On June 23, 2016, the British electorate voted to leave the European Union (EU), colloquially called the Brexit. This event marks the first time any nation has begun this process. While the details of the exit must be negotiated between the United Kingdom (UK) and the EU, the decision by the voters has significant political, economic and investment implications that need to be considered by all investors.
This report attempts to shed light on these issues and provide investors with comfort regarding the likely outcome of the vote. It covers the process by which the UK could leave the EU. A process which is not straightforward and may take two years or longer to complete. We look at the impact the Brexit, as it is known, will have on global trade and, consequently, global growth, currency movements, interest rates and equity markets. Obviously, the impact is not likely to be positive. The question is how negative of an impact the Brexit will have and on whom. It also focuses on the political issues revolving around the decision of UK voters to leave the EU. We intend to cover everything from the future of a united Europe, the future of a united UK, the status of London as the most important financial center in Europe and the status of immigration to the UK. We conclude with a summary of these issues and what, if anything, investors should do with regard to the situation.
Process and Mechanism for Leaving the EU
The process starts when the UK invokes Article 50 of the Lisbon Treaty which sets out the process for a member state to leave the EU in broad terms. Once Article 50 is invoked, the UK and EU begin negotiations to extricate the UK from the Union. The parties technically have two years to reach agreement on the terms of the UK’s demission. If no agreement is reached after this two year period, the UK would automatically cease to be a member of the EU unless an extension to the negotiations is unanimously agreed to by all member states. The negotiations cover approximately 80,000 pages of laws currently binding the UK to the EU. The areas of discussion that will require a negotiated agreement include how to divide assets currently held in common, resolution of current EU budget issues, the rights of EU nationals in the UK and vice versa, trade terms between the UK and the EU and many more complicated and difficult areas. Because of this a two year time frame to reach agreement seems tight. If an agreement is reached within the two year negotiating window, it requires a majority vote of member states for approval. If an agreement is not reached within two years or an agreement which is reached is not approved by a majority of member states, the UK is summarily dismissed from the EU and presumably will then have to negotiate trade, immigration and other political issues individually with each EU member state, a cumbersome arrangement to say the least. In any case, even if an agreement is reached, the UK will still have to negotiate trade and certain immigration issues with the world’s non-EU member sovereign states, since many of the current trade and immigration laws are based on the EU’s treaties with these non-member states. Obviously, this whole process is a cumbersome, difficult and costly process for the UK.
Not surprisingly, Article 50 gives the EU the upper hand over any departing state. The process is designed to keep any seceding state from dragging the negotiation out for too long. Additionally, while the EU will want to reach an agreement that allows its member states to enjoy favorable relationships with the UK, they will not want to reward the UK for leaving the EU, as that could encourage other member states to follow suit. On June 28th, German Chancellor Angela Merkel warned the UK, “Don’t delude yourself about the necessary decisions that need to be taken.” From the UK’s point of view, they would like an agreement which allows them to export freely to the EU but ends their revenue commitment to the Union and provides the UK with complete authority over immigration into their country.
Ending the revenue commitment to the EU should be easy for the UK, since they are walking away from the EU. As part of this deal, the UK will also relinquish the current subsidies they receive from the EU for education, health care and cultural institutions. Ending the revenue/subsidy stream is a net benefit for the UK. From 2008 through 2014 the UK net payments to the EU averaged approximately €4.8 billion per year.
It is highly unlikely that the EU will agree to accept UK exports on a duty/trade barrier free basis. This in essence would be rewarding the UK for leaving. While the EU will not want to be punitive in assessing high duties and trade barriers on the UK, there will be some increase in cost for UK exporters. At a minimum there will be increased paperwork and transportation costs associated with new border controls.
