"Seldom has any nation been met with such a simple yet consequential a choice, with the rich and poor, young and old, north and south all given a hand in creating history."
We refer to the historic Brexit referendum, as Britain sets course to become the first major country to leave the European Union that evolved from the ashes of the World War II.
The referendum triggered shockwaves globally, and what followed was whipsaw trading in Pound, plummeting stock prices, a global flight to safer assets and the abrupt stepping down of PM David Cameron. Global asset markets were caught unawares with the result, as the latest polls had swung decisively toward “Remain” and markets had not priced in the risk of Brexit correctly.
Two Sides of the Argument
This unprecedented event has its pro-Brexit roots in the emotionally-charged issue of internal migration, along with loss of sovereignty and EU’s burdensome economic regulations. So intense was the anti-establishment feeling with the EU, that voters brushed aside unanimous warnings of the economic perils of walking alone.
There were strong pro-EU camps in the closely-matched poll as well, with economics being their primary baton. The U.K. has enjoyed long-term economic and trade benefits by being part of EU and, according to some, the exit would be deeply disruptive to the nation in the short term and could even lead to a recession.
In any case, unwinding its 43-year membership with the bloc might just place Britain on a legal and political “no man’s land”, at least for a couple of years.
It Will Be No Velvet Divorce
Well, technically speaking, the Brexit referendum is not legally binding. However, it would be nothing less than political suicide to go against the will of the people and disregard the referendum.
Consequently, Britain will likely initiate the messy divorce proceedings with the EU soon and will have a two-year window to negotiate a new treaty to replace the terms of the existing membership. There will thus be no time for romantic visions and issues like trade tariffs, migration, EU budget and regulation will have to be settled in this tight span of time.
Among a dozen other potential roadblocks, the EU might just decide to strike a hard bargain, using the proceedings to discourage other countries from leaving the bloc. As a senior EU official remarked: “We are faced with a million mad questions and we won’t have answers any time soon.”
The Risks of Transition
The biggest economic threat would be a long wait for Brexit to become a reality and the new trade agreements to take shape. Quitting the EU bloc would mean Britain will lose access to EU's trade barrier-free single market. Thus, it must seek new trade agreements with countries across the world, which is easier said than done. The exit also leaves a huge question mark over London's status as Europe’s financial center.
Some skeptics believe that the political omens are not very auspicious, with too many shifting factors to speculate clearly.
The Ripple Effect Again?
The markets hate the unknown and Brexit has ushered in a massive amount of unknown risks and effects.This translates to high volatility on a global scale. Let’s discuss a few of the risks that are unraveling.
- Pound Goes Into Freefall: Currencies are riding on a Brexit roller-coaster as Sterling tumbled against U.S. Dollar and Japanese Yen. In fact, the British pound plunged over 10% and touched levels not seen since 1985, as the poll results took shape. Euro sunk considerably against major currencies as well, as investors feared for its very future.
- Brexit Tremors Affect Equities: Britain’s vote to leave EU sent shockwaves across global markets. Stock markets across Asia recoiled, with the Japanese Nikkei down nearly 8%. Stocks in London opened down about 16%, while Frankfurt and Paris indices fell about 10% and 8%, respectively. U.S. stock futures too got slammed as the results unfolded, with S&P 500 Futures down almost 4% at the time of writing the article. As investors flock to safety amid high volatility, U.S. equities look set for a dark spell.
- Safe Havens Beckon: Investors fled to the traditional safe-harbors of top-rated government debt, Japanese Yen and gold, while risk assets were scorched. At one point, the pound fell over 15% against the Yen, while Gold futures rose about 8.5%.
- Scotland’s Stance: Scotland has seen some strong remarks from its majorly pro-EU voters, who are adamant about Scotland wanting to be part of the EU. They might call for another referendum for the same and this could eventually break the U.K. apart.
- Federal Reserve’s Actions: Brexit also reduces the chances of a July rate hike across the Atlantic, as the associated risks might incline the Fed to put its tightening policies on hold.
A Moment of Global Fear
The Brexit has no historic precedent. As such, investors all over the world are grappling with the prospects of sustained anxiety in the global economy. In the immediate future, heightened volatility might continue to play havoc with asset classes, especially equities. But we believe that as the fire dies down, the markets will be calmer, and fundamentals will drive equities again.
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Zacks Investment Research