Brexit

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What is 'Brexit'

Brexit is an abbreviation for "British exit," which refers to the June 23, 2016, referendum whereby British citizens voted to exit the European Union. The referendum roiled global markets, including currencies, causing the British pound to fall to its lowest level in decades. Prime Minister David Cameron, who supported the United Kingdom remaining in the European Union, resigned on July 13 as a result. Home Secretary Theresa May, leader of the Conservative Party, became Prime Minister.

In November, the British High Court ruled that the government needs the Parliament's approval to trigger Article 50 of the Lisbon Treaty and begin the process of withdrawing the UK from the EU. The government has said it will appeal the verdict to the Supreme Court in December. If the Supreme Court agrees with the High Court's decision, the Parliament will have to vote on whether Brexit should take place. Otherwise, Theresa May plans to trigger Article 50 at the end of March 2017.

BREAKING DOWN 'Brexit'

Supporters of Brexit based their opinions on a variety of factors, from the global competitiveness of British businesses to the European debt crisis to concerns about immigration. Britain had already opted out of the European Union's monetary union – meaning that it uses the pound instead of the euro –  and the Schengen Area, meaning that it does not share open borders with a number of other European nations. "Out" campaigners argued that Brussels' bureaucracy is a drag on the British economy and that European Union laws and regulations threaten British sovereignty.

Mohamed El-Erian, the chief economic adviser at Allianz, wrote in a Bloomberg editorial that a British vote to leave the European Union is likely to impose major instability on top of economic fragility and artificial financial markets.

Scotland's Stance

Popular support for Brexit varied over time, but the June 23rd vote demonstrated that British citizens believed that Great Britain can survive without the economic cooperation, trade agreements and partnerships that benefited the country for the past several years. As a member of the United Kingdom, Scotland would be part of Brexit, but First Minister Nicola Sturgeon said in a statement on the Scottish National Party’s website that she plans to explore all options to remain in the European Union, including having its own referendum. 

Brexit Fallout

Fulfilling various negative predictions, the leave vote severely impacted markets worldwide. The British pound crashed by more than 11% against the dollar – its biggest-ever one-day fall – and London’s FTSE and Stoxx Europe 600 fell by 8% on the news. Both Barclays and Lloyds Banking Group saw their shares plummet more than 30 percent before rebounding slightly. Germany’s Deutsche Bank was down about 14%, the Bank of Ireland and two of Italy’s largest banks were all down by more than 20%. Shares in Greece’s big banks were down around 30%.

In the U.S., stock markets were down 3% across the board, with investors rushing to safe-haven assets such as bonds, gold and the Japanese yen. Morgan Stanley and Citigroup were down nearly 10%, with Bank of America, JPMorgan Chase and Goldman Sachs all trading down by between 5% and 7%. Oil prices also trended downwards by 5.2%. In a CNBC interview, former Federal Reserve Chairman Alan Greenspan said the fallout was worse than 1987, calling it the "worst period I recall since I've been in public service. The global economy is in real serious trouble. This has a corrosive effect that will not go away," he added.

The effect exacerbated friction among EU members that has been ongoing since the inception of the euro currency. Many participants in the common currency have long voiced concerns about the value of the euro being tied to the German economy and smaller, slowing economies are struggling from a currency that is artificially high. "I always thought we're going to start with the euro because the euro is a very serious problem in that the southern part of the euro zone is being funded by the northern part," Greenspan said on CNBC.

Jim Mellon, Chairman of the Burnbrae Group said the British vote to leave will put the euro at serious risk. The euro is "unsustainable," he said. He said the euro as a German currency is under-valued and for a French currency it is over-valued. "I think the euro is gone within three to five years, as it currently exists," Mellon said.
 
In the immediate aftermath, several analysts brought up the specter of recession. "It’s likely that the chances of a global recession have risen above 50%,” said Arif Husain, head of International fixed income, at T. Rowe Price. Bo Christensen, chief analyst at Danske Invest, predicted a “mild recession” in the U.K. and Europe and slow hiring and investments.
 

El-Erian’s Contrarian View

At least one influential voice suggested that a British exit from the European Union (EU) could actually be good for the political bloc. For former Pimco executive and current economic adviser at Allianz, Mohamed El-Erian, a Brexit may be just what the EU needs to stabilize and secure its future. In an article published in The Guardian, El-Erian proposed that Brexit could actually solve a fundamental problem currently plaguing the EU. That problem is a fundamental difference of opinion amongst EU member states as to what the purpose of the EU actually is supposed to be.

On the one side, the British view holds that the purpose of the EU is to exist as a “super free-trade zone,” whereas the German-French view is that the political bloc exists to facilitate greater integration. The divergence is ultimately a roadblock that El-Erian argued could be removed if the U.K. simply left. If such a roadblock were removed, then it could actually have a number of positive economic and political implications.

