to move our needle. For example,
in terms of trade, the UK makes up less than 4% of US exports. In terms of global GDP, the UK makes up less than 4% of global output, whereas the US produces about 25%. And in terms of equity markets, the UK represents less than 5% of global market cap, while the US represents more than 50%.  The point is a downturn in the UK is not enough to derail the US.

If we look past today’s sell-off and the hysteria in the headlines, conditions in the US remain fairly benign. Despite a negative surprise in employment in the past month, the general trends for US employment, income, consumption, and growth are still positive — albeit barely so.  As we pointed out before, this is simply a continuation of the conditions that have persisted since 2009 — slow, sluggish, but overall still in the right direction.  Brexit doesn’t fundamentally change those conditions for the US, and so we don’t see any reason to run for the exits.

Indeed we emphasize that prudent, long-term investors should not succumb to making sudden changes due to bouts of fear or panic, but rather stay focused on ensuring that strategies are properly aligned with needs, goals, and risk tolerances.   This helps prevent knee-jerk reactions driven by emotional responses to short-term volatility (due to Brexit or otherwise) and enforces the consistent, rational decision-making needed to achieve long-term investing success.

Victor K. Lai, CFA

This blog is for informational purposes only. Nothing on this blog represents advice. Investing is inherently risky and involves the potential for loss.