Brexit and Where Do We Go From Here

Over the past two weeks, news and media outlets have flooded our data feeds with news out of Britain and the European Union (EU) over “Brexit”. Prior to the June 23rd vote, equity markets moved higher in anticipation of a “remain” vote, while they sharply corrected after the vote for “Brexit”. The market slide continued the following Monday, and we were then followed by a recovery through last Friday. But what is “Brexit” and what do we know about its potential impact today?

What is Brexit: Brexit is a term coined for the recent referendum vote in the United Kingdom on whether the U.K. should remain a current member of the EU or to exit the EU. A British exit from the EU became known as Brexit. The British Prime Minister, David Cameron proposed the vote as a simple “in or out” nonbinding referendum vote. The Brexit or “leave” camp focused on the heavy bureaucratic oversight imposed by the EU, the tax burden of the EU, and the current migrant crisis impacting all of Europe. While the “remain” camp cited the economic benefits of being part of the EU, such as a consistent regulatory environment, no trade barriers, and free movement of labor and the massive undertaking and damage an exit to the EU could have on a fragile U.K./European economy.

The Vote: On Thursday, June 23, 2016, the citizens of the United Kingdom (which includes England, Northern Ireland, Scotland, and Wales) voted to leave the EU by a margin of 51.9% to 48.1%. More than 30 million people voted in the election. Of the constituents, England and Wales voted to leave while Scotland and Northern Ireland voted strongly to remain.

The Fallout: Stock markets around the globe were initially shocked to learn of the surprise decision by the U.K. to leave the EU. The strong market reaction was caused by two themes. Equity markets were caught off guard when the results were announced, as markets had moved towards pricing a “remain” vote in the days leading up to the election --- the result of short-term trading forecasts. More importantly, the markets traded lower as investors began to process the economic headwinds and fear a fractured EU could have on an already fragile global economy. Immediately after the results were announced, David Cameron announced his resignation as Prime Minister. Markets continue to seek a better understanding of the situation; however, it will be some time before clarity is provided.

Next Steps: The referendum vote was a gauge of the sentiment of the British people. The vote, in itself, does not mean that the U.K. is no longer part of the EU. The vote provided the British Parliament and leadership the authority to begin developing an exit strategy. The EU has specific rules and processes for a member nation to leave the Union. This is known as Article 50 of the Lisbon Treaty. Once Article 50 is invoked by the U.K., they will have a two year window to negotiate a withdrawal from the EU. Article 50 is relatively new and has not yet been tested. Therefore, this process will be new to both sides as it unfolds. For now, the U.K. continues to operate as it had before, as a member of the EU. Many pundits believe that the EU will be harsh during the negotiations with the U.K. to set a precedent that will prevent additional countries from seeking to leave the EU. Although investors would love to see immediate clarity provided on the future of the U.K. and the EU, we believe that the ultimate resolution will take time. The election of a new Prime Minister, the enactment of Article 50, and U.K./EU negotiations will be key points to a better understanding of what a post Brexit U.K. and EU system may look like. As part of the U.K. exit strategy, they will be faced with the challenge of not only negotiating the EU exit deals, but also setting up new trade agreements with dozens of countries, dealing with a declining currency, and reforming numerous laws that were previously covered under the EU. We believe there will be continued volatility as uncertainty remains prevalent in the EU and U.K.

Market Outlook for the Second Half of 2016

After the recent market volatility caused by the Brexit vote, the S&P 500 Index has gained 3.84% YTD, while the 10-year Treasury note yield has declined from 2.28% to 1.37% . Developed international equity markets, as measured by the MSCI EAFE Index are down 4.4% YTD and emerging markets, as measured by the MSCI Emerging Markets Index, are up 6.4% YTD.

We believe the risk for additional declines is much greater in Europe than in the United States, due to the Brexit decision. Although the U.K. is the world’s 5th largest economy (as measured by nominal GDP), exports to the U.K. make up only a small portion of the U.S. GDP. The greater risk comes from a slower European recovery and the uncertainty that this decision leaves in the market.

The United States continues to see moderate growth. The first quarter 2016, U.S. GDP was revised to 1.1% from an expected 1% today. The unemployment rate remains stable and low at 4.7% , while wage growth continues to remain tepid at around 2.5%. The impact from Brexit on the U.S. economy currently appears to be mixed.

• The global economic fear triggered by the U.K. decision drove investors to seek protection in safe haven assets such as U.S. Treasuries and the U.S. Dollar. The strengthening U.S. Dollar makes American goods and services more expensive for exports; however, it makes imports cheaper which also assists in keeping inflation low. Wage growth would also be impacted by lower inflation and weak exports. Goldman Sachs estimates that a 10% increase in the U.S. Dollar would shave about 0.6% off of current year GDP growth.
• Commodity prices should remain lower. After the Brexit decision, energy prices fell by about 5%. The lower energy prices should continue to provide a tailwind to the American consumer.
• Lower interest rates and the uncertainty of global growth, which has been a topic included in recent Federal Reserve statements, should give the Fed pause on additional rate hikes during 3Q 2016. Depending on how the global markets digest the progression of Brexit, the Fed may initiate one additional rate hike in 2016, although markets price the probability at about 18% .
• Global Risks: The U.K. could fall into a recession depending on how the exit strategy is handled and how tough the EU negotiations impact the Euro-zone during the process. A U.K. recession would also impact a European recovery. Any faltering by the broader EU economic region could then have a knock on effect for the U.S. The greater market risk would be the uncertainty of the future of the EU as a global entity if additional countries such as Spain, France and Italy choose to have similar referendum as the U.K. The structural integrity of the EU could then be brought into question, sending ripples through the global economy.
• We believe the emerging markets will continue to struggle as energy prices remain low, and the U.S. Dollar remains strong. Lower energy prices equates to lower revenues for many commodity dependent countries and a stronger USD equates to higher borrowing costs.

Overall, the U.S. consumer stands to potentially benefit from some of the recent events; however, the greater market fears may keep stock market appreciation low in the short-term. The economic indicators continue to point to a growing U.S. economy and one that should be resilient enough to withstand the market turmoil in Europe. Therefore, the potential volatility created by the Brexit may create opportunities both domestically and overseas which could be implemented through strategic rebalancing, rather than market timing, within a broader diversified investment plan.