Will Brexit Breakit?

British FlagThe last few months have been filled with debate over how the Brexit vote would end.  The markets have parroted this debate throughout the month of June with positive and negative swings leading up to last week’s vote.  On Thursday, words turned to action and the argument reached a crescendo when 52% of the British citizens participating in the historic referendum, cast their vote to leave the European Union (EU).  Much has been written and spoken since, about what this will mean to Britain and the world.  Which countries will remain in the European Union, what it will mean to global markets and more broadly, what is the long term future of economic globalization?  No one knows for sure how the next few weeks, months or years will evolve.  What history suggests are world equity and bond markets will be volatile as news on the economic impact sorts itself out. They (markets) will steady as facts become clearer.  Eventually, global markets will resume a more predictable pattern influenced more by traditional financial valuations and less by what seems to be a political statement made by the working middle class who are not necessarily benefiting from economic globalization.

The Vote

A 52% to 48% victory by those in favor of leaving the European Union is not what many would consider a resounding victory.  More telling is what happened within the percentages and the demographics of who voted to remain and leave.  London and Scotland voted to remain in the EU, Wales and the English shires voted to get out.  Approximately 70% of university graduates were in favor of the EU; an equally disproportionate 68% of those who hadn’t finished high school were against it.  Londoners and those under 30 were strongly for Remain; the northern English and those over 60 were strongly Leave.  70% of the skilled working class supported Brexit.[1]  While the 52% to 48% may be relatively narrow, the internal divide among the British citizenry is much wider.  The demographics seem to support what many acknowledge as the widening socioeconomic gap between the winners of globalization and its losers.

The Markets

Given the potential Britain’s exit from the EU had to create significant disruption, the global markets are behaving in a somewhat orderly fashion.  On Friday, the Dow Jones Industrial Average fell 3.4% while the S&P 500 dropped 3.6%.  Overseas, Britain’s FTSE 100 fell 3.1%, the Stoxx Europe 600 Index fell 7% and Japan’s Nikkei Stock Average declined 7.9%.  On Monday, except in Asia where most of the major indices were up, markets continued their slide.  The Dow dropped approximately 1.5%, the S&P 500 another 1.8%.  Britain’s FTSE 100 was off 2.5% and the Stoxx Europe 600 shed 4%.  Volatility will likely be the norm and investors should brace for the possibility of further declines.  Despite the drubbing, the markets remain higher than they were in February and some believe (Friday’s) declines may have been exacerbated by the expectation that Britain would remain.  Recognizing that volatility and declines are unsettling but in the spirit of maintaining perspective, consider whether the actual companies that make up the equity markets have done something to merit a drop of 5% or more.  Are the products of Procter & Gamble, GlaxoSmithKline or Nestle somehow less desirable than they were last Wednesday?  Assuming the answer is no, then it might be reasonable to expect that declines will be relatively short in duration and values will recover over time.

What’s on the Horizon?

Most believe the decision will have negative consequences for the British economy.  In relation to the US dollar, the Pound Sterling dropped just over 7.6% last Thursday and Friday.  The Bank of England will very likely keep liquidity high and interest rates low to offset anticipated inflation.  Average citizens however will likely pay more for goods and services.  This same drop in currency value may prove advantageous to British exporters because their goods will be less expensive in the global trade markets.

It is very unlikely that Britain will receive favorable exit terms from the remaining EU countries.  The EU’s immediate demand that England invoke Article 50 of the bloc’s governing treaty and withdraw quickly does not reconcile with the voids created by ruling Conservative Party resignations in key positions and squabbling within the opposition Labour Party and will make ongoing negotiations tense.  Exit terms will no doubt be a priority for the EU and will be used to motivate the populist parties in other European Union countries to reconsider any thoughts of exiting.  While possible, until exit terms are known, the domino effect is not highly probable.

In the United States, the UK’s decision to withdraw from the EU will likely cause the Federal Reserve to defer any planned summer rate hikes.  2nd quarter growth is predicted to be around 2.5% with a slight rise in inflation and represent steady signs of (slow) growth and improvement.  However, with little understanding about Brexit and its impact on global economies, look for the Fed to remain cautious and accommodative as they seek and study future economic data.  With respect to direct trade, British exporters will have a more competitive footing thanks to the Pound Sterling drop.  But imports and exports to the U.K. account for less than 5% of America’s total trade in goods and services so any drag on the trade balance should be slight.

The Bigger Picture

Jim Tankersley of the Washington Post wrote an informative article suggesting Brexit was part of a larger anti-globalization sentiment.  Among the many points he covered, he wrote, “The developments come at the hands of an anxious working class across the West, who feel left in the cold by many developments of the rapid integration of foreign products and people into their lives”.[2]  The driving forces of these populist uprisings in Europe and the U.S. (i.e. Trump supporters) are complex but the underlying thread seems to be a decline in the income share held by the broad middle class.  Global trade seems to have boosted incomes only for the poorest and the very richest workers in the world.  Outsourcing jobs and immigrants willing to work for significantly lower wages contributes to the anxiety.  What is becoming more clear and being voiced in political arenas is the realization that globalization comes with trade-offs.  Said differently, it is difficult to balance what is in the best interest of your electorate with the shared interests of the global community.

Markets and Portfolios

If Brexit is more populist uprising than economic meltdown, then markets should respond as they have historically and return to normalcy.  As mentioned earlier, have companies actually done anything to merit the loss of their underlying value?  The world will continue to require goods and services and companies will be there to fill these needs.  Trade alliances and global commerce may slow as politicians and trade representatives respond to current political influences but rest assured, Britain and countries all over the world want to do business with each other.  As typical with most geopolitical events and with the unexpected victory of the proponents to Leave, there are winners and losers.  Most portfolios, given heavier allocations to equities, will experience declines in times like these but the drops will be buoyed by fixed income.  Over time, a broadly diversified portfolio will show resilience in the face of future surprises and more immediately, temper the expected volatility that will ripple across markets as Britain and Europe come to terms and the rest of the global community learns what Brexit will mean.

[1] Wall Street Journal Saturday/Sunday, June 25-26, 2016

[2] Britain Just Killed Globalization as We Know It; Jim Tankersley, Washington Post