Finally, with regard to immigration/emigration, the UK will insist on the ability to limit new arrivals to their shores. In response, the EU will likely insist on limits for UK ex-patriots currently in EU countries. There is a sizable level of UK citizens in Spain and one or two other countries in the EU. While they are typically welcome and appreciated in these countries, by living abroad, they may lose certain UK benefits currently available to them and suffer adverse tax treatments going forward. Additionally, the relatively free movement of travel between the UK and EU will become more difficult. It is highly unlikely that visas will be required for travel between the UK and EU but entering the EU from the UK will not be as easy as it is now.
Political Harmony in Europe and Within the UK
This is the biggest issue currently troubling the capital markets. Having suffered through two global wars due to issues related to nationalism and imperialism, the markets are very concerned that the UK exit from the EU will lead to further deterioration in the union and a step back to the problems witnessed in the early and mid-20th century. We believe that this concern is over blown. However, the issue of political harmony across Europe and within the UK has the potential to keep the capital markets on edge and quite volatile for the next couple of years. We will begin a review of these issues with a bit of history.
The European Union can trace its origins to the end of World War II and the founding of an institution known as the European Coal and Steel Community (ECSC). This arrangement was established at the behest of France and Germany shortly after the war as a common market for the coal resources of the Alsace/Lorraine region. This region has alternately been a sovereign part of France and/or Germany over the centuries. As a matter of fact, that was exactly the point, through the 18th, 19th and 20th centuries, several wars were fought between France and Germany primarily, but often including other countries for economic advantage. The coal rich region of Alsace/Lorraine was often the spoils of war. The region was transferred to German sovereignty following the Franco/Prussian War of 1870/71, returned to French sovereignty following World War I and an important part of Nazi Germany’s desires in attacking France in 1940. After the end of World War II, France and Germany agreed to make the coal riches of Alsace/Lorraine available to either country with no duties, trade barriers or restrictions. The concept was to keep the region and its coal resources from becoming a reason for the two countries to go to war.
The concept was so widely embraced, popular and successful that it was expanded to cover a far broader range of resources and products, and, ultimately, to include many more countries throughout Europe. Eventually the ECSC became the Common Market and, as the Common Market expanded, it was renamed the European Union. Ultimately EU member states agreed to include the free movement of capital and labor. In the late 1990’s, many, but not all members of the EU, adopted a single currency to help facilitate freer trade at lower transaction costs. The UK opted out of the single currency.
The point of this historical backdrop is to emphasize the fact that the European Union was established to foster political harmony and unity first and foremost. It was introduced as a means of making sure economic disadvantage would not make wars in Europe likely. The great and significant economic benefits that the EU now provides its member states is almost a by-product of a desire to avoid war. With that in mind, the capital markets are concerned that the UK exit is the first step in a larger trend that would fragment the EU and once again create a situation where the countries of Europe are competing for economic advantage through tariffs, trade barriers and other restrictions. Not only is that situation bad for economic trade and, consequently growth, but it leads to political instability, nationalism and potentially armed conflict.
The reason we feel that this concern is over blown, as we mentioned in the first paragraph of this section, is two-fold. First, while nationalism is alive and well in Europe (as witnessed by the UK’s vote), imperialism is a dead letter. That does not mean that it could not resurface but in the current economic system, sovereign states understand that wealth is not generated through expansion and exploitation of natural resources. A nation’s wealth is largely created through productivity, technological advances and entrepreneurship. Second, we would argue that the main guarantor of peace in Europe is not the EU but NATO. While economic cooperation is important, military cooperation and coordination among nations makes military conflict between nations much less likely. Additionally, the NATO guarantee that an attack on a single member constitutes an attack on all members has been interpreted to mean that all NATO members would be involved in ending an armed conflict between two members. Again, this does not guarantee that armed conflict cannot occur but it is a significant deterrent to any individual member attacking another. As an example of this, Greece and Turkey, two NATO members, have had very significant territorial disputes over the past several decades. The two nations also have a history of belligerence to each other prior to joining NATO. All of the disputes between the two, since joining NATO, have been settled peaceably.
