An Investor Guide To Brexit Implications

by: Wells Fargo Asset Management

Summary

With results of Thursday’s vote, in which the majority of British citizens voted in favor of the U.K. leaving the European Union (E.U.) (Brexit), we’ve now got a classic case.

For equities, it might not be a bad time to nibble at opportunities. Yes, there is a lot of uncertainty, but I think we may be at peak uncertainty.

Anything that happens on the political front now will help give clarity about the path forward. What we can expect is some continued volatility in the markets as Brexit works.

We remind investors to stay focused on the long term and be patient. It’s going to be a bumpy ride while our global political comrades figure this out.

By Dr. Brian Jacobsen, CFA, CFP®

What happens after the dog catches the car it's been chasing?

With results of Thursday's vote, in which the majority of British citizens voted in favor of the U.K. leaving the European Union (E.U.) (Brexit), we've now got a classic case of "now what?" The thing that drove the U.K. was the desire to leave, not what to do afterward. It's quite telling that the Leave leaders are now saying they are in no hurry and that they should take some time to reflect on what to do next. Vote first and think later is one of the shortcomings of direct democracy.

What were the results?

Residents of the U.K. voted to leave by a narrow 51.9% to 48.1% margin. There was a generational divide, with the older population favoring Brexit and the younger population in favor of staying. One problem for the Remain campaign was that the elderly showed up in droves while the young stayed home. There was also a geographic division: Scotland, Northern Ireland, and London voted to stay. Wales and England opted for out. There was an educational divide: The college-educated voted in favor of Bremain, while others with less formal educational experience opted to vote for Brexit.

What does this all tell us? It's a country that is disunited, not United.

What's the political fallout?

The Tories are divided, which is part of what triggered the vote. In 2014, head of the Tory Party and Prime Minster David Cameron promised the anti-E.U. parts of his party a referendum on Brexit if they won the 2015 elections. Importantly, he also pledged that the party would respect the referendum results. This makes it unlikely that this referendum will just be ignored by Parliament. Now that it's happened, Cameron said he will step down as prime minister before October. This means that the Tories will have to elect a new leader. That could create more divides, possibly leading to new general elections. The general elections would then be a referendum on the referendum.

Infighting in the Labour Party is also stoking the political flames. Jeremy Corbyn, the head of the Labour Party, is being blamed for not getting the vote out. His supporters are defecting faster than fair-weather fans of the losing Super Bowl team.

From the sounds of it, nobody is going to officially trigger an Article 50 withdrawal from the E.U. until new leadership is in place. Whether new leadership gets in place through party votes or through a general election is unknown. To trigger a general election before 2020 would require either a 2-3 vote in the House of Commons or the prime minister losing a confidence vote. To pass the buck-or the pound?-triggering a general election seems quite likely.

What about geographic complications?

There are internal issues to the U.K. that will need to be dealt with. Scots and Northern Ireland (NI) want to stay in the E.U. Should NI unite with Ireland? Should Scots seek independence? The border between NI and Ireland will have to be defined. Up until now, it didn't matter, as there was the free movement of people within the E.U.; but if the U.K. is out, then the border needs to be defined, and that's controversial. Scotland's dependence on London and low oil prices make its finances untenable, but that doesn't mean it won't take a swing at independence despite losing a bid for independence in 2014.

What's this Article 50 thing?

The Treaty of Lisbon has a provision that allows for a member of the European Union to withdraw from the E.U. Only the country that wants to exit can trigger a withdrawal. It cannot be forced into withdrawing

Once a country triggers an Article 50 withdrawal, it's not a one-way street, as the U.K. can withdraw its request to withdraw from the E.U. The negotiations are supposed to take two years. If an agreement isn't reached at that point, the requesting nation-in this case, the U.K.-would be forced to exit without any special arrangements. That seems pretty unlikely, as it's mutually beneficial for trade and security purposes for the U.K. and E.U. to come to some agreement.

There are a lot of things to agree on, too. What happens to the 1.3 million Britons that live in other E.U. countries? What happens to the 3 million people from other E.U. countries that live in the U.K.? Where is the border drawn between Northern Ireland and Ireland? What happens to data sharing across borders? What happens to flight patterns? What happens to product safety standards? What happens to merger approvals? What happens to bank regulations? What happens to E.U. assets in the U.K. or investments funded by the European Investment Bank? This is why Article 50 negotiations are anticipated to take up to two years.