Longer-Term Effects

Because the exit process could stretch over two years once Article 50 of the Lisbon Treaty is invoked (and there is no deadline for invoking it), predictions about Brexit's future impact on British citizens are mostly speculation; however, experts suggest that Brexit is likely to mean slower economic growth for the country. A slowdown in investments may also lead to fewer jobs, lower pay and higher unemployment rates. Britain relies on the EU for export far more than the EU depends on Britain. The absence of seamless access to European markets also may mean fewer exports and foreign investments. Additionally, consumers and employers reacting to "doom and gloom" news about Brexit's potential fallout alone may contribute to an economic slowdown as companies hire fewer people and consumers spend less money.
 
In particular, slowed growth in Britain would translate to contraction in Ireland, since exports of goods to the United Kingdom account for nearly one-third of Ireland’s total output. The flow of Irish labor to the United Kingdom might be curbed, which would in turn exert pressure on Irish wages as more people compete for fewer jobs.
 
Michael R. Bloomberg, former mayor of New York City and founder of Bloomberg News, pointed out the EU could penalize Britain, imposing harsh limitations, to deter other member states from following its example.
 
Capital Economics, a research consultancy, stated that Britain’s exit could result in “looser monetary conditions” around the world. According to the firm, Britain’s exit could prolong the ECB’s bond buying program and even increase its size. “The Bank of England is likely to keep interest rates low for longer and, if necessary, may even announce further policy easing,” an analyst at the firm wrote in a note, adding that the European Central Bank (ECB)’s purchase program could potentially increase in size in the future.  
 
The pound could continue to take a pounding. If Britain can no longer rely on continental Europe for barrier-free trade and mobility, there is a strong chance that capital will leave the country to avoid getting stuck there. In other words, investors may sell pounds (or pound-denominated assets) to purchase those denominated in dollars, euros, or francs. A sharp fall could last for longer than anticipated as politicians and deal makers try to establish new trade agreements and economic pacts that can take many months or even years to ratify.

Furthermore, if the domestic economy of the U.K. does slip into recession, it will keep the Bank of England (BoE) from raising interest rates to protect the currency, further compounding the problem.

Upsides for Some

On the other hand, a weak currency that floats on global markets can be a boon to U.K. producers who export goods. Industries that rely heavily on exports could actually see some benefit. In 2015, the top 10 exports from the U.K. were (in USD):

  1. Machines, engines, pumps: US$63.9 billion (13.9% of total exports)
  2. Gems, precious metals: $53 billion (11.5%)
  3. Vehicles: $50.7 billion (11%)
  4. Pharmaceuticals: $36 billion (7.8%)
  5. Oil: $33.2 billion (7.2%)
  6. Electronic equipment: $29 billion (6.3%)
  7. Aircraft, spacecraft: $18.9 billion (4.1%)
  8. Medical, technical equipment: $18.4 billion (4%)
  9. Organic chemicals: $14 billion (3%)
  10. Plastics: $11.8 billion (2.6%)

Some sectors are prepared to benefit from an exit. Multinationals listed on the FTSE 100 (^FTSE) will see earnings rise as a result of a soft pound. Sterling weakness will also benefit tourism, energy and the service industry.

In May 2016, the State Bank of India (SBIN.NS), India's largest commercial bank, suggested that the Brexit will benefit India economically. While leaving the Eurozone will mean that the U.K. will no longer have unfettered access to Europe’s free trade single market, it will allow for more focus on trade with India. India will also have more room for maneuvering if the U.K. is no longer abiding by European trade rules and regulations.

Britain's Next Moves

Much of the future is riding on the Supreme Court's decision in December. If the government loses its case in the Supreme Court, it will fall on the Parliament to decide the fate of the British people. But the June referendum itself was touted as a way to give the British people a say in the matter and the House of Commons voted to conduct it. Since the members of parliament are meant to represent the people, they will feel pressure to agree to Brexit or risk being accused of ignoring the wishes of their voters. 

Once Article 50 is invoked, it sets a two-year deadline to negotiate trade agreements with the remaining 27 countries in the EU. The latest data has the EU accounting for 48% of U.K. exports and 51% of its imports.

What are the options the U.K. will have when finalizing its potential divorce with the EU?

The Norway Model: Join the EEA

The first and most logical option would be for the U.K. to join the European Economic Area (EEA). The EEA promotes free trade and the movement of goods via the EU "Single Market." On the face of it the cost to the U.K. to join the EEA may be small; however, there are problems. Joining the EEA would require the U.K. to pay into the EU, but it would relinquish any say in the laws and regulations set because it would be giving up voting rights in the European Council and the European Parliament. The British Treasury sees a Norway-style agreement as causing the least economic harm, but this also conflicts with the Brexiters' demand of "dealing on our own terms."