So our conclusion regarding political harmony within the EU is simply that while the prospect of disharmony among the member states of the EU is a significant concern to the capital markets, the likelihood of disharmony seems remote to us. NATO remains a strong and important alliance to Europe. The UK would be loathe to leave this alliance, as would any current member country. While nationalism is still strong in Europe, causing anti-immigrant feelings in many countries, the economic benefits of the union are very much appreciated from Greece to Germany to Portugal. If the EU handles negotiations with the UK on its exit appropriately, it is unlikely other countries will attempt to follow the UK’s lead. As evidence, Spain held elections three days after the UK vote with an anti-immigrant party involved. The result of the election gave the pro-EU conservative party a resounding victory.
While we feel that the likelihood for significant political disharmony across Europe is remote, the risk of political troubles within the UK due to the Brexit vote is quite high. In the Brexit referendum, Scotland voted very pro-remain. In September of 2014, the Scots voted overwhelmingly to remain in the UK instead of becoming an independent nation. The rationale sited at the time by most Scots was that leaving the UK would mean leaving the EU. Staying in the UK would provide EU membership. Otherwise, Scotland, as an independent nation, would have to apply for EU membership, which likely would be approved but might take up to ten years to formally adopt. There is considerable discussion in Scotland, at this point, that independence is not just a good idea for Scottish sovereignty but may be their only way back into the EU. Expect Scotland to push for another independence vote if the UK goes through in its attempts to leave the EU.
Likewise, Northern Ireland also voted overwhelmingly to remain in the EU. Unlike Scotland, Northern Ireland did not recently vote on independence but did vote on a referendum to join the Republic of Ireland. This vote mostly hinged on Protestant Northern Ireland preferring the legal structure of the UK versus that of the Republic of Ireland. There is no doubt though that Sinn Fein sees this as an opportunity and this is especially worrisome given the history of the “Troubles” in the past. Economically, since Northern Ireland shares its only land border with the Republic and much of its trade is with the Republic, keeping this border free and open to trade makes great economic sense. Additionally, Sinn Fein will see this as a political opportunity to press their desire for unification with the Republic on economic grounds. Do not be surprised in the coming weeks and months to see activities related to this.
So, while we feel political disharmony in Europe is remote, the prospect of disharmony within the UK is fairly high. Given this, it may even cause the political leaders in the UK to reconsider divorce from the EU. If they do not, we feel it is likely that the current geographic structure of the UK will be quite different five years from now.
Global Economic Considerations
Obviously, the economic implications of the Brexit are far reaching. But keep in mind that the UK is only the fifth largest economy in the world. Less than one sixth the size of the US economy and the EU as a whole. Additionally, the UK is less than one third the size of the Chinese economy. Globally, the UK is on par with economies like France, India and Brazil. While the impact of the vote is far reaching, in the long-term its impact on the global economy will be minimal. That being said, within the UK, the economic impact will be significant and negative. We have already seen this. This section will look at the impact outside the UK on currencies, trade, GDP growth, central banks, equity and fixed income markets.
The biggest impact the Brexit has had on currencies is, not surprisingly, on the £. At the time of writing, the £ is trading below $1.30. This is a thirty year low and has only ever been exceeded during the extreme US $ strength of the mid-1980’s. Additionally, this is a permanent change in the way the £ will trade in the future if the UK goes through with the Brexit. Hard currencies of developed countries over the long run tend to trade in very broad ranges versus the US $. For the UK, this trading range pre-Brexit would have been $1.25-$2.00. Much of the time the £ traded in a tighter range of $1.50-$1.65. This has changed. The new broad trading range for the £ is now likely, $1.00-$1.75 and expect the typical exchange rate to be around the current level of $1.30.
Other currencies have been effected by the Brexit vote, but much less so, and the impact is likely temporary. The US $ has strengthened versus most currencies, as has the Japanese ¥. The € has weakened modestly but is not near its lowest levels. Emerging market currencies have weakened as well against the US $ and Japanese ¥. That being said, we continue to feel, in general, that the US $ has peaked in value and will, over the next few years likely trade lower against the €, ¥ and emerging market currencies. The only long term impact of the Brexit on currencies will be the impact on the £.
