I wanted to take a moment to share our thoughts on the major news event today, the “leave” vote in the British referendum to leave the European Union, otherwise known as Brexit. Our thoughts will be limited to the economic and financial impact of the vote, as I will leave the geopolitical implications to the pundits for now. This is not to say that the geopolitical consequences will be trivial, as we believe the vote to leave the European Union was very much related to issues that are not obviously economic, including immigration, border control, and Britain’s relationship with Brussels. However, the geopolitical consequences will take years to play out and are beyond the scope of this update.
In the short-term, there is sure to be increased volatility in the markets as the markets despise uncertainty. Additionally, the vote to leave will likely weaken the British pound and boost the U.S. dollar as investors look for more stable currencies. Oil is likely to decline and increased Treasury purchases are likely to drive down interest rates. It’s clear that for at least the near-term, Brexit will enhance the U.S.’s status as a safe haven and we are likely to see greater than average asset flows into U.S. markets.
In the intermediate-term, this is likely to have a marginal impact on U.S. economic growth. The companies listed on the S&P 500 Index derive 2.9% of their sales from Britain and 11.5% from all of Europe. We don’t view Brexit as having a material impact on these sales figures, although the composition of sales could certainly change. Specifically, many American companies have long viewed Britain as an access point to the European Union’s single market, so there will be some relocation of American facilities from Britain to elsewhere in the EU. We don’t think Brexit will have a major impact on American exports to the EU and while there could be a decrease in exports to Britain, at fewer than 4% of overall exports this is a fairly small portion of the U.S. economy. Note that the U.S. economy is not heavily reliant on exports.
The economic impact on Britain is likely to be negative. While the Bank of England has earmarked 250 billion pounds ($344 billion) to unleash as needed for stability, capital flows and foreign investment is likely to diminish until there is further clarity. This could take some time, as Britain now has a two-year window in which to negotiate a new treaty to replace the terms of EU membership. Britain and EU leaders would have to negotiate issues like trade tariffs, migration, and the regulation of everything from cars to agriculture. Additionally, it is possible that Scotland revisits the idea of independence considering that residents in that region overwhelmingly voted to remain in the EU. Note that the residents of Northern Ireland also voted to remain in the EU. Moreover, where does this leave London’s status as a financial hub? Within the EU alone, more than 75% of all EU capital markets business is conducted through the U.K. Much of this is likely to shift to German and French banks in the coming years.
In many countries worldwide, we’ve seen a rise in anti-globalization sentiment and Europe is no exception. However, we don’t think this is the beginning of the end of the European Union. The common currency shared by most of the Union would render another exit very difficult, though not impossible. Britain was never fully part of this monetary union and so its exit is made much easier. Additionally, for Britain there was no historic relationship between integration via the EU and stable democracy. Most of mainland Europe has historically viewed the EU as a stabilizing force that helped put an end to domestic and international turmoil. Unlike Greece, which almost left the EU out of necessity, Britain has left the EU by choice and for a complex set of reasons. Finally, younger voters in Europe tend to be more in favor of the EU than older voters, so time is on the side of a continued EU.
Situations like this serve to remind us that the best defense against major market events is a good long-term plan. A properly diversified portfolio is designed to weather market events and provide for reasonable long-term returns. We’ve worked with our clients to put just such a plan in place. There will be periods of turmoil in the market caused by global events and Brexit is another example of this. However, we think the long-term fundamentals still appear reasonable and we expect this event to have a negligible impact on U.S. economic growth. This situation remains fluid so we will be closely monitoring the situation, but at this time we are not recommending any major portfolio changes as a result of Brexit. If you would like to review your portfolio in greater detail, we are of course happy to do so as always.
Ken Schapiro, CFA®
Condor Capital Management