A Chinese saying goes 三思而后行, literally "Think three times before you act", or more poetically, "Think before you leap". The leap off the figurative Brexit cliff, charmingly illustrated by this week's issue of the New Yorker, may not yet be upon us, and investors need not panic.
While the referendum victory of the "Leave" camp came as a surprise to market makers overtly relying on polls and perhaps a vain notion that reason would prevail at the end of a heavily emotional process leading up to a vote conditioned by decades of anti-European sentiment, the succinctly coined "Brexit" is by no means a done deal.
A number of possible outcomes, and none of them are catastrophic
PM Cameron's decision not to invoke Article 50 of the Treaty of Lisbon in the immediate aftermath of the referendum, to the great dismay of EU foreign ministers Commission President Juncker and EP President Schultz, may yet prove to be a stroke of political genius. It appears that Cameron has passed on the heavy burden of dealing with the formal exit negotiations, should they be initiated as per article 50, to his likely successor Boris Johnson. This achieves two things:
- Johnson's may very well turn out to have been a pyrrhic victory. as he has no realistic means to make good on the ample promises of his "Leave" campaign. Politically, this appears to be a dead end for him, and his awareness of this impasse shows in his most recent statements on social media, where he is striking a conciliatory tone with regard to "European cooperation", all the while pandering to his political base.
- By giving the incumbent British government leeway until Cameron's abdication "by October", numerous alternative scenarios could be explored. Most notably, another referendum could be organized - again to the great dismay of other EU leaders (but why should the U.K. care about niceties at this point?) - with an emphasis on the 18-25 demographic, which so woefully abstained from the first one. Defending a second referendum on the grounds of lackluster representation of the social stratum most likely to suffer from the ensuing economic uncertainty of Brexit should hardly be difficult.
Furthermore, the clear indication by Scottish first minister Sturgeon that another Scottish independence referendum as well as a Brexit veto from the Scottish parliament are very much in the cards puts enormous political pressure on London.
It is the view of this author that the prospect of the U.K. literally disintegrating, with an independent Scotland joining the EU (Commission President Juncker has indicated that he is looking forward to talks with Sturgeon for this very purpose in the coming days), deep generational rifts threatening socio-economic cohesion and the City of London aspiring to the status of an autonomous free trade zone à la Hong Kong present a risk that neither the incumbent government nor the House of Commons is eager to take.
Opportunity in uncertainty
The haste of virtually all EU leaders, with the notable exception of Chancellor Merkel, to "accept the will of the people" and press the U.K. to formally hand in the divorce papers to the EU Council may yet provide for much embarrassment, and the similar haste of the media to proclaim Brexit as a done deal create short-term opportunities for savvy investors looking to snatch up shares in heavily discounted companies. My main recommendation to cautious investors at this point is to look to the US and Swiss markets, and I personally like the irrational "Brexit" discounts on companies such as Rogers Corp. (NYSE:ROG), Celgene (NASDAQ:CELG) or Microsoft (NASDAQ:MSFT), to name a few. Meanwhile, the above-mentioned alternative scenarios are being tested. The IBB, having gone sideways for months now, has suffered another bloody day due to the looming uncertainty and the resulting "risk-off" reaction of many investors; yet, a great number of development-stage biotech companies which are entirely US-centric should not see their business model affected by Brexit in any tangible way.
In the event that the U.K. government should trigger article 50, investors must keep in mind that the U.K. will remain in the EU, and thus part of the single market, for another 2 years or so. Meanwhile, tedious negotiations will be taking place. Didier Seeuws, an experienced and highly regarded Belgian diplomat who has been credited with a key role in advancing stalled negotiations on the European Patent System, is poised to head the EU task force dealing with the disentanglement of the Pythagorean nod of legislation binding the U.K. to the EU. From this, we can deduce that the Brexit negotiations, once triggered, would be conducted cautiously and competently. Ultimately, the EU has an interest in a fair outcome to any such negotiations, and investors should benefit from greater clarity as these negotiations unfold. Until then, it isn't difficult to see financial institutions with great exposure to the City going through turmoil as they scramble to rearrange their activities, and I generally wouldn't recommend buying the dip on stocks such as Deutsche Bank (NYSE:DB), as they still appear to be in free fall.
Have a cup of tea and ponder your options
It is too early to predict which course the EU, with or without the U.K., is going to take from here on, but I would caution against the doom-and-gloom predictions of a domino effect ripping apart the EU in the wake of Brexit. The U.K.'s relationship with the EU has been a peculiar one from the beginning, and grievances in other member states are not directly analogous to those of the U.K. I believe the EU will accommodate grievances of other member states, notably in the area of immigration policy, while these member states choose pragmatism over staunch national pride as they continue to rely on EU structural funds and the common market.
Brexit or not, this is not the end of the world nor grounds for a 2008-style financial crisis, but rather, the return of a period of volatility that could present tremendous opportunities for value-minded investors.
To be continued...
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.
Additional disclosure: The author is long USD and US equities.