The British electorate has given its verdict on the UK’s membership of the European Union in no uncertain terms. In spite of the more emotional appeals to the contrary, this is not a disaster. On this extraordinary day, it is worth remembering that on the 20 February 2016, when David Cameron announced that the EU referendum would take place, the FTSE 100 index was at 5950, the 10 year Gilt yield stood at 1.41% and the sterling / dollar exchange rate was 1.44. At lunch time on Friday June 24 the FTSE 100 is trading at 6060, the 10 year gilt yield is 1.07% and the dollar exchange rate is 1.37. On the face of these numbers you could be forgiven for not knowing what has taken place in the past 24 hours!
In my judgement the financial system is capable of absorbing this shock, but investment portfolios will certainly not be immune from some impact. A period of heightened volatility is inevitable until the politics of the separation process become clearer. Weak sterling will benefit the UK stock market due to companies earning most of their profits from abroad. Volatility will throw up a number of attractive opportunities and we expect to be able to purchase high quality companies with solid dividends at good prices.
In the midst of the maelstrom, two factors suggest that the turbulence may pass sooner rather than later. First, growth fears should not be overblown. The UK will suffer a hit, but with governments and central banks standing by to provide support, the immediate impact in Europe should be relatively small. With the US economy still delivering solid performance and the Developing world stabilising, the picture for global growth should not change very much. More crucially, since its weaknesses were exposed in 2007, the World’s financial system has built-up its capital reserves and it is now well braced for trouble. The suppliers of capital (banks) are not overextended, the users of capital (investors) are not complacent and the world’s financial fire-fighters (the central banks) are fully engaged in ensuring that any sparks of fear are rapidly doused with liquidity. In this context the potential for a single adverse event (such as Brexit) to have a domino effect is low.
I strongly believe that in many ways the vote will not be as negative on markets as implied by many commentators, politicians and remain campaigners. For a start Central Bankers are likely to respond to the vote by supporting markets; the Federal Reserve in the US is likely to delay any rise in interest rates further, whilst Central Banks in the UK, Eurozone and Japan are likely to increase intervention in order to prevent a “Lehman” moment. Yesterday’s vote could be a key event on the road to a much needed loosening in fiscal policy in Europe as politicians work to prevent a European recession (the vote may even accelerate beneficial wider EU reform). In essence I believe that the world need not enter a self-inflicted recession on the back of this vote.
Once Article 50 is evoked there are two years to renegotiate the UK’s relationship with the EU. It will be in everyone’s interests to do so sensibly and, as an economic powerhouse, the UK will have a good bargaining hand. It must not be forgotten that Britain with an open economy, strong rule of law, a functioning democracy, good education, the historic benefit of having English as our mother tongue and fundamentally pro-business policies that reward hard work, over the medium term the UK will certainly prosper. Any asset price falls combined with a weakening in sterling will make UK assets very attractive to foreign investors. Let us also not forget that the UK stock market is one of the highest yielding in the world in an environment where yield is increasingly hard to find. It is for these reasons that I do not fear the future and am quietly optimistic about the future.
Some of the issues explained:
- Article 50 is the part of the Lisbon treaty which, once evoked, sets in motion a two-year process in which a member state can notify the EU council of its decision to leave. The decision to trigger Article 50 is a decision for the Prime Minister and the Cabinet and, once triggered, results in the UK’s ejection from the EU at the end of the two year period (unless the rest of the EU unanimously decides to extend the negotiations). In that time there is no change as the UK still votes on EU policy (& the time frame could be extended if it’s agreed by all EU member state, the UK’s membership of the EU continues on the current terms while the European Council will negotiate with the UK on tariffs/quotas/free movement etc.
- There’s an outside chance of a renegotiation of terms despite comments to the contrary in recent weeks by both Leave and Remain campaigns. Jean-Claude Juncker also made similar comments earlier this week (warning that ‘out is out’ and that the UK won’t be able to negotiate a better/different deal than the one already agreed by Cameron earlier this year). Despite that, though, it’s possible that Cameron, before leaving, attempts to re-open discussions (albeit this is not our central case expectation). Boris Johnson has also emphasised this possibility.
- The UK economy: There’s potential for uncertainty to dampen consumer & business confidence (and to delay business/capex decisions). There has already been some softening of confidence and investment spending data in recent months/quarters (e.g. see FIG 3). Given that there’s likely to be increased stimulus from central banks with no change in the UK’s EU relationship for two years, we expect the downside in the economy to be less significant than the widely touted central bank case of Treasury/OECD/IMF and so on. Growth may just stagnate near term.