Pro-Brexit politician Nigel Farage of the U.K. Independent Party believes the Norway model would be a step back for Britain. “We are a country of 65 million people. If Norway, Iceland and Switzerland can get deals that suit them, we can do something far, far better than that," Farage said in an interview with the BBC.

Lastly, and maybe most importantly, joining the EEA would mean the U.K. would have to accept the free movement of people, which would conflict with Brexiters stance on immigration.

The Swiss Model: Bilateral Trade Agreements

Switzerland's model is similar to the Norway model in that Britain would retain certain economic ties with the EU but with little say in negotiations and laws. The difference is that under the Swiss model, the UK would have to sign bilateral trade agreements with every other country individually, which becomes clunky as each trade agreement usually requires renegotiating every few years.

The size of the Switzerland economy makes this model a little easier for the Swiss. Switzerland's GDP is around $700 billion compared to the UK's, which is just shy of $3 trillion.

The Canada Model: Bilateral Trade Agreements with Strict Rules

A third option is to copy the Canadian model. Together, Canada and the EU are in the midst of negotiating the Comprehensive Economic and Trade Agreement (CETA), but it is yet to be signed into law. If the U.K. leaves itself just two years to sign trade agreements, the Canada approach may not be as feasible as many people think. CETA agreement negotiations have lasted seven years already.

What Brexiters are overlooking is what Canada is giving up, or more importantly what Canada can afford to give up. Canada already enjoys free trade with the United States via the North American Free Trade Agreement (NAFTA). So with NAFTA already in place the importance of a trade agreement with the EU is not as important for Canada as it would be for the UK. Moreover, CETA does not include financial services, which is a substantial part of the U.K.'s trade with the EU.

WTO: Go It Alone

You want out? You're out. A full break from the EU and the UK relying solely on the World Trade Organization (WTO) in dealing with the EU would be the most conclusive split with the EU and access to the EU's "Single Market." It would be a true go-it-alone approach. The UK would have no requirements for the movement of people in the EU (the pro-Brexit main argument); they would have no obligations to pay money into the EU budget, and the UK would have to renegotiate its co-operation on crime and terrorism with the rest of the EU.

Not only would the U.K. be giving up its trade agreement with the EU, but it would also surrender trade agreements with 53 other countries it is entitled to via the EU's Free Trade Agreement.

While the WTO has frameworks to ensure there is no discrimination between countries when organizing trade deals, there is a danger that, if after two years the UK hasn't negotiated individual agreements and there is no extension under Article 50, then the UK would fall back on the basic WTO agreements the EU has with its other trading partners. One part of the standard agreement is a common tariff the EU has on all countries with no prior agreement. The 10% tariff on all imported cars to the EU would be a financial disaster for Britain.

Impact on the U.S.

Companies in the U.S. across a wide variety of sectors have made large investments in the United Kingdom over many years. American corporations have derived 9% of global foreign affiliate profit from the United Kingdom since 2000. In 2014 alone, U.S. companies invested an aggregate total of $588 billion into Britain. The U.S. also hires a lot of Brits. In fact, U.S. companies are one of the U.K.’s largest job markets. Output of U.S. affiliates in the United Kingdom was $153 billion in 2013. The United Kingdom plays a vital role in corporate America's global infrastructure from assets under management, international sales and research and development (R&D) advancements. American companies have viewed Britain as a strategic gateway to other countries in the European Union. Brexit will jeopardize the affiliate earnings and stock prices of many companies strategically aligned with the United Kingdom, which may see them reconsider their operations with British and European Union members.

American companies and investors that have exposure to European banks and credit markets may be affected by credit risk. European banks may have to replace $123 billion in securities depending on how the exit unfolds. Furthermore, U.K. debt may not be included in European banks' emergency cash reserves, creating liquidity problems. European asset-backed securities have been in decline since 2007. This decline is likely to intensify now that Britain has chosen to leave.

The day after the vote, the British pound dropped to historic 30-year lows against the dollar. Moreover, weakness in the pound could be contagious and affect the euro as well. A weaker British pound and euro will likely hurt the bottom line of U.S. export companies doing business with customers in the United Kingdom and European Union, as the cost for American products and services would increase, tempering demand.

Jim O’Sullivan, chief economist at High Frequency Economics, said Brexit would not have major impact for the U.S. public outside of financial markets. “But a significant impact on Wall Street would negatively affect confidence on Main Street,” he wrote shortly after the vote, adding that the firm had not “seen anything thus far to suggest a major impact on the U.S. banking system, especially given the starting point of high capital ratios, as was evident in the annual stress test results released yesterday.”  

