In a shock to global financial markets, the citizens of the UK have voted to leave the European Union (EU) by a margin of 52% to 48%.
This is a momentous decision that appeared unthinkable on the eve of the vote.
Economists are attempting to determine the long-term implications of the Brexit vote for the UK and EU economies. It is impossible to quantify at this point, as much will depend on whether the negotiations between the UK and the EU are amicable or contentious. Under Article 50 of the EU Treaty, Britain has two years to negotiate the terms of its exit from the EU, though many analysts believe it will take much longer. That task will fall to the next Prime Minister, as current Prime Minister David Cameron has announced his resignation and expects to be gone by October.
What’s playing out quickly is the reaction to the referendum.
What Investors Need to Know
Here are the four things that investors need to know:
- While the unthinkable has happened, we do not believe this will result in a financial crisis akin to 2008. The financial crisis of 2008 was driven by a massive and widespread deleveraging process that began with the U.S. consumer and extended to the global banking system. There is simply not enough leverage in the global financial system for that to transpire.
- The Brexit vote increases the possibility of a global recession. We have said for some time that a policy mistake in a slow growth, deflationary world would be particularly damaging. The early 2016 economic slowdown and market correction provides an appropriate framework in considering how a policy action proved disruptive to the global economy. By raising interest rates and diverging U.S. monetary policy from that of the rest of the world, the Federal Reserve’s actions strengthened the U.S. dollar and sparked a chain reaction of unintended consequences: capital outflows from emerging markets, lower oil prices, wider high yield spreads, concerns about risk to the global banking system, and ultimately fears of a looming global recession. That transpired over the span of many months. A similar phenomenon is now likely to play out in a matter of days as investors seek the perceived safe haven of U.S.-dollar denominated assets. Once again the yield curve is flattening and corporate borrowing costs are rising. The strong dollar will again prove a headwind to U.S. exports and corporate profitability.
- Make no mistake: This is a shot directly at the globalization boat. Every international market is perceived to be riskier and investors now require a higher risk premium to be exposed to international markets and currencies.
- The global economy is now back to where it was in 2010 and 2011, when we were debating the efficacy and sustainability of the European Union, the Eurozone and its common currency. Ultimately, we believe that much like European Central Bank President Mario Draghi’s response to the 2011 crisis, when he decided to do whatever it would take to save the euro, central banks will do whatever is necessary to limit the fallout from the Brexit referendum and provide support to the global economy.
As always, volatility in markets ultimately creates buying opportunities and already we are seeing extreme divergences in the performance of certain sectors, industries and companies. All told, investors should expect volatility to persist and returns to be weaker as markets deal with this uncertainty.
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