On the heels of the historic vote out of the United Kingdom to exit the European Union (BREXIT), capital markets are responding with significant downside volatility as investors attempt to determine the ultimate effect of this decision on global business activity. While uncertainty is resulting in expanding risk premiums across asset classes, it is critical for investors to look past the technical and emotional response of markets in the near term to determine the impact of the BREXIT vote on the future path of global economic fundamentals.
In the very near term, outside of capital market volatility, BREXIT will have very little impact on day to day business as the UK remains a member of the EU. In order to formally initiate the “leave” process, the UK will need to trigger Article 50 of the Lisbon Treaty which starts the clock on a two year process to negotiate the terms of withdrawal, terms for future trade agreements between the UK and the EU, and terms for future trade deals between the UK and countries outside the EU. The resignation of Prime Minister Cameron may delay the initiation of this process, relieving pressure for immediate action in the emotional aftermath of the vote but presumably resulting in a euroskeptic leader charged with negotiating with the EU. To quote BlackRock, the process is likely to be “messy, drawn out and costly”. The EU will take a tough negotiating stance with the UK to avoid emboldening domestic populist movements across Europe and prevent contagion. The protracted nature of the negotiations and the likely rancor will create uncertainty, a challenge for financial markets.
Against this backdrop of uncertainty, we anticipate central banks around the world will redouble efforts to provide ample liquidity to financial markets to prevent any dislocations associated with real or perceived illiquidity – in our estimation, this is not a “Lehman moment”. Currencies will likely remain volatile with a weaker British Pound and Euro potentially providing a tailwind for export-oriented businesses. We would anticipate increasing pressure to reduce fiscal austerity as an outcome of the BREXIT vote, a potential positive for the European economy.
At the time of this writing, equity markets around the world are down led by Europe and Japan down ~7% while US stocks are down ~2%. Currencies have likewise been impacted, with the Euro weaker by 2%, the Pound Sterling weaker by 5.4% and the Yen stronger by 2.5%. Bond markets have benefited from a flight to safety with the ten year US Treasury note yield below 1.6% while the UK 10yr Gilt yields 1.1% and the 10yr German Bund yields -0.07%. Uncertainty associated with the long term implications of BREXIT as it relates to economic growth will likely persist as questions remain around timing and terms with respect to a new agreement with the European Union. We are truly in uncharted waters; however, over time the normal functioning of markets and economies will restore the price discovery function to markets and reconnect markets with underlying fundamentals.
Heritage has maintained strategic positions in international markets based on a belief that over time, the increased return potential coupled with benefits of diversification will act to drive modestly better riskadjusted returns for our clients. Our clients’ direct exposure to the UK is limited at <5% of equity exposure while Europe in total represents ~20% of equity portfolios. As noted, equities worldwide are being impacted in the immediate aftermath of the referendum. In the near term, the impact of the BREXIT vote will be primarily seen in confidence measures which may impact hiring, investment and spending within the UK economy as well as Europe.
For diversified client portfolios, fixed income and significant cash reserve holdings will provide a buffer. In our view, it remains too early to make any judgements with respect to the ultimate impact of the referendum on economic growth – an emotional reaction is unwarranted. However, we will be closely assessing the potential impact of this vote to our larger investment thesis over the coming weeks and will make portfolio shifts accordingly.