One benefit of the weaker £ is the fact that UK exports have become much cheaper. The problem for the UK is that slightly more than 65% of its exports go to current EU members. While these exports are cheaper in € terms, the EU will likely impose duties and additional trade restrictions as part of the UK’s divorce from the union. The EU will have to avoid rewarding the UK for leaving. These new duties and trade restrictions will offset the £ weakness, leaving the UK in the same place they were prior to the Brexit. Outside of the EU, the UK’s largest export market is the United States at £31.7 billion. While the weaker £ does benefit the UK in this instance, exports to the US are less than 1% of the UK’s overall GDP.
Additionally, since most of the trade treaties which govern UK exports and imports are based on EU agreements, the country will not have to renegotiate trade deals with its trade partners around the world. This is a cumbersome and expensive proposition. More importantly since the UK economy is less than one sixth the size of the EU overall, it is not likely that the UK on its own will receive as favorable trade terms from other countries as they might have received being part of the EU.
Globally, the Brexit will not affect international trade as long as the UK leaving does not lead to a Eurozone break-up, which we do not believe is likely. UK imports and exports together account for less than 0.5% of global GDP. This is not even a blip on the global radar.
Global GDP Growth
Unfortunately, the UK had been one of the strongest growing developed countries in the world, prior to the Brexit vote. That is certainly now at risk. It seems likely that the UK will fall into recession due to the confluence of a weakening currency, credit downgrade by the rating agencies (more on this later) and the negative impact of the vote on consumer sentiment. Europe had basically been teetering on the brink of recession and the negative consumer sentiment that the UK’s vote will have on the continent is also likely to push the EU into recession.
If this comes to pass, as seems likely, the recession is not likely to be severe. We would expect a mild recession of relatively short duration. It is not likely to spread to the United States and, with Japan seemingly always on the verge of or in recession, should have only a minor impact on the rest of the world. Of course, do not expect a major rebound from this recession if it occurs. It is far more likely that the UK and EU economies will rebound anemically from this situation. The equity markets in Europe and the UK have basically anticipated this potential over the past year and will probably not deteriorate much further if the continent falls into recession.
In general, the reaction of central banks around the world to the Brexit will be to ease monetary conditions further or to at least not tighten monetary conditions. This is of course especially true of the Bank of England. Currently the base rate in England is 0.5%. While that is a historically low rate, it is actually the highest base rate for any of the major developed economies. It is likely that the Bank of England will lower that rate to a level near zero between now and the end of the year.
In Asia, the Bank of Japan must be quite upset. They have been feverishly trying to use monetary policy to weaken the ¥ with mixed results prior to the Brexit vote. After the vote, as mentioned previously, the ¥ has appreciated against most other world currencies. Unfortunately, the Bank of Japan has very limited tools at its disposal these days to weaken the ¥. They are stuck in permanent quantitative easing and negative short and long-term interest rates.
Prior to the Brexit vote, the Federal Reserve had signaled its interest in raising their Fed Funds target rate at least once more this year. Undoubtedly they would still like to do it just in an attempt to normalize short-term interest rates in this country. Their hands are tied though at this point. A rate increase would likely strengthen an already strong $ and hurt American manufacturing further. It would also surprise the markets significantly at this point which could lead to increase capital market volatility and then, potential recession. The Fed Fund futures market has priced futures all the way out to December of 2018 as if no Fed Fund rate increases will occur.
Global Equity Markets
Equity markets fell dramatically on the news but have largely recouped their losses. This is not surprising, although the speed of the rebound in equities was faster than we thought it would be. The major takeaway with regard to equity markets is that they will be increasingly volatile over the next couple of years as the Brexit process evolves. This is the first time that the capital markets have experienced a break-up in the EU. There is likely to be news regarding the process that will be negative for trade, growth and/or political harmony on the continent and within the UK. The equity markets will likely be volatile as a result.
