Little Britain: Implications Of Brexit

| About: SPDR Gold (GLD)

Summary

Britain votes to leave the EU.

Turmoil in markets.

Rush for safe-haven assets.

The referendum is over. And it looks like the "leave" camp will prevail. At the time of writing this article, votes were counted in 300 of the 382 voting areas and the "leave" camp was leading with 51.7% of the vote. Ahead of the referendum, polls had shown slight edge for the "remain" camp. The results have shocked the markets.

A Big Shock

All major indexes in Asia were down. At last check, the Nikkei 225 Index in Japan was down more than 7%. Hang Seng was down more than 4%. The S&P/ASX in Australia was down more than 3%. The BSE Sensex in India was down more than 3.5%. The Shanghai Composite Index was down 1.2%.

There was also turmoil in the currency markets, with the pound dropping 10% against the U.S. dollar.

FT.com/Bloomberg

Emerging market currencies have also taken a big hit as expected. The dollar rose 7% against the South African rand, 4% against the Turkish lira and 5% against the Mexican peso.

Gold, a safe-haven asset, has not surprisingly jumped. Prices crossed $1,300 an ounce in Asian trading as investors ran to the safety of the precious metal.

FT.com/Bloomberg

Below is the performance of some UK-exposed stocks in Asian trading.

FT.com/Bloomberg

Implications

Political

To start with Britain, it will create a deep divide in the Conservatives party, the centre right party that won a majority in the elections last year. It was David Cameron, the British Prime Minister, who had called for the referendum before last year's general elections. Cameron had taken the gamble at the time to appease the eurosceptics in his party. It was also to ensure that the United Kingdom Independent Party or UKIP under Nigel Farage does not eat into Tory votes. The strategy worked for Cameron and the Tories won handsomely. Since being reelected, Cameron has been campaigning for remaining in the EU. His remain campaign suffered a blow a few months ago when Boris Johnson, London's former mayor, backed the "leave" camp. The referendum has deeply divided the Conservative party and Britain.

For a start, Brexit most likely would mean the departure of Cameron as Prime Minister. We could also see calls for Scottish independence from the union once again. Scotland had voted to stay in Great Britain two years ago. Scots have voted to stay in the EU so a Brexit could lead to renewed calls for independence.

In the EU itself, there could be calls for similar referendums. Remember there is more euroscepticism in France than in Britain. In fact, a recent article in the Independent, a UK newspaper, had highlighted this. The article, citing research conducted by the Pew Research Centre, said more than 60% of French voters have an unfavorable view of the EU. In Greece, 71% of those surveyed had an unfavorable view of the EU. Interestingly in the UK, 48% had an unfavorable view of the EU. That is high but significantly less than France and Greece.

Independent/Pew Research

Economic

What will be the cost of Brexit to the UK? According to the British Treasury, the GDP will be 6.2% lower than it would otherwise have been by 2030. Brexit will cost each British household $6,000 annually. At this moment, the terms of exit are not known. Britain will, of course, try to negotiate favorable terms of exit. That would mean continued access to the single market. Countries such as Switzerland and Norway are outside the EU but enjoy access to the single market. Britain will want an arrangement like that. However, it is unlikely that the EU will agree. Switzerland and Norway allow free movement of people from EU. If Britain wants access to the single market, it will have to keep its borders open. But the biggest selling point of the "leave" camp was immigration. So it is highly unlikely that any agreement will be reached on this. Most likely, Britain will be out of the single market. That means tariffs. While Britain will have the ability to negotiate bilateral deals with countries such as China and India, something the "leave" camp had stressed on, such deals take years to materialize. The tariffs and trade barriers will be placed immediately.

The impact on global economy will also be significant. Remember that the global economic recovery is still fragile. The U.S. economy is stronger than most developed world economies but the U.S. is growing below trend. The euro zone GDP returned to pre-crisis levels recently but that was mainly because of unprecedented efforts from the European Central Bank (ECB) to fight deflation and boost growth. Indeed, despite the efforts of central banks, economic growth in the developed world is below trend. Then there is China. Not only is the world's second largest economy seeing a slowdown, but the market is also worried about the high leverage. China's actual debt to GDP could be much higher than what government figures show. A credit crisis in China would be even more catastrophic than Brexit.

To sum up, the last thing a struggling global economy needed was Brexit. Things will only get worse from here.

Markets

I already discussed the immediate impact of Brexit on the global markets. Given the fact that Brexit negotiations could go on for years, we are looking at a prolonged period of uncertainty for global markets.

Remember that several U.S. businesses, including all the major banks, are headquartered in Britain. Caterpillar (NYSE:CAT), for example, has sizable operations in Britain. The company employs some 9,000 people in Britain and has 16 plants in the country. The products manufactured in Britain are mainly exported to Europe. If Britain has to exit the single market, then CAT's products will face tariffs in Europe. Since at this stage the terms of exit are not known; it creates significant uncertainty for businesses like CAT.

Gold will be the biggest beneficiary of Brexit. This is for two reasons. First, the precious metal benefits from the uncertain environment. Second, a Brexit vote delays a rate hike in the U.S. The Federal Reserve is unlikely to raise rates in this uncertain environment. It has already cut rate forecasts for 2017 and 2018. And there is one more important reason for the Fed to hold, a strengthening U.S. dollar.

Victory for the "leave" camp has already pushed the U.S. dollar higher against a basket of currencies. A stronger dollar is negative for a recovering U.S. economy.

A stronger dollar will be also negative for commodities.

Disclosure: I am/we are long CAT.

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.