Brexit Stage Right

Author: Rusty Guinn
Date: June 25, 2016
Category: Macro Trends
Tags: , , , ,

It was an eventful end to the week, nowhere more so than in the United Kingdom, where voters surprised markets, political observers and even bookies with a resounding vote to leave the European Union. We know many of our clients and partners have questions about how this may affect the world, financial markets and their investments. As always, the answer is complicated.

In the aggregate, we think it is fair to summarize the effects for different parts of the world as follows:

  • United Kingdom: Definite economic costs and uncertainty, but manageable long-term impact on the economy and markets.
  • European Union: Very small near-term economic costs, but massive long-term risks to both economies and markets.
  • United States and the rest of the world: A warning bell.

Effects in the United Kingdom
The implications for the United Kingdom from a political perspective are obviously large, but we remain relatively calm about Brexit’s direct economic impact. We see no reason to believe that the U.K. will not be in a position to negotiate appropriate, and in some cases more advantageous, trade agreements than it had before, although there is clearly some uncertainty. It is hard to imagine, for example, that the major German importers of British machinery, engines, aircraft and vehicle parts and pharmaceuticals will not be influential in ensuring their own production costs do not explode. For Great Britain, this has the feeling of an event with definite frictional costs as its agencies, companies and employers adjust to whatever the new reality will be.

Likewise, while the Brexit debate focused a great deal of attention on the explicit costs of EU membership, transfer payments, benefits and rebates, we think the real impact of those items is much smaller than that of the indirect and uncertain impacts on the economy. In any case, we think that the United Kingdom is likely to remain competitive in a world economy. While we believe the European Union could demonstrate (for the benefit of France and any other would-be dissenters) its hegemony through punitive negotiations with Downing Street during the separation process, the likeliest outcome remains a relatively successful muddle-through for the U.K. over the long-term.

U.K. Exports to Germany in 2014

blog-brexit-treemap

Source: AJG Simoes, CA Hidalgo. The Economic Complexity Observatory: An Analytical Tool for Understanding the Dynamics of Economic Development. Workshops at the Twenty-Fifth AAAI Conference on Artificial Intelligence. (2011)

Effects in the European Union
If the market has said anything today, however, it is that the major concern is the European Union. The markets that declined most on Friday were not stocks traded in London, but rather those traded in Milan, Paris and Madrid. As Epsilon Theory author Ben Hunt has been saying, Brexit’s analog is not Lehman, but rather Bear Stearns — a precursor and a scare, but in itself not a market-changing event. The Lehman event that many investors and markets are concerned about is the potential for referenda in other EU-member countries, especially France. Make no mistake, the potential break-up of the European Union could be a monumental event for the world economy and markets. We believe today’s actions discount only a fraction of the potential impact from such an event.

One-Day Returns on June 24, 2016

blog-brexit-column

Source: Bloomberg, as of 06/24/2016. FTSE 100 Index, CAC 40 Index, Deutsche Boerse AG German Stock Index, IBEX 35 Index, FTSE MIB Index.

We believe the ECB and the remaining EU members will be doing everything in their power to ensure no further deterioration in the union, in liquidity and in markets. Should they be successful in messaging this to markets, it would not be surprising to see all of Friday’s market action reverse and markets return to their previous low volatility state. We continue to believe that EU stability and government messaging around that stability will remain the most significant concern for markets for the foreseeable future.

Effects in the United States and the rest of the world
We believe the direct impact of Brexit on the U.S. economy and financial markets is likely to be muted; indeed, the impact on U.S. markets today was far less than almost anywhere else in the world. In the near-term, the effects are largely related to currency and are deflationary — for which reason no investor should be surprised to see further central bank action back on the docket in the U.S., Japan and elsewhere. In fact, even now market expectations (based on Fed Fund futures) for 2016 include a non-zero probability of a cut in interest rates in the United States.

This currency effect manifested itself greatly in Asian markets on Friday, where the yen was a primary beneficiary of a weaker pound — and the Nikkei its unwilling victim. And despite almost no investor focus and protestations that anyone predicting a yuan devaluation is delusional, China’s currency is now set at a 5-year low. As always, the game has many players.

More importantly, from a long-term perspective what Brexit tells us is that the seemingly inexorable push toward populism and against globalization has taken root around the world. As the United Kingdom moves away from the European Union, it would be naïve to ignore that the reason many voted to leave had to do with concerns over immigration, the impact of free trade and the loss of national sovereignty.

These same principles lie at the center of the upcoming U.S. elections as well. While we expect limited direct impact of Brexit in the U.S., we recommend investors keep a watchful eye on policy direction concerning trade and international cooperation. These could have a profound impact on long-term growth in the U.S. and long-term potential returns in U.S. financial markets.

 

salient-partners-rusty-guinn-brexit-stage-right-june-24-2016

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