Global Fixed Income Markets
Despite a major downgrade by the rating agencies, UK bond yields have fallen on the Brexit news. This is likely due to the feeling that the UK economy is possibly headed for recession as a result. Treasury yields in the US have also fallen dramatically on the news. This is a safe haven result. Investors across Europe are investing in the relatively high yield of US Treasuries. At the time of writing, the ten year US Treasury is trading at an all-time low yield of 1.36%. While both the rally in UK bonds and US Treasuries seems over done to us, the global fixed income markets are likely to experience a low yield environment for the foreseeable future. This is not due to the Brexit but a result of other structural and demographic issues.
Impact on the UK
This is where the “rubber meets the road” so to speak. The decision of British voters to leave the EU will impact the UK by far the most of any country around the world. We have already discussed the potential political impact on the UK and the possibility that the country could fragment as Scotland reconsiders independence and Northern Ireland considers joining the Republic of Ireland. The last section dealt with the impact of the decision on the £. This section of the report will consider the other economic impacts on the UK.
Cost of Capital
This is an often overlooked but very important consideration on the microeconomic front for the UK. On many levels, the cost of capital for UK companies will increase. First, a weaker currency means that importing anything into the UK, including capital becomes more expensive. Second, since trade terms across the globe will be more negative for UK companies, attracting capital will become a more difficult proposition. Third, Standard & Poor’s cut the UK’s credit rating from AAA to AA, a two notch move. S&P cited as their rationale the prospect that the Brexit could lead to a deterioration in the country’s economic performance. Fitch followed suit, downgrading the UK from AA+ to AA and noted that they expect an “abrupt slowdown” in GDP growth in the short term. While the UK remains a very highly rated country, this does affect each and every UK company in the public debt and equity markets. Whenever the country of origin’s rating is downgraded it creates and automatic downgrade for every company with a credit rating in the UK making capital more expensive. Finally, at the moment, London is the undisbuted financial capital of Europe. Given the Brexit, this status is in jeopardy and will also increase capital costs in the UK.
One of the major reasons cited by voters for approving the Brexit is to gain control over immigration into the UK. Currently, any person holding a passport from an EU country has direct access to the UK, its labor markets and, under certain conditions, its public support and welfare provisions. UK citizens who voted for the Brexit often cited a desire to keep England English, and to limit foreign born nationals in the country.
This is shortsighted. Let’s consider some facts. The Oxford Migration Observatory estimates that there are three million EU-born migrants who live in the UK. It appears that 63% of these migrants are working. This is a fairly high labor participation rate. Consider that in the US labor force participation currently stands at 62.6% and does not count persons who are not eligible to work (i.e. children). The Migration Observatory’s estimate includes children, so a 63% participation rate is quite high. Currently unemployment in the UK stands at 5%, slightly higher than the US but still full employment according to most economists. Net migration to the UK in 2015 was 330,000 people, about half coming from the EU. In a June 23rd article in the New York Times Steven Erlanger states, “there was no question that . . . the immigrants contributed more to the economy and to tax receipts than they cost.” We agree.
The UK needs immigration from two standpoints. Given that the country is basically at full employment, forcing immigrants to leave the country will create labor shortages and increase the cost of labor. No doubt there are people in the UK that would welcome this but it is not good for the economy, UK businesses or the stock market. Futhermore, even if all the current immigrants in the UK are allowed to stay but further immigration is curtailed, the UK has a growth problem. Population growth among native Britains is flat at best and actually falling by some measures. Immigration is an important source of labor and aggregate demand for the UK. If immigration is curtailed the UK runs the risk of becoming Japan, a country with severe economic growth issues. Since, on a long-term basis, real GDP growth is a function of population growth plus productivity growth, a falling population (like Japan currently has and the UK would have without immigration) typically leads to stagnation in an economy. Like it or not, the UK depends on immigration to support aggregate demand, economic growth and reasonable labor costs. Without immigration, the UK economy will suffer higher labor costs and slower or no growth in GDP.
