Investment Advisory Team
Below is a summary of the surprising Brexit vote that shocked the markets and world overnight.
- The UK voted last night to exit the European Union (EU) by a margin of 51.9% vs 48.1% with heavy voter turnout.
- The UK has been a member of the EU since 1973 and was seen as a key beneficiary, serving as a world and regional financial hub.
- Some of the key concerns of UK citizens surrounded member payments to the EU vs perceived benefits; burdensome regulation; uncontrolled immigration (particularly since the Syrian refugee crisis); and national sovereignty since EU membership involves giving up some control over UK affairs.
- Given the UK has debated EU membership for years, the vote was expected to be close but most experts and market participants expected the UK to remain in the EU given long-term benefits. The surprise outcome is a key factor behind the sharp market reaction today.
The Brexit vote is triggering a sharp risk-off trade worldwide and a flight to safety.
- Markets are pricing in years of implications very rapidly. It is not clear the losses will be self-sustaining.
- Global equity markets have declined sharply with European markets down between 4-13% and the Nikkei off by 8%. Emerging Markets have shown some initial resiliency, down between 2-3%, buffeted by the likelihood the Federal Reserve postpone rate hikes for the foreseeable future.
- Safe havens have benefitted: the dollar (+3%), Yen (+3.6%), and gold (+5%).
- Government bonds have rallied and yields have fallen to lows (10yr Treasury @ 1.5%).
- Markets being hit the hardest are those seen as most vulnerable to exit the EU in the future – Greece (-14%); Italy (-11%); Spain (-13%). UK stocks are down 3.9%, but the pound is down 8%. UK stocks represent 14% of the MSCI EAFE Index, so diversified portfolios clearly have exposure to the event.
- The UK market is quite cheap today with low valuation multiples and a dividend yield of nearly 5% (over 2X the S&P 500). The market is dominated by global multinationals.
- Todays moves are likely exaggerated by hedge funds, which have suffered from poor performance and have lacked a”big trade”.
Global monetary policy will likely become even more accommodative.
- We expect central banks to take action to reassure the markets by providing liquidity and possibly announcing new stimulus measures.
- Rate hikes in the U.S. are likely off the table for the foreseeable future. MARKET UPDATE It is not a quick process to leave the EU or even guaranteed.
- The vote is not a binary outcome, but beginning of a longer process of negotiations.
- Next steps are for UK and EU to begin a negotiation process for the UK to exit the bloc under Article 50 of the EU treaty. This process can last 2 years or longer.
- Among the most important negotiation points will surround the UKs access to the common market given its export dependency on the EU.
- The referendum does not mean that the UK is automatically out of the EU. The opponents of Brexit may pursue a second referendum, which have been successful in prior anti-EU votes before in the region. However, it appears doubtful at this time major concessions will be offered by the EU since doing so would risk negotiations with other members and the UK is not in a very good bargaining position.
Volatility is being driven by a high degree of uncertainty given the political nature of situation and lack of precedence.
- Markets hate uncertainty.
- An unproven negotiation process brings uncertainty, which is expected to suppress UK consumer and business spending and drive market volatility.
- The decision will likely increase populist strains in the EU with key elections upcoming in Spain (2016), Germany (2017) and France (2017). This is fueling fears about the viability of the EU and common currency – perhaps the biggest concern coming out of this referendum.
- Markets appear to be pricing-in a “whos next” premium into European assets.
- Deep reforms in Europe are needed to maintain the long-term survival of the economic union.
Barring unforeseen contagion, the UK appears to have the most to lose from the vote.
- UK economy will likely enter a recession, which will also negatively impact European growth conditions given close economic ties.
- The longer-term growth potential of the UK will likely be lower post Brexit due to less immigration and lower fixed investment.
- Scotland voted to remain in the EU (62% vs 38%) and Brexit may give rise to another vote to secede. Northern Ireland also voted to remain in the EU (56% – 44%). The fracturing of the UK appears a higher probability today.
- Less than 8% of the EUs exports go to the UK but 43% of the UKs exports go to the EU. The country will be forced to renegotiate trade terms with member countries individually.
- A UK debt downgrade appears likely and inflation should rise given sharp declines in the currency.
Historically, it has not paid to sell into a crisis-driven panic as illustrated in the table below.
- Outcomes stemming from crisis events are often less severe than the markets fear.