How Investors Can Prepare For The Brexit Vote

by: Kevin Mahn

Summary

Some have suggested that investors are now more focused on the implications of the Brexit vote than they are on what the Federal Reserve does with interest rates this summer.

Some in England believe that they are “not getting out as much as they are putting in” with respect to EU membership.

Others in Great Britain believe that they should remain within the EU and are fearful of how a Brexit would impact their exports and standing within Europe and the rest.

While the odds of a Brexit occurring have increased in recent weeks, overall sentiment still seems to be pointing towards them staying put.

Based on all of the reports that I have read at this time, I still believe that the referendum will likely return a “No” vote.

Delivering on an earlier campaign promise to let the people decide the fate of Great Britain and the European Union (NYSEARCA:EU), current Prime Minister David Cameron will bring the referendum to a vote on June 23, 2016. The stakes are significant and could have both short- and long-term implications on worldwide stock markets as well as the economies of Great Britain and the eurozone as a whole. Some have even suggested that investors are now more focused on the implications of the Brexit vote than they are on what the Federal Reserve does with interest rates this summer. Before we get into the potential implications to investors of a decision to leave the EU (a.k.a. a "Brexit"), or a decision to not leave the EU, I believe it would be beneficial to provide a historical context to the debate and highlight some key areas that could be impacted.

Click to enlarge

Photo Credit: A European Union (EU) flag is framed by British Union flags, also known as a Union Jack, in this arranged photo taken in Utrecht, Netherlands, on Wednesday, June 15, 2016. Photographer: Jasper Juinen/Bloomberg.

Great Britain has long been a member of the EU, but notably absent from the eurozone, the group of nations who elect to use the common euro currency, preferring, instead, to still use its native British pound (GBP). Nine other countries in the 28 member EU (i.e. Bulgaria, Croatia, Czech Republic, Denmark, Hungary, Lithuania, Poland, Romania and Sweden) also do not use the euro as their currency. There have been many vocal opponents within Great Britain questioning the need to remain within the EU going forward, citing concerns over trade agreements, immigration policies and regulation costs. Overall, some believe that they are "not getting out as much as they are putting in" with respect to EU membership and that there could be better potential uses of this funding within their own borders and an improved economic outlook if they could have more control of their own destiny. Others in Great Britain believe that they should remain within the EU and are fearful of how a Brexit would impact their exports and standing within Europe and the rest of the world.

From an investment viewpoint, trade and economic growth are at the heart of the potential implications of this referendum vote in England. According to BBC.com, approximately 28% of what is produced in Great Britain is sold abroad. Interestingly, while about half of this overseas trade in the United Kingdom (NASDAQ:UK) is conducted with the EU, England imports more overall than it exports to the EU. Hence EU country members need Great Britain as much (and perhaps more) as Great Britain needs the EU from a trade relations standpoint. Additionally, the cost of adhering to EU regulations are considerable for Great Britain, but were they to go it alone, there would still be some associated costs for them to access EU markets.

While the odds of a Brexit occurring have increased in recent weeks, overall sentiment still seems to be pointing towards them staying put. A June 11, 2016 Newsweek article entitled, "Betting Odds Move in Favor of Brexit as Leave Tops Poll" stated that the implied probability of a vote to stay in the EU in the June 23 referendum fell to 70 percent from 78 percent earlier this week, according to odds supplied by bookmaker, Betfair. Stated differently, there is just a 30% chance of them voting to leave the EU according to these same odds though the popular The Sun newspaper in England just endorsed a "Yes" vote which could change public sentiment in the days leading into the vote. Based on all of the reports that I have read at this time, I still believe that the referendum will likely return a "No" vote.

It is important to recognize that even if the referendum resulted in a "Yes" vote to leave the EU, actual implementation of such a decision would not take place until 2018 given the two year requirement of such a notification in accordance with EU policy. Such a "Yes" vote would likely result in short-term volatility due to the uncertainty of how this will play out within the global capital markets and stoke fears of possible contagion where other member countries may consider leaving the EU as well. That could ultimately lead to the longer term demise of the EU and the dismantling of the common euro currency. While such an outcome would be unprecedented and its market impact within the region unknown, it could prove beneficial to portfolio managers who would then be able to more easily pinpoint particular economies and currencies within the eurozone for investment that they believe offer the greatest growth potential as opposed to weighing out the ramifications of one governing body and one common currency across multiple countries and cultures.

Over the shorter term, it could also weaken both the British pound and euro currencies and further strengthen the U.S. dollar. A strengthening U.S. Dollar could impact large U.S. multi-national companies that derive a significant portion of their revenues overseas. Potential investment strategies for such an event could include investing in exchange-traded funds (ETFs) that benefit from a strong U.S. dollar or U.S. mid-cap and small-cap companies that would not be as impacted by weaker exports and U.S. dollar strengthening.

"Yes" vote or "No" vote, this may also be an opportunity for investors who believe that there is more growth potential overseas than domestically at this stage of the market cycle to allocate to international markets that they find most attractive. For example, if investors believe that Great Britain stocks will rally after the referendum and that the UK economy will continue to improve, there are seven current ETFs, some that incorporate currency hedges, which are focused on Great Britain. According to ETF Database, as of June 13, 2016, they are as follows:

Ticker Name Assets
EWU iShares MSCI United Kingdom ETF $2,078,176,000
FKU First Trust United Kingdom AlphaDEX Fund $158,629,000
DXPS WisdomTree United Kingdom Hedged Equity Fund $33,405,000
EWUS iShares MSCI United Kingdom Small-Cap ETF $17,564,000
DBUK Deutsche X-trackers MSCI United Kingdom Hedged Equity ETF $5,578,000
HEWU iShares Currency Hedge MSCI United Kingdom ETF $3,486,000
QGBR SPDR MSCI United Kingdom Quality Mix ETF $2,491,000
Click to enlarge

On the other hand, if investors believe that European markets, as a whole, will rally after the referendum and that the eurozone will continue to slowly improve, there are 94 current ETFs (which I will not list here but can be found at etfdb.com) that are focused on Developed Europe.

In our view at Hennion & Walsh, given the outflows that we have seen from these markets heading into the vote, it is highly likely that U.S. stocks, United Kingdom stocks and European stocks will all rally if the referendum returns a "No" vote and Great Britain decides to stay as a member of the EU, if only for the time being. Conversely, if a "Yes" vote is returned, these markets may suffer a bit over the short term, but not by as much as some may anticipate given that this potential outcome is at least partially priced into market valuations. This will lead to future market volatility though in the days and weeks that follow given the uncertainty over what may, or may not, happen next.

Disclosure: The overview above is for informational purposes and is not an offer to sell or a solicitation of an offer to buy any of the securities listed. Hennion & Walsh Asset Management currently has allocations within its managed money program and Hennion & Walsh currently has allocations within certain SmartTrust® Unit Investment Trusts (UITs) consistent with the themes discussed above.

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. I have no business relationship with any company whose stock is mentioned in this article.