Evaluating The Consequences Of Brexit

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Brexit has become a markedly emotional topic so investors should be very careful before they assess its effects.

While most opponents of Brexit predict that it will be catastrophic for the country, this is certainly not the case.

The article discusses the pros and the cons of such a scenario.

While Grexit was the most widely discussed theme last summer, Brexit is the most popular topic this summer. As there is no precedent to draw some conclusions from, investors are doing their best to get informed about the consequences of Brexit. Unfortunately, most people have become extremely emotional over this issue lately and, when emotions prevail, the IQ approaches zero. Therefore, investors should do their best to leave emotions aside and assess the potential impact based on reasonable arguments.

First of all, many opponents of Brexit, including the Prime Minister of UK, claim that Brexit will be catastrophic for the country. They state that the international trade will be pronouncedly restricted due to the subsequent tariffs and duties. However, they forget that a Brexit scenario will not necessarily result in tariffs and duties. To be sure, there are many countries that are much farther from European Union [EU] than UK will be in a Brexit scenario, namely Russia and Libya, which have concluded preferential trade agreements with EU and hence they do not pay any duties when they sell their products to EU. Therefore, it is very likely that Britain will achieve the same preferential agreements. Of course EU is now threatening Britain for the opposite in order to influence the result of the referendum but after the event it is really unlikely that the two regions will not agree on a deal that is win-win for both. All in all, the concerns over significant hurdles on the exports of UK to EU are clearly overblown.

It is also essential to keep the expectations down to earth and realize that Brexit will not be catastrophic. Britain was one of the strongest economies before it joined EU and will easily remain one of the strongest ones even in a Brexit scenario. Unlike Greece and the other PIIGS, it has its own currency, which is much stronger than the dollar and the euro. Therefore, any "experts" who predict that Brexit will have catastrophic consequences are either pundits or they simply serve propaganda for their own reasons.

The real effects on Britain will be the subsequent hurdles on the movements of foreign citizens in the country. While those hurdles will not be insurmountable, they will certainly have a negative effect on the number of people who visit the country, either for tourism or for a job. Unfortunately for the country, every step away from globalization means fewer efficiency synergies and hence the GDP of the country will be negatively affected. Nevertheless, while this effect is certainly negative, it is not likely to have a severe impact on the economy. Britain has great labor resources so this effect is likely to be contained within reasonable limits.

On the other hand, the country will also enjoy some positive effects from a Brexit scenario. First of all, it will save a significant amount of money which it now spends to contribute in the budget of EU. To be sure, Britain paid £12.9 B to EU in 2015 and the situation is only going to get worse, as most PIIGS have hardly shown any signs of a sustained recovery. Therefore, in a Brexit scenario this amount will be spent on much more promising endeavors.

Moreover, Britain will save even more money by canceling or amending some strict EU regulations, which greatly burden its economy. For instance, European refineries are forced to spend excessive amounts every year to meet extremely strict environmental standards while their Asian counterparts do not incur such expenditures. Therefore, the latter have an extremely strong competitive advantage over the former. That's why about 20% of European refiners were driven to bankruptcy during the rough years (for refiners) 2009-2014 while most Asian refineries survived. In a Brexit scenario, Britain will have the option to reduce the burden of such regulations on its companies and thus increase their competitiveness.

Finally a Brexit scenario will enable the country to escape from the exhaustive bureaucracy of the politicians of EU. More specifically, the latter almost never solve any problem unless it escalates to such an extent that it frustrates their voters. Even in such cases, European politicians usually do not solve the problem; instead they prefer the method of kicking the can down the road. More specifically, they take the least possible measures to alleviate the situation temporarily and postpone the solution to the future, hoping that someone else will have to take the painful decisions at that time. The Greek drama is an excellent example. Therefore, if Britain seizes the opportunity, it will be able to handle its problems much more efficiently than it can within EU.

While the above points summarize the potential consequences of Brexit, most investors may be wondering how these points will be reflected in the market after the referendum. First of all, if the outcome of the referendum is Brexit, it will take about 2-3 years to be implemented and at least another 5 years to start showing its first tangible results. Therefore, it will take almost a decade to see the first tangible effects of Brexit on the UK economy and these effects are not expected to be dramatic. Consequently, the UK stock index [FTSE] and the iShares MSCI United Kingdom ETF (NYSEARCA:EWU) are not likely to be significantly affected by the outcome of the referendum. This is already reflected in their price chart, as they have underperformed S&P (NYSEARCA:SPY) by only 2.5% in the last 6 months while they have outperformed S&P by 2% in the last 3 months. Of course FTSE and EWU may initially plunge in the case of a Brexit outcome but such a reaction is likely to prove only short-lived. All in all, the UK stock market will hardly be affected by the outcome of the referendum.

On the other hand, the British pound (NYSEARCA:FXB) will be affected much more by the outcome of the referendum. More specifically, in a Brexit scenario the pound will have to devaluate in order to outweigh the resultant hurdles to the international trade of UK and the movement of foreign citizens across its borders. The market was early to discount Brexit in FXB, as it sent it 10% lower in the last 6 months, until 10 days ago. However, in the last 10 days the pound has retrieved most of its losses, possibly reflecting a favorable trend for the "remain" outcome in the referendum. Therefore, if the result of the referendum is Brexit, FXB is likely to plunge, by 5% to its 52-week low or even more. On the other hand, if UK citizens vote against Brexit, FXB is likely to enjoy a great rally, at least 5% from its current level to reach its 52-week high.

All in all, investors should feel confident that the UK stocks will be hardly affected by the outcome of the referendum, apart from a possible initial reaction. On the other hand, they should be aware that the pound is likely to experience a major move on the announcement of the result, either down (Brexit) or up ("remain"). As the two outcomes of the referendum have almost equal chances at the moment, it is evident that the market has reflected them in the price of the pound only with a 50% chance each. Therefore, when the result is announced, the pound is likely to experience a major move. Foreign exchange traders should keep this in mind and avoid leveraged positions, which may be prone to a margin call. They could also hedge their positions with options but the latter have remarkably high implied volatility and hence they are markedly expensive. Therefore, I do not recommend such a strategy.

To sum up, a Brexit scenario will certainly not be disastrous. It will certainly result in reduced efficiencies in some aspects of the British economy, though the magnitude of this effect is likely to be limited. On the other hand, if Britain seizes the opportunities that will arise from escaping the exhaustive bureaucracy and the un-business-like character or EU politicians, it will enjoy great benefits in a Brexit scenario. The future is always like this; it depends on whether people grasp the opportunities that show up. While the result of the referendum is likely to have a minimal effect on UK stocks, it is likely to have a significant impact on the British pound. Investors should be well prepared for this and avoid leverage in the foreign exchange market.

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.