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Brexit: Major Implications and Asset Allocation Recommendation

What Happened?

  • Sterling weakened nearly 8%[1] on June 24, 2016 in the immediate aftermath of Brexit.
  • Switzerland’s central bank gave a rare confirmation on June 24, 2016 that it had intervened in the currency market to weaken the Swiss franc in the wake of Britain’s vote to leave the EU.
  • Following the U.K.’s vote to leave the EU, the Swiss franc came under upward pressure, the Sterling National Bank said in a statement that it had intervened in the FX market to stabilize the situation and will remain active in that market.
  • Gold rose almost 5%[2] on June 24, 2016 as people rushed into safe-haven assets.
  • David Cameron resigned as Prime Minister shortly after 8am, announcing that he thinks Britain should have a new Prime Minister in place by the start of the Conservative conference in October. He will leave the task of triggering Article 50 to his successor. He will be under intense pressure to activate Article 50 and commence exit negotiations.
  • Caterpillar Inc., an American corporation which designs, manufactures, markets and sells machinery, engines, financial products and insurance to customers via a worldwide dealer network, said on June 24, 2016 that the UK is an intrinsic part of its European supply chain and Caterpillar urged all parties to reach an agreement that quickly removes uncertainty.
  • BP plc, one of the world’s seven “supermajor” oil and gas companies, said it is far too early to understand the detailed implications of this decision, and uncertainly is never helpful for a business such as its.
  • EU financial equities were hurt as EU banks exceeded 5 standard deviations, based on a 3-month moving average[3].
  • Scottish nationalist Nicola Sturgeon said on June 24, 2016 that the Scottish National Party will begin to prepare the legislation to allow a new referendum to take place before the UK leaves the EU. This means that the second Scottish independence referendum is likely to happen within the next two years. The First Minister added that the Scottish parliament must be fully and directly involved in the UK negotiations with Brussels.
  • Britain’s vote to leave the EU fired up populist Eurosceptic parties across the continent on June 24, 2016, giving fresh voice to their calls to leave the bloc or its euro currency.
  • Right-wing and anti-immigrant parties in the Netherlands, Denmark, Sweden and France demanded referendums on membership of the union, while Italy’s Five Star Movement said it would pursue its own proposal for a vote on the euro.

How Will a Brexit Actually Work and What Happens Next?

June 27, 2016 – July 1, 2016:

The European Central Bank summit is planned for June 28-29, 2016; EU countries could start giving U.K. the cold shoulder and pressuring Cameron to trigger Article 50; the U.K. could find itself excluded from EU meetings about withdrawal negotiations and restructuring talks.

July 1, 2016 – September 1, 2016:

Cameron or the next Prime Minister could trigger Article 50 of the Treaty of European Union and thus, the U.K. will begin its two years of negotiation to exit the EU; Cameron could step down as Prime Minister; the U.K. will begin lengthy talks to renegotiate EU agreements and trade arrangements.

Fall, 2016:

Cameron resigns as Prime Minister; EU council of ministers will agree to negotiation mandate via directives to the commission.

Winter, 2016:

The U.K. and EU will have renegotiated the EU budget payments to add from Britain, the rights of U.K. citizens in Europe, the rights of EU citizens in the U.K., the pensions of British EU civil servants, the relocation of EU agencies based in the U.K.

2017:

The U.K. and EU will have renegotiated trade relations that somewhat preserve the U.K.’s access to the single market; if no trade deal is finalized, the U.K will have no choice but to trade with the EU under WTO rules.

What are the Economic Implications of the Vote?

From an economic perspective, exiting the EU will be negative for Britain, and to a lesser extent Europe. The U.K. is currently in the latter stages of the mid-cycle phase of the business cycle. Business activities and sentiment have weakened ahead of the vote, but consumer demand is holding up and the economy remains in a slow but steady expansion. The vote to exit will likely hurt business sentiment and investment immediately. The big problem is the uncertainty surrounding what future rules will govern the U.K.’s commercial relationship with the EU. There is no template for a country exiting the EU since it has never happened before. The rules say there is a two-year window for the EU to determine how they want to treat commerce after the exit.

The U.K. relies on exports to other EU countries for nearly half of its exports, but the preferential trade access the country enjoys as part of the EU could be eliminated. The U.K. is the center of Europe’s financial system, but the regulatory treatment of its financial operations on the continent may change. This uncertainty, with the fact it could take years to sort out the new relationship, is likely to weigh heavily on U.K.’s business decisions. This uncertainty is likely to slow economic activity in the near-term. I am not sure whether it will be enough to shock the economy into a recession, but I certainly expect it would be a negative short-term event for the U.K.

For Europe, the story is more complex. Europe does not rely on the U.K. as a market for exports to the same extent, and if the financial services industry in London were displaced, over time it might actually bring business to other European financial centers. At the same time, a vote to exit raises many questions about the stability of Europe in terms of the political support for European integration. This is more difficult to measure in terms of near-term economic impact, but it is also likely to hurt business and investor sentiment. Overall, I think it will be negative for Europe’s economy, but not to the same extent as the U.K. itself.

What Could a Vote to Exit Mean for Investors?

Certainly, the U.K. vote to leave has roiled global and European markets. The most vulnerable of the European markets, Spain and Italy, were down more than 10% on June 24, 2016 and even Germany was down approximately 7%. As I mentioned, a vote to leave also raises questions about both the U.K. and the future of other countries in the EU, so ultimately the vote to exit means more uncertainty. This comes at a time when the global economy is struggling to regain traction, so any additional headwinds just make the environment much more difficult.

Generally, more uncertainty means investors want to take less risk. That could set a negative near-term tone for global stock markets, and U.K. stocks and the pound in particular, but also the euro currency. In such a risk-off backdrop, the U.S. Treasury may be a safe haven, so a vote to exit might continue the Treasury rally and support the dollar.

What Does the Vote Mean for the U.S. Economy?

The vote to leave likely has little direct impact on the U.S. economy over the long term. U.S. economic trends are heavily driven by the U.S. consumer (roughly 70% of GDP), which continues to benefit from tighter labor markets and rising income expectations that are little impacted by the vote in the U.K. As a result, I still believe the U.S. continues to experience a mix of mid- and late-cycle indicators, and the odds of recession remain low.

Recommended Sector Allocation and Asset Allocation

I expect continued uncertainty and currency volatility, particularly some weakness in the euro. I recommend investors focusing on long-term goals, increasing allocations to the U.S. markets. Among all sectors, I favor staples, technology, and I suggest underweighting telecom and utilities. Regarding U.S. asset classes, I favor U.S. large-cap equities and U.S. Treasury, neutral on Japan, non-safe-haven sovereigns or non-treasury, U.S. high yield, agricultural commodities, and I suggest underweighting Renminbi.

[1] Strategas Research Partners, LLC

[2] Strategas Research Partners, LLC

[3] Strategas Research Partners, LLC

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