In our Q2 2016 Quarterly Outlook, we highlighted the potential negative impact on the global economy if the UK elected to no longer be a member of the European Union (EU). In an outcome that surprised the markets and pundits both, British voters voted yesterday to exit the EU, albeit by a slim margin (52% to 48%).
This is a historic event as no nation has ever exited the EU. The uncertainty and fear caused by such an unprecedented event — combined with the size of the UK and the EU economies — has led to the dramatic repricing of risk globally as evidenced by plummeting stocks this morning. Following is an excerpt from an email we sent to LNWM clients earlier today about what Brexit is likely to mean.
What Brexit Means
Because the vote for “Brexit” caught the markets by surprise, near-term reaction has been intensified as investors unwind trades placed with the expectation that Britain would remain in the EU, and the market begins to price in the uncertainty of exit negotiations, which will potentially persist for years. Exiting the EU is not a point in time but rather a drawn-out, uncertain process.
The ‘leave’ victory has two key long-term results, in our view:
1) There will be a period of economic and political uncertainty in the UK and Europe (British Prime Minister Cameron has already resigned).
2) The potential for further European disintegration as peripheral countries debate and reconsider their independence from the EU.
We believe Brexit will have an impact on global growth, with some economists predicting a 1% to 3% hit to economic growth in the UK and a bit less of an impact in Europe and globally. In an already fragile global economic environment, any uncertainty and decline in expected growth rates will surely be accompanied by an increase in market volatility.
While near-term reaction to Brexit is likely to overshoot to the downside, we believe the longer-term impact will be limited. In fact, UK and European leaders have already indicated commitments to continued strong relations between Europe and the UK. Nonetheless, markets are certainly likely to begin pricing the potential for other countries to exit the EU.
We view Brexit not as an economic crisis but rather a political one, and we remain steadfast in our view that central banks will continue to be supportive of economic growth and will do what is necessary to limit the negative impacts of Brexit.
While we do expect market volatility to increase due to Brexit, we don’t view Brexit as a reason to change any of our fundamental strategies and portfolio positions. Rather, we think opportunities could arise from recent market overreactions.
Going forward, we will be focusing on the strength of the dollar relative to major foreign currencies. In response to Brexit, the US dollar has gained dramatically vs. the British pound and not so much against the euro (only by 2% to 3%). We believe the Fed is very cognizant of the negative effects of US dollar strength. The combination of a Brexit-driven rally in the dollar and downward revisions in economic growth estimates is likely to cause the Fed to reconsider the trajectory of future interest rate hikes. US dollar strength also affects US corporate profits, which we continue to monitor closely.
Regarding fixed income, the Brexit decision is likely to push bond yields lower, although we think the initial move down is overdone. We are re-assessing how much US interest rates can rise from here, mostly due to economic growth estimates coming down and less due to lower inflation expectations (although the two are related).