News alert: Unless you've been living under a rock, you've surely heard that citizens of the United Kingdom go to the polls June 23 to vote on whether to stay in the European Union or leave.
Why it matters: Popularly known as "Brexit," the fear is that if the "Leave" vote wins, other countries will question whether they wish to remain in the European Union or exit.
What are markets doing? Global markets have been jittery. Government bonds around the world have rallied, while yields fell, as investors rotated into safe-haven investments. The FTSE 100 Index, the U.K. version of the Dow Industrials, is down about 4.8% since the end of last November. Increased volatility has been seen in the British currency: the pound sterling. Additionally, U.S. stocks rocked back and forth last week, tugged lower and then pushed higher, driven by shifting perceptions on whether a Leave or Remain vote is ahead.
What's at stake? The Brexit vote has triggered concerns about a potential domino effect, where the U.K. could be the first to fall and other European Union countries could follow.
"The referendum itself has opened the door to EU-skeptic parties in Europe to push for similar votes elsewhere in the union. A vote to leave the EU could bolster the chances of populist parties gaining power throughout the EU, which would create greater uncertainty about the future viability of the EU," says Fotios Raptis, Senior International Economist, TD Economics TD Bank Group.
Simply put: this vote is important because the success of the European Union relies on all of its members contributing economically to the group as a whole, says Devin Ekberg, Investools® Content Development Manager.
"The EU is weakened when one member country either doesn't contribute economically like Greece or wants to separate itself voluntarily, like the U.K. in this case. The U.K. is one of the strongest contributors to the EU, and with other countries experiencing much weaker economies, it might be devastating to the other participants," Ekberg says.
Weighing Risks in U.K. and Around the World
There's more. A Leave vote could cut U.K. growth in half.
"The uncertain environment following a leave vote would cause household and businesses to delay purchases and investment decisions. This would then motivate a downward revision in our growth outlook for the U.K. over the next two years to around half of our baseline assumption," Raptis says.
How could financial markets react on vote to Leave? Many analysts expect market volatility. No one knows how much. Global stocks could tumble, the British pound could weaken, and bonds and gold could rally.
"Some capital flight from the U.K. to more certain asset classes in the U.S., Eurozone and other advanced economies is likely to occur immediately following a leave vote, and this will be captured by a dramatic decline in the pound relative to the dollar and the euro. The increase in global economic uncertainty will likely result in risk-off market sentiment, with stock indices falling and low-risk assets such as government bonds heavily bid," Raptis says.
Watch FX markets. "We anticipate that a leave vote would see the pound depreciate about 10% relative to the dollar following the referendum vote, and could very well fall an additional 10% in ensuing weeks," Raptis says.
What if the Remain vote wins? An old market adage states: sell the rumor, buy the news. Markets are anticipatory animals and some sectors have begun to price in the potential for a Brexit. If the Remain vote wins, expect some unwinding of Brexit trades already in place.
On a Remain vote win, Fotios says: "We anticipate some of the sell-off in risk assets related to the referendum uncertainty to unwind."
Are Brexit Fears Overblown?
There's no denying the referendum is big news. But, has the 24-hour news cycle overdone the potential and immediate impact? Possibly. Forecasts of a European Union break-up steal headlines and attract click-throughs. We aren't suggesting you ignore the news, but understand the long-term impact could take years to sort out.
"The media has overhyped the immediacy of any long-term impact of the Brexit. A Leave vote will be volatile, but no one really knows the long-term effects of it until the negotiations take place over several years," Ekberg says.
"There's this idea that June 23 will be a date that everything is known with certainty and the world will react as such, but I think it's much more likely that it's drawn out over several years and the volatility of an actual Brexit will be dampened over that long time frame," Ekberg concludes.
Stay tuned: Tallying the Ballots
The European Union referendum begins June 23 with voting from 7 am to 10 pm. No official exit poll is scheduled at the conclusion of voting. The early results are expected to be released by 12:30 am. Credit Suisse estimates one-quarter of the votes will be counted by 3 am, half by 4 am and the last set of results to be released by 7 am.
FIGURE 1: BREXIT EFFECT ON BRITISH POUND. The British pound has weakened versus the U.S. dollar (GBP/USD) ahead of the vote on June 23. Image source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
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