London’s Status as Europe’s Financial Center
At the moment, London is the undisputed financial center of Europe, second only to New York City on a global basis. It has, in the past twenty years, surpassed the importance of Tokyo as a financial center and that is where our story on this issue begins. Thirty years ago, in the mid 1980’s the Tokyo stock and real estate markets were flying. Japanese investors were gobbling up real estate in the United States like it was candy. Tokyo was rivalling New York as a financial center and people generally felt that the Japanese economy was unstoppable. Then in the early 1990’s the Nikkei 225 average crashed after reaching a peak of 38,915 in late 1989. Japanese real estate values plummeted and many Japanese interests in the US went bankrupt. The Japanese economy stagnated as population growth slowed, the populace aged and immigration was severely restricted. The economy and stock market have never rebounded. The Nikkei 225 average today trades at 15,300 and Tokyo is at best the fourth or fifth most important financial center in the world .
This is not the only story of a city loosing its mantel as a major financial and business hub. In the 1960’s and 70’s, Montreal was the largest business and financial center in Canada. The Quebecois movement gained momentum throughout the end of the 20th century and pushed for independence. Many businesses, banks and other organizations questioned the wisdom of headquartering in a city and country that might suddenly become a very minor world player instead of resource rich Canada. Slowly over the past three decades Toronto has surpassed Montreal as the business and financial capital of Canada. And, in the end, Quebec has never seceded and remains a part of a united Canada.
If this can happen to Tokyo and Montreal due to immigration and independence issues it can happen to London. There is no doubt that Tokyo and Montreal are very vibrant and culturally rich cities. There is also no doubt that they have been surpassed as important business and financial centers and are weaker economically. If the UK goes through with the Brexit, Paris, Brussels or Frankfurt are likely to grow in economic importance at the expense of London.
If we were to liken the Brexit to an economic downturn, this current event would be like the shallow mild recession of 1990/91 associated with the first Gulf War rather than the Great Recession and financial crisis of 2008/09. That is not to diminish the importance and potential impact of what is happening, especially if things go very badly. But the current situation is not tragic. That is because it doesn’t directly impact the global financial system like the financial crisis did. It is not too big of a shock for central banks to control and not going to cause major financial institutions like Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac or AIG to fail. The fallout from this crisis, as we have hopefully shown, is mainly going to fall on the UK, partially on the EU and very little on the rest of the globe.
There are two market risks associated with the Brexit. In the short run, the risk is a liquidity shock or something like the Flash Crash. We have avoided this so far and the riskiest time for something like this to happen is in the first couple of weeks after the event. That is not to say that markets will not be volatile and traumatized during the Brexit negotiations. They will and there will likely be days when markets fall precipitously. These days will likely be followed by a slow steady rebound in markets, as was witnessed initially. In the long-term, the risk is a Eurozone break-up, which is a much bigger deal, as we discussed, and something that EU leaders will be very cognizant of in their negotiations with the UK. Every step of the way, EU leaders will consider how their treatment of the UK will encourage or discourage other member states to remain in the EU. For this reason, the UK is unlikely to be granted a favorable deal with the EU.
Finally, as mentioned several times, the biggest party hurt by the UK’s decision to leave the EU is the UK. Capital, labor and trading costs will rise in the country. Many businesses will find it harder to compete on a global basis. The importance of London and the UK will wane. There will still be valuable investment opportunities, just as there are in Japan but it may be more important to utilize the expertise of an active, expert international manager to navigate these waters.
Other than that, we advise our clients to maintain the status quo in their portfolios. Global diversification across multiple asset classes and strategies will still likely be a winning strategy for investors. With the help of a professional wealth advisor, pick the right strategic asset allocation and stick with it through the volatility that the current environment is likely to produce.
Disclosures: This piece discusses general market activity, industry or sector trends, or other broad-based economic, market , or political conditions and should not be construed as research or investment advice. The opinions expressed are those of the author and do not necessarily represent the opinions of Enterprise Bank & Trust. Past performance is no guarantee of future performance. No diversification strategy can guarantee against loss.