Monday, June 27, 2016

Impact of the ‘Brexit’ on Global Markets

Nicholas Zaiko, CIMA®
Senior Investment Consultant
Bridgebay Financial, Inc.

The impact of the Brexit vote on June 23, 2016 is expected to lead to weaker global growth and apply pressure on Central Banks to keep interest rates low for longer than had previously been anticipated. 

Although global stocks regained some of the losses following the Brexit results, the markets will continue to be volatile with periodic flights to quality and safety.  The US stock and bond markets are seen as safe-haven assets and should be the beneficiaries of more international uncertainty.   On July 5th the flight to safe haven assets intensified with foreign investors pouring money into US fixed income markets.  High yield bonds saw massive inflows.  The 10-year treasury yield fell to 1.37%.  

There will be continued economic, political and geopolitical uncertainty that will create heightened volatility.  Increased political uncertainty combined with moderate to slow global growth and continued accommodative central bank low rate policies will keep markets nervous. 
The EU could try to discourage other countries from leaving the economic union by punishing the UK capital markets that currently benefit as a gateway to the EU. 

The UK leads Europe in capital markets and other financial services. As much as 85% of hedge fund assets, 78% FX trading, 74% interest rate OTC derivatives trading, 64% private equity and 50% of all European fund management goes through London.

The UK vote to leave the European Union (EU) has started a long period of political, economic and market uncertainty for both the UK and EU.  Markets will continue to have increased volatility with periodic sell-offs in stocks and other global risk assets as the Brexit process evolves.  The EU is also threatened from within by populist groups that may also want to leave the EU, though the Spanish elections following the Brexit vote retained the current Rajoy government that favors remaining in the EU.  Italy has a referendum vote in October.

Political Turmoil
UK Prime Minister David Cameron, who favored Remain in the EU, will resign by October, 2016.  Already the Conservative Party is having other leadership issues as well as the head of the Independent Party’s resignation.  Essentially, the UK is experiencing considerable political infighting and turmoil.   Ironically the referendum is considered non-binding but no leader has the political will at this time to challenge it.  This may be an opening for the next prime minister.
Additionally, Scotland may call for another independence referendum to leave the UK in order to remain in the EU.  Northern Ireland had also voted to Remain and they too may seek to leave the UK in favor of remaining in the EU.

The UK exit is expected to be complicated as decades of negotiations and trade agreements are laboriously unwound.  Per the Treaty on European Union Article 50, the UK will have 2 years from the date the UK officially notifies the European Commission (EC) of its intention to leave the EU
To complete its exit.  The earliest departure would be June, 2018.  Any potential savings from leaving the EU are expected to be overrun with losses in services, new investment flows and exports resulting in a net loss to the UK economy.  The Brexit will most likely lower UK growth and investment and potentially lead to higher UK unemployment and inflation. 

The EU loses a global financial center with strong access to world markets.  Many banks have already indicated that they may re-locate operations from London.  US Banks and other global organizations with operations based in the UK will most likely reduce both their presence and investment inflows in the country.

Another loss to the EU is the UK’s contribution to the EU budget.  This leaves Germany and France as the major EU budget contributors.  The EU has already begun to expand its base of members and privileges in an effort to replace the potential loss of the UK.   

Bank of England (BOE) Governor, Mark Carney, announced that it has been providing liquidity to some banks and announced that its top priority is to provide liquidity to avoid any financial stress in the UK market.  The BOE had been expected to gradually raise rates but will now be lowering them and being more accommodative to markets.  The British pound fell to 31 year lows and will continue to be volatile as more political news evolves.  Interest rates in the UK may be cut and the BOE will use all of its tools including quantitative easing. 

Both S&P and Fitch promptly lowered the UK debt rating from AAA to AA with Negative Outlook and Moody’s placed the UK on Negative Outlook with the expectation that they will soon follow with a downgrade.  The rating agencies have stated that the decline in the country rating will not impact the credit rating of UK-based companies at this time.

GBP Currency
The British pound has already weakened and may decline further as the markets decipher the impact of the UK leaving the EU.  This will lead to a temporary spike in inflation. The Pound is the most liquid UK financial asset and the immediate victim of the Leave vote. 

Euro Currency
The euro has declined in response to the UK vote.  A weaker currency will negatively impact foreign investors invested in EU stocks.  Even if stock prices rise in the near-term, it will not be enough to offset the decline in currency.  Economists are now expecting lower growth and increased job losses across Europe.  High quality (German, French) European government bonds continue to be in high demand in spite of negative interest rates. 

Other Global Markets
The UK represents only 4% of the global economy.  The US and Asia markets have been slightly affected by the UK’s exit from the EU and in some cases US bonds and Japanese stocks have benefited as investors seek out safe haven assets.  In the UK, large cap UK companies with global operations will actually benefit from the drop in the British pound as 75% of them generate revenues outside the UK.  They will outperform the domestically focused UK stocks that will experience the adverse effects of a UK recession.