How To Invest 

There are a number of positions investors can take to profit. Precious metals (gold is an obvious choice in this regard), the U.S. dollar, bonds and utilities look like excellent choices for traders and investors seeking to benefit from the maelstrom.  Before and after the vote, there were signs of a flight towards digital currency: Bitcoin has become an unlikely safe haven, as has the currency ethereum.

The Foreign Exchange Market

It wasn't just the actual leave decision: ever since the idea of a Brexit surfaced in late 2015, sterling had been suffering with respect to other major currencies (it fell over 10% against the euro from November 2015 to March 2016). The United Kingdom’s reluctance to change interest rates have been partly responsible for pushing the currency lower. For investors seeking a position in the FX market, the U.S. dollar could be a safe bet, as could the Swiss franc. The dollar is already poised to pop when the Federal Reserve raises interest rates later this year and now, post-Brexit, its value could jump even further.
 

The Stock Markets

With the massive amount of uncertainty surrounding Brexit and its potential long-term effects, now may be a good time to add appropriate global stocks selling at all-time lows to your portfolio – or to hedge your current positions against the uncertainty.  One example is mainstream index funds or ETFs that track major markets and are either hedged daily or monthly. For investors wanting to carry on investing in Eurozone equities, but don’t want the risk of the pound, there is the MSCI EMU index. The ETF tracks a basket of large cap Eurozone blue chip stocks which can protect you from some of the downside risks. Meanwhile, domestic investors could see the FTSE 100 increase in value. With over 70% of FTSE 100 members operating globally, currency head winds are likely to increase earnings and revenue, thereby increasing share prices.

Certain sectors could also benefit, including tourism, energy, and the services industry. The tourism industry would certainly benefit from a weak currency, while energy-intensive manufacturers can operate independently of the European Union’s expensive policies. Long-term investors are presented with an opportunity to buy low and hold on sectors that have been most affected.

 

Who Will Be Next to Leave the EU?

Worry over the future of the EU continues to sweep through the continent. The populist movements in Europe have seen the Brexit vote as a win, and calls for other national referendums have already begun as people wonder who will be next in line to leave the EU as the Euro-skeptic movement grows, despite European leaders' calls for calm.

Here are some of the candidates for referendums:

  1. France is seen as the first in line for a so-called Frexit. The French National Front (FN) party, lead by the charismatic and anti-EU politician, Marine Le Pen, hailed the Brexit vote as win for nationalism and sovereignty across Europe. “Like a lot of French people, I’m very happy that the British people held on and made the right choice. What we thought was impossible yesterday has now become possible,” Le Pen Said. She [Le Pen] has vowed, if elected French President next year, an EU referendum for France will take place within six months.
  2. Italy might have the biggest support amongst voters when it comes to a potential exit from the EU. Hours after the Brexit result, Italy's head of the Northern League, Matteo Salvini reiterated his stance that it was time for Italy to give the people a voice. "This vote was a slap in the face for all those who say that Europe is their own business and Italians don't have to meddle with that," Salvini said. The Northern League has an ally in the five-star movement. Virginia Raggi, who was elected mayor of Rome, is a campaigner for the anti-establishment movement and has also called for an Italian referendum on its EU membership. The fragile (at best) Italian banking sector is causing a divide between the Italian government and the EU. The government would like to bail out the banks but under EU regulations they can't be bailed out without bond holders taking the first hit. The problem Italy faces is that the majority of bond holders in Italy are private "mom and dad" investors.
  3. Greece's departure, or Grexit, was long coined before Brexit. Interestingly, the Greeks have voted to leave the EU in the past – specifically, July 2015 – and the measure failed, with only 39% voting to leave. The "no" result meant that Greece was forced to restructure debt and accept continued austerity. While Greece might be seen as a likely contender now – the "yes" vote for Brexit could give anti-austerity parties in Greece and their supporters enough momentum to succeed in a new referendum – its close financial ties to the EU make a departure much more difficult. Greece currently owes €32 billion to the IMF and €20 billion to the European Central Bank.
  4. Scotland, which voted for Independence from the U.K. in 2014 and lost, voted overwhelmingly in favor of the U.K. staying in the EU. As a result, some leaders are calling for a second referendum on Scottish independence. "I think it would be democratically indefensible for Scotland, if we had voted to stay in, to face the prospect of being taken out," Scotland's First Minister Nicola Sturgeon said in an interview with Reuters. If Scotland did leave the U.K., it would likely rejoin the EU.

Denmark and Holland are other likely candidates for possible referendums on EU membership.

In May 2016, global research firm IPSOS released a report that showed Italy and France at the top of the list of countries who believe their country should hold a referendum.

 

Source: IPSOS