Unless you had trouble sleeping last night and were up watching TV, you would have awoke this morning to find that the UK voted to leave the EU and that Prime Minister Cameron had announced he would resign once a new PM is chosen. While the vote was expected to be close, no one can argue that the vote to “Leave” was a surprise. Markets across the world were discounting a “Remain” vote and, as such, the markets tonight and this morning are reacting in line with the uncertainty that the leave vote creates in the UK and the rest of the world. As noted in our recent piece on Brexit, a UK vote to depart the EU not only impacts the commercial enterprise of the UK and all of its trading partners, but also impacts the geographic borders of the UK and will ultimately cause a halt to immigration. The subsequent impact on the rest of the EU is in question. Also as noted in our Brexit note, the UK leaving the EU may cause other EU members to consider leaving as well, especially the stronger members that will be required to make up the UK’s share of “EU dues” that will no longer be forthcoming.
The UK’s vote to leave the European Union (EU) has clearly weakened the near-term outlook for the UK and global economies. However, we think that the issue will ultimately prove to be less damaging than many estimates have suggested. In the meantime, the market response to the outcome has been predictably negative, with the pound dropping overnight to a 30-year low of $1.34, which has subsequently stabilized at about $1.37. It is important to note that there were some analysts that had predicted a drop to $1.20, so the reaction has been less severe than some expected. The outcome clearly creates considerable short-term uncertainty which is likely to weigh on the UK economy in the coming quarters. Business confidence will presumably drop sharply and will likely be volatile as the situation unfolds over the next weeks and months. It will be imperative for UK leadership to stabilize the political and economic circumstance and quickly select a new governing party and leader.
The decline in the British Pound will serve the UK well as their goods and services will be more attractively priced. This will likely prevent the UK market from falling completely out of bed. While all of the European markets are down, the UK market is still above the February lows. It is important to remember that this referendum is not an act of law, but rather a vote expressing the wishes of the British people. However, the vote was so close that there will likely be demands for recounts, disputed interpretations, etc. Moreover, the UK will remain inside the EU for at least two years and possibly longer, all of which depends on negotiations between the UK and the EU leadership in Brussels. The protocol for an EU exit is very specific and it is likely that the EU will be very, very tough on the UK, if for no other reason than to discourage other members from initiating similar referenda. However, the EU project with a common currency, but disparate financial cultures, policies and controls among the sovereign members has been a very difficult puzzle to solve. This issue has become more acute in the post-financial crisis world and is trending in the wrong direction.
As expected, EU uncertainty has weakened the Euro and the safe haven currencies such as the Yen and USD have risen in value. The increase in the Yen creates further problems for Japan as the strengthening Yen makes their goods and services more expensive at a time when they can least afford a headwind to growth. This event will obviously cause the Yellen Fed to put off any rate hikes for the foreseeable future, regardless of any lip service they may pay. 10-year sovereign yields are down across the board with Japan at -20 bps, Germany at -5 bps, UK at 108 bps and the US 10-year at 1.57%. Our expectation is for yields to move lower as central banks will continue to believe they can “fix” the problem with more monetary easing. This event will also test the pricing and liquidity of the markets. The market’s initial reaction to Brexit has been a sharp drop down, but all things being equal, the down leg has been relatively orderly. While the US market is off sharply today, it remains nearly 12% above the February lows. It is important to note that the uncertainty of the Brexit vote prior to today has now been replaced by the uncertainty of how remaining EU members and the rest of the world will be impacted by this decision.
Globalization has done much to promote the top and bottom line of global companies, but one of the unintended consequences of globalization is the impact it has on the middle class of developed countries. Jobs and opportunities find their way to countries that offer the lowest cost employment, which in recent years as been in emerging countries like Mexico, China and Vietnam. As a result, middle class workers of developed countries have become increasingly less willing to live with the status quo. Developed country populations are expressing themselves with their voices and their votes, which is manifested in our own political climate. We suspect that this dynamic will continue.
The current economic and political landscape across the globe has been fragile and subject to surprise such as we saw last night in Britain. It is for this reason that we have been and remain cautious and defensive in our portfolio positioning. As always, we appreciate your confidence expressed in your continued partnership with us and welcome your questions, comments, and insights at anytime.