The aftermath of Brexit

by Theodore Hatsis CIMA®, Head of Research, Centrepoint Alliance

On Friday 23 June, the British electorate voted to leave the European Union (EU), ending a 40 plus year relationship with 51.9% of the vote in favour of leaving and 48.1% in favour of remaining. As a result, the British pound (GBP) was hammered on Friday afternoon, falling approximately 10 per cent versus the US dollar, its lowest level in about 30 years. Equity indices around the world tumbled and volatility increased sharply resulting in further pricing pressure on risky assets and a rally in developed market government bonds - US 10-year bond yields had fallen more than 30 basis points to 1.44%, their lowest level since 2012.

What happens next?

The UK government is likely to invoke Article 50 of the Treaty on European Union, which provides for a two-year period for negotiating a country’s withdrawal from the EU. Article 50 has never been invoked, which raises significant uncertainty regarding the process for negotiating and securing EU approval for an exit agreement. An extension can be granted however this requires unanimous approval by all remaining 27 member countries.

Implications

The political fallout from the referendum will cast a shadow over UK politics. Prime Minister David Cameron has already announced his intention to resign with more political turmoil expected in the coming weeks and months. The vote to leave the EU could spur a breakup of the United Kingdom as a whole. 

Coupled with political uncertainty in other parts of Europe, the implications are potentially quite significant around the meaning of the European Union going forward. Although we feel this is more of a political crisis rather than a financial crisis, the potential for economic spill-over is very real.

What does the future hold?

The shock of the result will no doubt dictate the direction of markets in the immediate term, and will no doubt introduce a number of different challenges and risks going forward. Although difficult to predict in the short-term, heightened volatility is assured due to media hysteria and market unknowns.

We expect relative calm once the initial shock has transpired, as transitioning out of the EU will take time. Who leads the UK will also need to be determined.
An immediate impact on business confidence is likely with decision making in both the UK and Europe likely to stall. This could result in a pull-back of the UK economy with Bank of England likely to cut official interest rates back to possibly zero. Currency movement is also likely to be highly volatile. 

The long-term impact of Brexit is also difficult to predict. The EU is the UK’s largest trading partner, with about half of UK exports going to EU countries and exports to the EU accounting for about 13% of UK GDP in 2014 [1]. 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 more likely than not, will need to be re-negotiated. A prolonged and possible messy exit and negotiation process could create a significant drag on UK exports and overall economic growth and a smaller but material drag on EU growth.

UK banks could face higher funding costs and weaker loan growth. We do not think this would represent a major credit risk to the banks which currently benefit from strong credit quality indicators. The recent results of the Bank of England's stress test on the UK banking system serve as a good measure of the bank’s resilience against a pronounced Brexit-induced shock. The good news is unlike Grexit, UK banks do not face redenomination or sovereign default risk.

International markets implications

Global equity markets will continue to be volatile with opportunities presenting themselves for global managers. Re-rating of UK and European stocks off the back of currency, sector and revenue contribution is highly likely. Companies with defensive revenues such as consumer staples and utilities are likely to benefit while consumer discretionary and other cyclicals, those more sensitive to potential negative changes to economic growth, are likely to be hit hard. Bond markets will rally as a flight-to-quality will lead to further drops in yields. Developing market bonds and peripheral European bonds, and credit markets will come under pressure as investors gravitate towards Gilts, Treasuries and Bonds. 

Impact to Australia

Australia will not be immune to the impact of Brexit given our strong and long standing ties with the UK and the EU. Most immediately, the impending Australia-EU Free-Trade Agreement becomes more complicated and could end up being less attractive.

The importance of Australia's relationship with the EU tends to get under-reported in all the excitement about China however the EU consistently shows up as one of Australia's main trading partners.

The EU is Australia's largest services export market, valued at nearly $10 billion in 2014. Services account for 19.7 per cent of Australia's total trade in goods and services [2], and will be an important component of any future free trade agreement.

The UK was Australia's eighth-largest export market for 2014; it represented approximately 38 per cent of Australia's total exports to the EU. Our ongoing relationship with both the UK and EU remains crucial.

One immediate positive to come has been the fall in the Australian dollar as investors flock to the US and US treasuries. The RBA along with their global counter-parts will be keeping a close eye on global growth in the immediate future to determine whether further stimulus will be required.