Why U.S. Investors Should Keep A Close Eye On Brexit

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Includes: EPS, FILL, GNAT, IPW, IVV, IXC, LLSP, RSP, RWL, RYARX, SDS, SFLA, SH, SPLX, SPUU, SPXL, SPXS, SPXU, SPY, SSO, SZC, UPRO, VFINX, VOO
by: Nick Cox

Summary

Uncertainty is the enemy of stock markets everywhere.

U.S. corporations have substantial investments in the U.K. as well as in Mainland Europe.

Brexit would be negative for stocks and for sterling short term; in the long term, it is hard to gauge.

Investors should check importance of European revenues for specific U.S. corporations.

The most likely consequence of the U.K.'s referendum on June 23rd on leaving the EU, the so-called "Brexit", is still that the people of the U.K. will vote to remain in the EU.

This is by no means certain, though, and opinion polls have tightened recently. Uncertainty is what stock markets hate more than anything else. A recent article on Seeking Alpha advised stock investors to keep a close eye on the stock market consequences of developments in the U.S. election, especially the Party conventions.

While that is true, I believe the Brexit issue could be more critical for investors. The U.S. election looks more and more like a shoe-in for Hilary Clinton. Regarding Brexit, political and economic consequences could be highly relevant for U.S. investors. This applies not just to the U.K. economy but to the wider EU countries and their knock-on effects on U.S. corporations. The importance of this for the U.S. can be seen in the recent comments on the matter by President Obama, expected to be repeated when he visits the U.K. this week.

The Banks & the U.K.

U.S. banks are apparently especially concerned over the issue. Some have made financial contributions to the "Stay in Europe" campaign. These reportedly include Goldman Sachs (NYSE:GS), JPMorgan Chase (NYSE:JPM) and Morgan Stanley (NYSE:MS). Bank of America (NYSE:BAC) has warned that 9% of U.S. companies' global foreign affiliate profit emanates from the U.K. Only the Netherlands is higher, and that is for tax reasons.

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The bank has pointed out that U.S. corporate investment directly in the U.K. now amounts to about US$588 billion. That is more than double what's invested in South America, the Middle East and Africa combined.

U.S. investment banks have invested heavily in London, especially Goldman Sachs. 90% of its European staff are located in London. Their derivatives and currency trading business there would be especially at risk if Britain were to leave the EU. There seems little doubt that the value of sterling (already in a decline) would fall further. So U.S. companies such as the big investment banks in London would see remitted profits decline in U.S. dollar terms.

The banking business in the U.K. might be further hit by domestic financial instability. The country is already running a record current account deficit of 7% of GDP. This is being financed by capital inflows, which would reduce with Brexit.

Within the U.K., sectors seen as being worst affected would be manufacturing in general and autos in particular. BMW (BAMXY) has already warned about its Rolls-Royce operations in the country.

While the general effect on the U.K. economy is hard to quantify exactly, there is general consensus that it would be negative. The forecasts in the graph below quoted by "The Economist" magazine show this.

Of course, it should be borne in mind that the strong pro-Brexit campaigners do not agree with the idea that Brexit would be bad for the economy. Only time would tell, but what seems clear is that the financial markets would in the short term take a very negative view of the U.K. leaving the E.U.

Effects on the E.U.

A report by Global Counsel reckoned that the European countries most at risk from Brexit are the Netherlands, Ireland and Cyprus. Ireland's economy is particularly aligned with the U.K. for geographical and historic reasons. It is also involved in much of the "tax inversion" strategies that have been so contentious in the U.S. recently.

Apart from specific European economies, the general erosion of business confidence in Europe is the biggest risk. Already investment in Europe is well below trend, and any new projects are likely at best to be delayed.

The biggest knock-on effect of all, though, is the possibility that other countries might follow suit. The Front National in France, the Alternative Fur Deutschland in Germany and the Cinque Stelle movement in Italy are all parties who might call for such actions. Europe, the world's largest economic grouping, would be likely to be more protectionist.

