Don't Sweat The Brexit Vote

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Includes: EWU, EZU, FXB, FXE, SPY, UUP, VXX
by: Eric Parnell, CFA

Summary

The United Kingdom European Union membership referendum is scheduled to take place next Thursday, June 23.

Much of the focus is on whether voters in the United Kingdom will choose to ‘remain’ in the European Union or opt instead to ‘leave’.

The ‘Brexit’ vote is not necessarily the immediate market event some are making it out to be.

The much more significant story lies in the longer-term implications of this vote even taking place at all.

The United Kingdom European Union membership referendum is scheduled to take place next Thursday, June 23. Much of the focus is on whether voters in the United Kingdom will choose to 'remain' in the European Union or opt instead to 'leave'. While it will potentially have profound implications for the British and European economies, the 'Brexit' vote is not necessarily the immediate market event some are making it out to be. Instead, the much more significant story lies in the longer-term implications of this vote even taking place at all.

Volatility Rising

A great deal of fuss is being made about the 'Brexit' vote next Thursday, and for understandable reason.

To begin, investors and the financial media had up until recently written off the referendum as a foregone conclusion. For while some in the United Kingdom (NYSEARCA:EWU) are agitating for change, cooler and more rational heads will prevail in the end and voters will opt to 'remain' in the European Union (BATS:EZU). But recent polls have been telling a decidedly different story, as eight of the last ten polls conducted by seven different polling organizations since June 9 have 'leave' in the lead with an average margin of 3.7 percentage points. As a result, many have been waking up to the fact that 'Brexit' may be a very real possibility.

Market volatility has stirred out of its recent doldrums as a result. This is due to the fact that if the United Kingdom decides to leave the European Union, it introduces a great deal of uncertainty into capital markets in terms of exactly what the implications of this decision will be on a variety of fronts including future economic growth, currency market volatility, a potential loss of confidence in the British pound (NYSEARCA:FXB) and shifts in foreign capital flows. As a result, we have seen readings like the CBOE Volatility Index (NYSEARCA:VXX) suddenly spike to their highest levels since late February.

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It's Not About Next Thursday

Indeed, market volatility is likely to continue rising leading up to next Thursday's vote. And depending on the final decision, this volatility is likely to continue at least into the short-term after next Thursday regardless of the decision. For if the final vote is to 'leave', the markets will almost certainly have an immediate reaction to the uncertainty that is likely to follow. And if the decision ends up being to 'remain', all of the hedging that investors have put on in recent days in preparation for a possible 'leave' vote will need to be unwound. Put simply, expect greater volatility in capital markets over the next couple of weeks regardless of how the final vote comes down next Thursday.

The good news for investors and the markets, however, is that whatever happens next Thursday is not likely to have an immediately lasting effect. Despite any wild swings that we may see in the next couple of weeks, a sense of calm and normalcy is likely to soon return to capital markets regardless of the final vote. The fact that the British Pound, while meaningfully lower relative to the U.S. dollar (NYSEARCA:UUP) over the past year, is still trading well above its lows from late February suggests as much.

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For if the decision ends up being to 'remain', investors will breathe a collective sigh of relief and return to business as usual.

But even if voters end up choosing to 'leave', it is not as though the United Kingdom will be immediately out of the European Union when the sun rises the next day on Friday, June 24. Instead, a 'leave' vote will effectively mark the beginning of what is likely to be a long and drawn out negotiating process that could take a couple of years to work itself out. In other words, a 'Brexit' vote would not end up being a shock event. Everyone knows the vote is coming and we know a meaningful probability exists that the U.K. may decide to leave the European Union (it currently stands at 33% according to the Bloomberg Brexit Watch, but it has been rising in recent days). And even if the 'leave' vote comes to pass, it is not likely to be a Lehman style event where markets are cascading lower from the shock and spillover effects of it all. Moreover, even with an event as immediate and traumatic as the Lehman bankruptcy, it took two weeks, and other institutions like Washington Mutual and Wachovia joining the failing-financial-institution party, before U.S. stocks finally gave up to the downside in a very big way.

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In short, if it took roughly two weeks for markets to react to Lehman, it is almost certainly going to take much longer for any 'Brexit' decision to have a lasting and sustained impact on risk markets. And another thing that investors can rest assured is that major global central banks from all around the world will be flooding the financial system with as much liquidity as needed in order to avoid any market dislocations. In fact, Mario Draghi and the ECB have already promised as much according to Reuters. This reactiveness by central banks has the potential to not only calm any investor jitters but could even end up sparking a 'Long Term Capital Management 1998 bailout' style rally, propelling the S&P 500 Index (NYSEARCA:SPY) to new highs as a result.

As a result, the negative implications for financial markets resulting from 'Brexit' are not about next Thursday. But this does not mean it is not a problem for financial markets. To the contrary, the real dilemma for not only Europe and the UK but the entire global economy and financial system actually runs much deeper than anything that might happen next week.

It's Really About The Long-Term Fate Of The Euro Zone

The much more lasting point from the upcoming 'Brexit' vote is what it represents for the long-term survival of the European Union and the euro currency (NYSEARCA:FXE).

Just like the referendum on Scottish independence from 2014 and the potential for 'Grexit' in the summer of 2015 following the election of the leftwing Syriza party in Greece, the 'Brexit' vote is the latest in a growing line of political events that demonstrate the direction of the long term sentiment about the Euro Zone experiment. In order for the European Union to survive and truly succeed in the long-term, it requires the blending of political borders and the union of fiscal policy to go along with its monetary counterpart.

Instead, what these recent events show is the exact opposite in that countries are shifting toward a more protectionist stance and working to reclaim greater independence and sovereignty. And the rise in popularity of various Eurosceptic parties in countries across the Euro Zone suggests that this is a problem that is only going to get worse going forward.

So regardless of how the 'Brexit' vote turns out next week, what we have today more broadly is a European Union that is slowly breaking apart. If the decision is made in the U.K. to 'leave', it will only accelerate this disintegration as it will likely embolden other countries in the European Union and the euro currency to follow the same path to the exits. And even if voters decide to 'remain', it does not mean the problem is resolved. It may disappear from the headlines, but it's only a matter of time before voters in some other struggling economy across Europe consider making similar 'leave' efforts of their own, particularly in the wake of seeing that the decision was too close to call leading up to the U.K. vote on the topic.

Bottom Line

The markets are likely to react in the days surrounding the Fed 'Brexit' vote. But investors should not overreact to any such volatility, as markets are likely to stabilize not long after the vote has been completed regardless of the outcome. As a result, investors are likely best served to stay the course and weather any short-term market swings.

Instead, the far greater implications from an investment perspective is the ultimate fate of the European Union. The U.K. decision to even hold a referendum on the topic coupled with the fact that a 'leave' outcome is still a very real possibility just one week ahead of the actual vote suggests that a growing legion of the general population across Europe are coming to the conclusion that the Euro Zone experiment is not working. And if the European Union ends up breaking apart before it's all said and done, now you're talking about a real and sustained long-term impact for global capital markets. This will be something to actively prepare and position for if and when the day finally comes.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

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.