June 22, 2016


We must confess we hadn’t planned to write about the UK. Like most, we had expected that sanity would prevail at the 11th hour given countries rarely commit economic suicide. However as at Saturday afternoon the “Brexit” vote has won the day, Cameron has resigned, and most of the World (including the UK) is wondering what it all means.

  • The UK “Leave or Remain” referendum was won 52/48 by the “Leave” vote.
  • Whilst not constitutionally binding, it can reasonably be expected that whoever comes to power will accede to the wishes of the majority of the (voting) populace and commence divorce proceedings with the EU.
  • This involves invoking the relatively new “Article 50” of European law which has a two year deadline. Its execution will likely involve significant complexity.
  • Economists generally believe the decision will weaken the British and European by reducing and restricting trade between the UK and EU (given Britain both imports and exports a significant amount of its economic consumption and production, respectively, to continental Europe).
  • London faces a large-scale exodus as it loses “passporting” access to the EU single market.
  • Standard & Poors have already announced that they will likely lose their AA rating which will increase borrowing costs.

What are the primary concerns?

Possibility of Recession
The overwhelming view in economic circles is that the uncertainty alone has the potential to thrust the UK into a recession of both GDP (2 negative quarters) and stock market (down 20%) varieties.

The rise of Dissent
Although a cursory check of the history books suggests populism is a relatively common post-crisis manifestation this current wave is somewhat alarming. This particular referendum (only the third one UK-wide in history) was ostensibly an immigration question and was essentially class warfare. From the anarchists in the Greek Syriza party to the extraordinary rise of Trump to UKIP’s blinkered NIMBYism – it’s a cheap vote to convince people that their pain is someone else’s fault: Core Europeans, Mexicans, migrants. Sadly though, it’s a vote nonetheless. Witness the spike on Google in the UK today for “What is the EU?” My guess is that they are predominantly “Leave” voters as the “Remainers” know the answer. Horse, barn door, bolted.

Difficult Negotiations Ahead with the EU
Should the Brits follow through with leaving (which seems likely) they will be forced to negotiate bilateral trade deals such as Norway and Switzerland have done. However, these negotiations may be challenging as one suspects the continental Europeans, still smarting from a slap in the face, will be formidable negotiators especially when we consider the potential domino effect of others who may wish to leave the EU (Greece, The Netherlands etc).

Possible Break-Up of the UK
Both Scotland and Northern Ireland were resounding “Remain” results, which places the UK as we know it on fairly shaky ground. Indeed, there are already suggestions that the Scots (who were 2/3rds in favour of remaining with the EU) will once again move to a referendum on whether or not to seek independence from the UK.

And what of Gibraltar, that  rocky tax haven with a population the size of Dubbo? Given its military strategic importance is without question and that Spain want it back (referendums defeated in 1967 and 2002) the Gibraltans voted 96% in favour of “Remain”. The Spanish have already called for joint control post Brexit. What comes next here is unclear…

No Credible Post-Brexit Plan
Worryingly, none of the Brexiteers have yet mapped out a credible plan for the disentanglement of the UK from the EU.

The British elite lament that the UK has been undeniably better off as a consequence of having joined the EU in 1973. They suggest the “Leave” campaign was full of misinformation and that the EU treaties were always for the betterment of pan-Europe, both economically and geopolitically.

One thing is certain, those treaties  took years and sometimes decades to construct and the UK has thrown them away in what is being seen by many as a “day of madness”.

How have markets reacted?
At the time of this writing, stock markets have fallen precipitously (Australia down 3%) and bond interest rates have dropped as well. With the exception of precious metals, commodity markets are also generally down, and the British pound has dropped by about 8% against the U.S. dollar.

Why have markets reacted so violently?
Without question, the primary reason is that markets had incorporated a belief that Britain would remain in the EU. Stock markets had been up significantly over the last couple of weeks, and interest rates had started to move back up after being lower earlier in the month. These movements were generally believed to be an indication that the market expected Britain would remain in the EU.

Because the vote did not go as most expected, stock markets are giving back those gains and more, and interest rates are now falling instead of increasing. We emphasize, though, that while these moves have been swift, this is normal market behaviour when a significant event (like Britain leaving the EU) turns out differently than what the market had anticipated.

Why has the Australian market reacted so strongly to Britain’s decision?
We truly live in an interconnected, global economy at this point. Any decision by an economy that is the size of Britain’s (fifth largest in the world) will impact markets elsewhere, including the Australian market. The European market is a significant trading partner for many Australian firms, so it’s not surprising to see Aussie stocks decline since Britain’s decision is thought to be a net negative for Europe from an economic perspective.

Will Britain’s decision precipitate a global recession?
It’s impossible to say whether we are headed toward a recession, but Britain’s decision likely increased the likelihood of a recession in the UK or elsewhere. However, the strong caveat here is that markets are forward looking and have already started to incorporate this likelihood, meaning you can’t use this information to your advantage. This increased likelihood of recession is no doubt one of the reasons that stock markets have moved down sharply while bond prices have moved up sharply.

How did markets get this wrong?
While outguessing markets is difficult, in hindsight markets will always appear to have been overly optimistic or pessimistic, which means it’s easy to critique them while looking in the rear view mirror. This particular vote was expected to be close, so markets weren’t certain but were tending toward a “remain” vote.

What will markets do from here?
While it’s very difficult to predict markets, it is highly likely markets will be volatile for some time to come. Stock market volatility has been relatively low over the last few years, but it can change quickly. The VIX, which is a measure of annualized stock market volatility, has gone from about 17 percent to 25 percent in reaction to the news, which is higher than the long-term average of about 20 percent per year.

It is important to remember, however, that higher volatility can work in both directions. While we could certainly see more days when stocks fall significantly, it’s also possible we will have days when they rise significantly.

What should I do with my own portfolio?
Our guidance is the same that it has always been. If you have built a well-thought-out investment plan that incorporates your ability, willingness and need to take risk, you should not change your plan in reaction to market events. Doing so rarely leads to productive results.

Your plan incorporates the certainty that we will go through periods of negative market returns, and market reactions like this are also the primary reason we emphasize high quality bond funds and bond portfolios, which help buffer the risk of stocks. The early read on this bond approach is that it’s doing exactly what we expect it to since high quality bonds have appreciated significantly in reaction to the Brexit vote.

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