June 27, 2016

Brexit: Domino or Distress Signal?

The result of the Brexit referendum took global markets by surprise, despite polls suggesting it was a distinct possibility. On Thursday, June 23, a high turnout of British voters (72%) voted 52% to 48% for Britain to leave the European Union (EU). In addition, David Cameron’s announcement of resignation sent shockwaves out, leaving Britain with a double-dose of uncertainty.

While this vote marks only the beginning of a long process, global markets reacted strongly to the news. Investors fled to “safer havens” like the yen, dollar, and gold. The pound dropped to a 30-year low against the dollar, briefly falling to as low as $1.32, and oil fell sharply. Short-term volatility is likely to happen and widely anticipated as the markets respond to this crisis, but what will the medium and longer-term impacts be?

The process of Britain’s exit, along with its future leadership, is uncertain, and the country will undoubtedly experience some difficulties as it untangles itself from the EU, which could take a very long time. Recession in Britain is very possible; although Britain accounts for only 3.9% of the world’s output, many large global companies are based there, which may cause an economic ripple effect. The Economist suggests that “as a rule of thumb, whatever the reduction in Britain’s GDP growth, Europe’s economy will suffer a drop of about half as much.”1

For financial markets, the Brexit storm may come with a silver lining, as central banks may intensify their monetary stimulus. For example, the Bank of England has already begun to signal that it may lower interest rates or even revive its quantitative easing program. Such stimulus, if widely applied, could lead to a rebound in asset prices and a resurgence of economic growth.

Longer-term, the biggest question is whether the Brexit will be the first domino to topple the progress of globalization, with other European countries following suit. Certainly, the Brexit referendum is encouraging to nationalist and protectionist factions. There is already talk of which comes next: the Frexit or the Grexit. Risks to the future of the EU may spell significant challenges ahead. (Read more in Tony Arnerich’s June 20 blog post, Brexit, Schmexit, here.) On the other hand, the Brexit could act as a wake-up call to European leadership, both within Britain and in the rest of Europe. The message of dissatisfaction has become impossible to ignore, and could launch a new effort to strengthen the European economies and governing structures, as well as to improve global trade agreements. In other words, this could be the distress signal that helps global economies avoid a geopolitical iceberg.

The full implications of the Brexit will not be known for some time. The vote does not initiate the actual parting from the EU; most likely, the withdrawal will require invoking Article 50 of the Lisbon Treaty, which launches a two-year time frame for negotiations. We believe short-term market reactions are inevitable but likely to settle out, and will continue to look ahead at the longer-term economic impacts and what that means for investors.

British flag

1 “Why Brexit is grim news for the world economy,” The Economist; June 24, 2016