The E.U. can't force the U.K. out, though it can present options. For example, the E.U. could suggest that the U.K. become like Norway in its relations to the E.U. Norway is like a member without a voice. No matter what, the withdrawal agreement will set a precedent for other withdrawals.

The U.K. actually has a pretty good negotiating position because it has a free option. It's like being able to see what the prize in the box is on the game show "Let's Make a Deal" before having to decide whether to give up the cash or choose what's in the box. If the box isn't going to be better, the U.K. can withdraw its withdrawal request.

What's the economic fallout?

The most direct result will be a decline in business investment in the U.K. Businesses may decide to withhold spending until they know whether the U.K. will be in the E.U. or not. Investment may just be diverted to other jurisdictions, like Ireland, France, or Germany. Business spending has already been on pause, so this just means more of the same: low growth for longer in the U.K.

Otherwise, what changed from June 23, 2016, to June 24? Nothing. No policies changed. The U.K.'s relationship with the E.U. didn't change. If the U.K. slows, that has ripple effects, as the U.K. is the fifth-largest economy in the world. Three percent of U.S. exports (0.5% of gross domestic product [GDP]) goes to the U.K. So, a slowdown there could have a mild effect on U.S. exports.

The U.K. imports more than it exports, to the tune of 7% of GDP. Approximately 50% of the U.K.'s exports go to the E.U. The weaker pound could help exports a bit, but a lot of exports are in financial services. If those financial services jobs are moving elsewhere to stay part of the E.U., then that weaker pound may just drive up import prices rather than spurring exports.

What's next?

The U.K. needs to decide what it wants. It's not clear that the Brexit decision is backed by a coherent negotiating strategy. This is a political crisis, not a financial crisis. Banks are in good shape. We're not talking about something like Grexit, as the U.K. doesn't use the euro like Greece does. There's no risk of the U.K. threatening to default on its debt.

The E.U. could come in with a deal to keep the U.K. in.

Because there are concerns about political dominoes falling, a deal to keep the U.K. in that also holds out the promise of reforming the E.U. could help break the chain reaction of Brexit triggering other referendums or the rise of anti-E.U. parties like Alternative for Germany, Podemos in Spain, Five Star Movement in Italy, far right National Front in France, Party for Freedom in the Netherlands, and the Slovakia People's Party.

Investing implications

With further drags on investment spending due to political uncertainties, I think the real danger is in the erection of trade barriers, which leads me to favor small- and mid-cap domestic-oriented firms in every country. As an example, in the U.S., the S&P 600 (small caps) gets 80% of revenues from the U.S. The S&P 400 (mid caps) gets 72% from U.S. The S&P 500 (large caps) get 68.9% from the U.S. Typically, information technology, materials, and energy companies are the most global. They're the ones that may get hit hardest if countries close their doors to global trade. The least global firms tend to be utilities, telecommunication services, and health care.

Markets don't get things right all the time, but the idea that markets are implying a low probability of rate hikes in the foreseeable future seems reasonable. A stronger dollar gives the Federal Reserve another excuse to not hike. Low rates and political uncertainties could make core bond strategies and conservatively managed high-yield strategies star performers. For equities, it might not be a bad time to nibble at opportunities. Yes, there is a lot of uncertainty, but I think we may be at peak uncertainty. Anything that happens on the political front now will help give clarity about the path forward. What we can expect is some continued volatility in the markets as Brexit works its way through the system. We remind investors to stay focused on the long term and be patient. It's going to be a bumpy ride while our global political comrades figure this out.

Original blog post.

The views expressed are as of 6-27-16 and are those of Dr. Brian Jacobsen, CFA, CFP, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the authors and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.

Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. Wells Fargo Funds Management, LLC, a wholly owned subsidiary of Wells Fargo & Company, provides investment advisory and administrative services for Wells Fargo Funds. Other affiliates of Wells Fargo & Company provide subadvisory and other services for the funds. The funds are distributed by Wells Fargo Funds Distributor, LLC, Member FINRA, an affiliate of Wells Fargo & Company.

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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.