Going alone - UK to leave the European Union

Following an intense, often messy and in parts tragic campaign, the UK has voted to leave the European Union. Risk assets and the currency have reacted negatively and it now seems we’ll enter an extended period of uncertainty both for the UK and the European Union (EU) as the details of the exit are worked out. In the grand scheme of things, the near-term economic impact is likely to be limited, but there is a risk that the shock of the result triggers wider pent-up concerns around more substantive factors.

After months of discussion, intense campaigning and tinged by the tragic death of MP Jo Cox, the British people have gone to the polls for the first time in more than 40 years to decide on the nation’s future in Europe. With a vote of 52% the electorate has instructed the Government to begin the process of negotiating an exit from the EU. With this widely held to be a one-way path, there is every reason to think this process will be protracted and difficult. On purely economic grounds, many will want as orderly and amicable a process as possible. However, with a number of polls on the continent showing increasing dissatisfaction with the EU and growing separatist sentiment, there is a very strong risk that the politics overrides the economic and investment case. In such a scenario, the incentive for EU politicians would seem to be to make any exit as painful as possible to quell domestic factions which could lead to further disintegration of the trading bloc.

What happened

Whilst polling data had shown for some time that the result would be close, a shift in favour of the Remain camp in the last few days meant many were caught by surprise by final result, reflected in the market reaction. At the same time, although betting odds had been consistently tilted heavily towards a Remain vote throughout the campaign (last seen ranging between 70-80% implied probability), further reports from the bookies had raised questions over the predictive ability of these odds given the unconventional betting patterns. With a strong turnout of 72% of the electorate, despite the fairly close result, it does seem clear that a strong mandate has been handed to the government.

Market reaction

The initial market reaction has been negative after sentiment in the days preceding the referendum itself seemed to have shifted to favour a Remain vote. The pressure valve that is the currency has seen sterling fall particularly sharply, touching levels not seen since 1985, while global equity markets are deeply into negative territory. Whilst market swings witnessed in the run up to the election had more to do with investors trying to second guess one another than true market impact, the prospect of protracted uncertainty across the UK and Europe is likely to keep volatility elevated.

Following the immediate shock to UK equities there is scope for differentiation within the market – large-cap stocks, which tend to be multi-nationals, could outperform both due to their relative lack of domestic economic exposure and the ability to repatriate overseas earnings at a favourable exchange rate. On the flip-side, mid- and small-sized companies are likely to face more pressure, being more tapped in to the UK economy.

Despite the current turbulence in markets, we don’t believe the economic predictions from either campaign had any real validity and, despite an expectation for a short-term GDP hit, the underlying economic impact is likely to be limited in the grand scheme of things. With little fundamental basis to work on, following the initial impact, markets could stabilise somewhat, though the risk remains that the result is a trigger event that causes renewed investor worry about more substantive factors. As always, it is worth remembering that long-term investment returns are primarily driven by the top-down impact of global macroeconomic conditions, and the bottom-up factors of enterprise and innovation at individual investee companies.

Outlook

The economic impact of the UK leaving the EU is effectively unknowable, but in the grand scheme of things we expect the impact to be relatively limited – economies and their agents will adapt, and the shock of the result will dissipate over time. Although uncertainty will remain, with the referendum complete we expect markets to get back to focusing on more substantive issues, which we have been continuing to monitor carefully even while much attention has been temporarily diverted. Perhaps one of the major investment concerns from the Leave vote is the risk it becomes a trigger for pent-up concerns over some of these.

At the top of the list is how the US Federal Reserve manages US interest rates. We think the Fed has created a no-win scenario for itself, as its preferred measures of inflation and employment are approaching its targets just as profitability at US corporations seems to be coming under pressure. It now faces the risk of either accelerating the onset of recession by hiking too quickly, or letting an economic malaise take hold without the traditional re-boot mechanism of cutting interest rates.

A less probable, at least in the near term, but higher-impact risk is a disorderly unwind of the debt bubble that has been fuelling Chinese growth for the last decade. Sharp but brief falls in global equity markets last summer and again at the start of this year provided a taster of what could happen if China continues to play fast and loose with its capital allocation.

Against these concerns, we continue to see pockets of opportunity with policy stimulus continuing to be a key driver of markets in the near term.

Politics is a growing factor

In closing, one key aspect of the EU referendum worth holding on to is the growing impact politics will play in the formulation of macroeconomic policy-making.

Globally we are seeing anti-establishment rhetoric growing as extraordinary monetary policy drives an increasing sense of social inequality. Asset price inflation has materially exceeded wage growth for a prolonged period, giving rise to the perception that policy is being set for the benefit of the few at the expense of the many.

This in turn is manifesting in anti-establishment politics, evidenced by the successes of Syriza, a far left party, and Golden Dawn, a far right party, in Greece as well as the rise of Donald Trump in the US and Jeremy Corbyn in the UK - regardless of your views of Mr Corbyn, I think most would agree he is decidedly not ‘establishment’. Not only is political instability likely to drive volatility in markets, there are also worrying signs of a growing appetite for government interference in the actions of nominally independent Central banks, just as the unconventional monetary policy experiments extend further into the unknown.

Uncertainty around how the UK actually leaves the EU and on what terms will remain for the foreseeable future, but is likely to fade into more of a background process. In the meantime, there are more significant factors to consider that are likely to have broader ramifications on globally-diversified portfolios, and we will continue to monitor the investment outlook and act accordingly.