A report from the Bertlesmann Foundation reckoned Brexit would lead to German GDP declining from 0.3% to 2% below what it would have been without Brexit. The range of decline they forecast can be taken, I think, as showing how difficult it is for economic forecasters really to calculate how serious the consequences might be.

One specific industry in Europe seen to suffer is the tourism sector. 76% of U.K. holidays abroad are in E.U. countries and these amounted to 29.3 million in 2014. The fall in sterling and the likely increased costs of package holidays would hit the European tourism sector quite hard.

A Vox-CEPR Policy Portal paper sees the effect of a Brexit as being worse for the U.K. than for Europe. This is because U.K. trade is a far smaller share of GDP for the E.U. than E.U. trade is for the U.K. Most European countries run a trade surplus with the U.K. but a deficit in services. The paper sees a decline in trade growth in Europe as a consequence. It sees manufacturing in Central and Eastern Europe being especially hard hit, along with tourism. On the positive side for Europe, it sees the E.U. benefiting from new investment flows going to E.U. countries rather than to the U.K. That would only have an effect in the long term, though.

According to E.U. figures, merchandise trade between the E.U. and the U.S. amounted to over US$700 billion in 2014. There is almost US$5 trillion in total commercial sales between the two each year. So problems in Europe will have a knock-on effect on the U.S. economy as a whole, not just on U.S. firms investing in Europe.

In the last 15 years, the U.K. received 15% of all foreign direct investment into the E.U. So quite a lot of this might migrate to E.U. countries in the long term.

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As the above chart shows, though, U.K. investment in Europe is also quite substantial, and this would definitely decline in the case of Brexit.

Conclusion

If Brexit occurs, the IMF has predicted this would lead to long drawn-out negotiations for the two years that has been ear-marked for such a process. This would lead to loss of confidence, disrupted trade patterns and lack of investment. It would lead to greatly increased financial volatility. However, the IMF's Christine Lagarde did recently admit that they are uncertain of many of the effects of Brexit and its ramifications for Europe and for the world economy.

It might also lead to political volatility, and the likelihood that Scotland would demand a referendum to leave the U.K. and stay in the E.U. The U.K. would want to negotiate to continue to enjoy free trade with Europe, but this would conflict with the E.U.'s "free movement of persons" agenda.

The biggest negative both before and after the Brexit vote is uncertainty. This makes both U.K. equities and sterling very uncertain bets at the moment. Sterling has already been in decline against the U.S. dollar in recent years. The chart below illustrates how this has accentuated in the past year.

It is not just against the dollar that sterling has declined. It has fallen 12% against the euro since November. Investment bank Nomura recently predicted that sterling would fall by a further 10% to 15% in the event of Brexit.

So U.S. investors might want to look at their portfolios and take evasive action in case Brexit occurs, or take positive action if they are confident Brexit will not occur. In general, S&P 500 companies have limited exposure to Europe, as the chart below illustrates.

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On average, these companies get 12% of their revenues from Europe, but of course, some get a lot more than this. Investments at risk focus around U.S. companies with large interests, particularly in the U.K. but also in Europe. ETFs focusing on Europe are at particular risk.

Many famous U.S. consumer goods companies have wide exposure to Europe. These include Nike (NYSE:NKE), Coca-Cola (NYSE:CCE), McDonald's (NYSE:MCD), Priceline (NASDAQ:PCLN) and Philip Morris (NYSE:PM). For large scale manufacturers, risks would seem to abound for Ford (NYSE:F), Dow Chemical (NYSE:DOW) and DuPont (NYSE:DFT).

Linked here is a report from MarketWatch illustrating some of the U.S. companies with the greatest exposure to Europe.

As with any financial decision based on political events, it is a difficult path to tread. If Christine Lagarde and the IMF do not know what the effects of Brexit would be, how can anyone be certain?

Those who feel Brexit will definitely not happen could make a good profit by the likely boost to U.K. based businesses and sterling based investments in that event. Much of the potentially negative effects may already be priced into currencies and stocks. A cautious wait-and-see approach without firm commitments at this stage may be the most sensible approach.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.