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Brexit Bruises

| June 24, 2016
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Investors went into yesterday’s Brexit vote with surprising complacency. Risk assets rose in the days leading up to the vote on polls suggesting a solidification of “remain” sentiment, only to plunge overnight as the “leave” result became clear. While most Americans slept, crude oil plummeted as much as 5%; safety assets such as gold jumped 5%, with the yen rising and U.S. Treasury yields compressing significantly. U.S. equity markets opened markedly lower this morning.

Put simply: investors got this one wrong. Here are some points to bear in mind as markets and politicians find their footing

  1. This is not a “Lehman moment.” The banking system is fully equipped to handle this news without the financial contagion that marked the 2008-09 crisis. While many were caught off guard and had to reverse course (and trading positions) abruptly, U.K. equity markets are still higher today than one week ago. Although the pound has weakened approximately 3% on the week, the euro has fallen just 1%.

  2. The vote does carry economic consequences. The restoration of barriers with Britain’s largest trading partners will blunt growth somewhat, and take time to remove through bilateral agreements. The vote also reflects, and may further engender, political instability within the U.K. and across the European Union. Confidence and consumption may well suffer, risking a negative economic feedback loop.

3. New arrangements may be hard to forge. The Brexit vote may force remaining EU members to take a hard line on British bids for bilateral economic and travel accords across the region. Friendly terms would risk inviting others to think of leaving the EU as a pain-free way to enhance national sovereignty.
The value of EU membership, and the difficulty of replicating its economic benefits, was made clear even within the U.K. as Scotland voted to remain in the EU. The Brexit result will most likely force Scots to choose between the EU and the U.K.—and perhaps to revisit their recent election to stay with Great Britain.

4. The risk of political contagion is real. The possibility that other countries might follow the U.K.’s lead is one reason that early market moves show continental Europe faring somewhat worse than the U.K. itself. The populist party in Spain is expected to perform well in elections this Sunday; a few months later, a vote on changes to Italy’s constitution may carry similar populist repercussions.A union forged to help prevent another war in Europe thus appears to be on course to dissolve. The U.K. has thrown the gates open to the possibility of such an evolution where a global financial crisis and recurring panic over Greek debt failed to do so.

5. Currency contagion could follow. Objections to European control of local affairs have built over time, and extend beyond trade and politics into monetary policy. While the U.K. itself never adopted the euro currency, now that the first domino of political sovereignty has fallen, those of monetary sovereignty might be next—undermining not only Europe’s economic ties but its currency union as well. Count this as an additional factor in the negative feedback loop affecting confidence, investment and spending.

6. Minor impacts on base case. The Brexit decision and the continued slow-motion train wreck that is the European economic and monetary union can have a meaningful impact on expectations for near- and medium-term growth. This bodes poorly for global companies doing business there, and for investors seeking an end to the earnings recession of the last few quarters. In addition, the political implications, both across the Continent and in the U.S., may prove far-reaching. Political uncertainty tends to beget market uncertainty, and higher volatility tends to beget lower price-to-earnings multiples for equities—blunting multiple expansion as an alternative to real growth in driving markets higher.

With that said, volatile markets are no environment in which to improvise changes to asset allocations. Furthermore, Clear Harbor’s base case for muted earnings, economic growth and monetary policy remains intact. We have long been cautious on the sustainability of the European welfare state; the ECB and other central banks are already at the zero bound, and disposed to continue easy policies to support risk taking. Further rate hikes by the Federal Reserve, recently postponed by mixed economic data in the U.S., are now all but certainly off the table for balance of 2016.

Although we recognize significant flaws in the EU’s practices and policies, we do not welcome yesterday’s decision from a geopolitical perspective. The U.K. should not only continue to play a critical role in providing a counterbalance within Europe, but also serve as an additional beacon of democracy and peace around the world. The goal of greater European unity is as important today as it was when the European Economic Community, the EU’s predecessor, was established nearly 60 years ago.

Each EU nation ceded a portion of their sovereignty to unelected officials in Brussels, and yesterday’s vote gave British citizens the power to say “no.” Between now and November, citizens of other nations on both sides of the Atlantic will have similar opportunities to voice their angst with their elected officials, a tepid economic recovery, and the uncertainties of moments of fundamental change.


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