The European Union - often known as the EU - is an economic and political partnership involving 28 European countries. It began after World War II to foster economic cooperation, with the idea that countries which trade together are more likely to avoid going to war with each other. It has since grown to become a "single market" allowing goods and people to move around, basically as if the member states were one country. It has its own currency, the euro, which is used by 19 of the member countries, its own parliament and it now sets rules in a wide range of areas - including on the environment, transport, consumer rights and even things such as mobile phone charges.
We give this brief background on the EU to provide some context as the United Kingdom (UK) shocked the world late last week by voting narrowly but decisively to leave the European Union. The UK has been a member of the EU since 1973 and is a leading trading power and financial center. The EU is the UK’s largest trading partner, with about half of its exports going to EU countries and exports to the EU accounting for about 13% of its total GDP, according to the IMF. Many of those exports are services, including financial services and insurance, that previously benefited from access to EU markets without having to meet regulatory requirements at the individual country level. The UK also benefited from EU trade agreements with over 50 other economies, which now require re-negotiation. It is the third largest economy in Europe after Germany and France. It is the 11th largest exporter in the world and the 6th largest importer. The UK is one of our top trading partners and last year U.S. based companies sold $56 billion worth of goods to it.
Given its importance to the world’s economy, the news sparked a sell-off in the global stock markets and sent the value of the British pound tumbling to a 30-year low, though bond and gold prices rallied in a flight to safety. Prime Minister David Cameron has already announced he will resign after failing to convince voters to stay in the union.
The “Brexit,” as the British exit from the EU is widely known, is unprecedented — no country has ever left the union, which has created tremendous uncertainty among investors as to its full ramifications, which may not be known for years. For the UK to leave the EU it has to invoke an agreement called Article 50 of the Lisbon Treaty. Mr. Cameron or his successor needs to decide when to invoke this - that will then set in motion the formal legal process of withdrawing from the EU, and give the UK two years to negotiate its withdrawal, though this deadline could be extended if needed. The article has only been in force since late 2009 and it hasn't been tested yet, so no-one really knows how the Brexit process will work. Mr. Cameron, who has said he would be stepping down as Prime Minister by October, said he will go to the European Council soon to "explain the decision the British people have taken". EU law still stands in the UK until it ceases being a member - and that process could take some time. The UK will continue to abide by EU treaties and laws, but not take part in any decision-making, as it negotiates a withdrawal agreement and the terms of its relationship with the now 27 nation bloc.
While Brexit creates near term uncertainty and potential negative economic consequences for the people of the UK, why would 52% of the population vote for it? It appears the main issues behind Brexit were related to immigration and a desire for independence from the bureaucracy of the EU. According to Business Insider, 630,000 foreign nationals settled in Britain last year. Britain's population has grown from 57 million in 1990 to 65 million in 2015, despite a native birth rate that's now below replacement. On Britain's present course, the population would top 70 million within another decade, half of that growth immigration-driven. British population growth is not generally perceived to benefit British-born people. Migration stresses schools, hospitals, and above all, housing. The median house price in London already amounts to 12 times the median local salary. Rich migrants outbid British buyers for the best properties; poor migrants are willing to crowd more densely into a dwelling than British-born people are accustomed to tolerating. Thus the Brexit vote was a rebellion against the forces of immigration as well as a desire to take more control of their own destiny vs. letting foreigners dictate certain laws and regulations.
While at this time no one truly knows the full ramifications of Britain’s exit from the EU, the main issues appear to be:
◾ Will Brexit undermine confidence and increase uncertainty enough that businesses retrench further and the forecast for global economic growth declines?
◾ Will other countries leave the EU and is this the beginning of a slow breakup of the EU? A recent poll showed 61% of the French people want out of the EU.
◾ Can Great Britain negotiate a successful and speedy exit from the EU without undue harm on trade agreements?
◾ Who will be the next prime minister of Great Britain, and what policies will this person implement?
◾ Will Scotland try to break apart from the United Kingdom? Its population voted not to leave the EU.
◾ Could Brexit not happen at all? There have already been murmurs that last week’s vote will lead the EU to offer new, more generous terms to convince Britain to stay, prompting a second referendum.
◾ How will the Federal Reserve in the U.S. and Central Banks around the world respond? It appears near-term rate hikes in the U.S. are almost off the table now. After the Brexit vote, the odds for any rate hikes this year fell to only 10% by December.
◾ What will this mean for elections in the U.S. and around the world in the near term? It appears the anti-establishment vote is gaining momentum.
Given that investors, pollsters and betting markets widely anticipated that the UK would not exit the EU before last week’s vote, the global markets had to “reset” after the Brexit vote leading to increased volatility and a sharp drop in the equity markets on the day after the vote. Part of the drop was the reversal of the run-up earlier in the week on the anticipation that the Remain vote would win. We don’t expect the markets to “calm down” anytime soon as we expect more volatility in the weeks and months ahead as investors attempt to digest all of the implications of Brexit. However, remember the markets tend to discount new information quickly and the collective wisdom of the market will be discounted into market prices. We believe the best course of action for investors is to not make any rash moves and to ride out this expected near term volatility with a sound, well balanced and broadly diversified portfolio. The markets historically have always climbed a “wall of worry” and this isn’t the first time the global markets have faced uncertainty. It is because the markets are uncertain and risky that we are rewarded with higher longer term returns, but only if we stick to our long-term, disciplined strategy. Feel free to contact us in Wealth Management if you have any questions.