Excerpt of letter sent to CMG clients Friday on Brexit:
While it would be foolhardy to predict the details of what happens after the United Kingdom voted to leave the European Union, we wanted to address the potential impact of this unprecedented and historic vote. With global valuations already stretched and growth tepid and declining, the amount of uncertainty that the vote has brought into the market can have a significant impact and knock-on effect on financial markets and global politics. Below are our insights on what may come next.
Economic and Financial
The impact on financial markets has been startling. Currency markets have exhibited volatility not seen since the financial crisis and the collapse of Lehman Brothers. The British Pound has seen its largest one day drop ever and has hit its lowest level since 1985 against the dollar. European financial markets are down across the board, the Euro has weakened, the Yen and Dollar are higher against most global currencies and the Swiss central bank has intervened to prevent further appreciation in the Swiss Franc. The safety trade is on with U.S. Treasury bonds up sharply. Below are our thoughts on what may happen next:
- The Fed and US Interest Rates: The likelihood of a rate hike in September has declined precipitously and there are now predictions of a potential rate cut. As a result of the vote and the upcoming US election, it now appears highly probable that the Fed does not cut rates at all this year and bond yields are likely to remain lower for longer as a result. We remain in the rates will remain lower for longer camp.
- Risk of Recession: The UK is likely to fall into a recession and the risk of a US and global recession has increased. The EU accounts for approximately 50% of UK exports. We don’t see how this decision helps UK growth over the next several years while the UK and EU negotiate an exit. The big questions surround the UK’s status with respect to the EU common market and how subsequent trade agreements will be negotiated as well as the free movement of people (Norway can serve as a template). Further, the EU and specifically Germany loses a liberal economic ally and will now have less support for free market initiatives in the EU. Longer term, the UK is a major player in the world economy. They will negotiate, compete and do well.
- Greater Volatility: Much like the uncertainty surrounding Grexit over the past several years, we will likely see heightened levels of volatility in ebbs and flows for some time as details regarding Brexit are negotiated.
- This event is a major stress test on unconventional central bank policy.
- United Kingdom: Today, United Kingdom looks a lot less “united.” Prime Minister David Cameron, who just last year secured the first Tory majority in 23 years, announced he intends to resign in October, a staggering defeat. Later this year, voters will determine who will lead the transition out of the EU. No one has any idea of who that person will be. Scotland is considering another vote to leave the UK in order to stay in the EU and there has been a call in Northern Ireland to leave the UK. In fact, the majority of votes to remain in the EU came from voters in Scotland, Northern Ireland and London. A UK without Scotland and Northern Ireland is a weaker UK.
- EU: In the short term, populist, anti-EU politicians stand to gain. Spain is set to have elections on Sunday and their two party system is likely to fragment while smaller parties gain power. It is not unreasonable to expect ideologically Eurosceptic candidates to harness the Brexit vote to stir voters. Immigration and the refugee crisis were key motivating factors for voters in the UK. Greek and Italian citizens will also be watching closely to see if the UK benefits from the exit. Longer term, if the impact of Brexit is negative for the UK, the EU could actually become stronger and more motivated to integrate if other member countries see what they stand to lose. Conversely, if the UK does well, it could spur other countries to consider their options. Politicians campaigning to leave the EU have promised voters control over immigration and a stronger economy. Now they have to deliver. Easier said than done.
- NATO and Russia: A fragmented EU will make discussions within NATO more difficult. It will be essential for the US, the EU and the UK to work constructively to insure that the NATO alliance is not weakened. Anytime European institutions are weakened, Putin and Russia stand to benefit. We believe they stay united.
For the rest of the commentary and this week’s market sentiment analysis see Steve Blumenthal’s: On My Radar: Brexit!