Brexit (British Exit of the Eurozone) And You

Although we sent something out this past Friday, the events of Brexit are so dramatic that another more in depth discussion is warranted. In general, your portfolios are behaving as we expected and the surprise Brexit vote will not create a liquidity or banking crisis similar to the collapse of Lehman Brothers in 2008.

We are witnessing seismic volatility in the stock market around the world concerning the British vote to exit the Eurozone (EU). As you have probably read, 17.4 million Brits voted to leave the EU and 16.1 million wanted to stay. The vote had a lot to do with nationalism, anti-immigration sentiment in Britain and dissatisfaction with David Cameron in his own party. The vote was approximately 52% to leave and 48% to stay. Not what I would call a mandate!

The immediate effect of the vote is that the British economy is thought to slow from 2.1% growth to 0.9%. The slowdown has little to do with Brexit directly and more to do with the uncertainty surrounding the vote which is causing British consumers to pause in their spending and British companies to delay capital spending. As a result, the pound has decreased in value while Gold, the US dollar and sovereign bonds belonging to Japan and the US rose!

For the next few months, nothing will really happen. Britain will not leave the EU yet (the referendum was non-binding and David Cameron the British prime minister said he will do nothing about Brexit and leave it to his successor). Even when Brexit occurs, Britain will continue to trade with the EU (their biggest trading partner). The British economy is closer to the US economy in that it is driven more by the consumption from the British, than exports such as China or even Germany and Japan.

Once a new British government is formed, there may be a vote to use an article (50) in the EU agreement to start the exit process which gives Britain 2 years to exit. In the meantime the British government will have to rewrite treaties with the EU. Except for giving work to scribers and bureaucrats there is not much difference to the terms Britain will have with the EU. Great Britain represents the 2nd largest economy in Europe after Germany and the EU needs the trade agreements with Great Britain as much as Great Britain needs them with the EU.

On the political side we may be seeing the dismantling of Great Britain. The Brexit vote will most certainly embolden the Scottish separatist movement which narrowly voted to remain as part of Great Britain in 2014. Scotland overwhelmingly voted to stay in the EU. Furthermore, Northern Ireland has a dilemma. Ireland is in the EU, Northern Ireland voted to stay in the EU overwhelmingly and the idea of border guards separating Ireland from Northern Ireland may easily revive Irish unity passions.

For Europe, the uncertainty may sew more uncertainty. Greece, Italy, the Netherlands and France may want to leave the EU. Almost all of this related to internal political maneuvering. The major effect of all this coming and going is that trading costs between current and former EU members will increase and the importance of the EU members sitting in Brussels may diminish. Beyond that not much will change. The lack of a coordinated economic policy that could be easily enforced on member states resulted in the anger that has fueled the exit movement. What will happen probably depends upon how smoothly the British exit occurs. But that won’t stop the rhetoric as many groups desire to take advantage of the current state of uncertainty.

All of this uncertainty is fueling another round of European Central Bank quantitative easing. It also means that the Federal Reserve will probably not raise interest rates for 2016. If the markets continue to slide, Quantitative Easing round 4 may be initiated.
What does this mean for your investment portfolio? First, interest rates around the world have dropped and may drop lower. So fixed income securities will continue to provide almost no income and should be purchased for safety purposes. Second, the US economy has minimal exposure to the disruptions that Brexit represents as our exports approximate 13% of our country’s GDP.

Third, the S&P 500 has exposure to overseas earnings of 40% but the entire stock market’s exposure is closer to 30% and not all of that is Europe. This volatility is an overreaction to the unexpected vote and uncertainty as to how smoothly Britain’s disentanglement from the EU will be. With all of these uncertainties it is prudent to be cautious. For investors willing to assume more risk investing in the US economy is a good idea. Investing in Europe or Great Britain is a bit too soon as the real cost to their economies and equity markets is in the details of Great Britain’s departure which is currently unknown.

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