Brexit and Your Investments

Posted by Rick Miller on June 30, 2016

• The long-run economic impact on investments of Brexit is likely to be small, and the United Kingdom will be most directly affected.
• Stock investors are likely to experience increased volatility as the details of the new agreement between the United Kingdom and the EU are hammered out.
• Bond investors will likely experience a longer period of low interest rates as stock investors seek a safe haven.
• Stock market movements on Friday reflect surprise and disappointment at the Brexit vote.

Brexit (the exit of Great Britain from the European Union) is an example of an apparently unsuccessful economic and political union. Great Britain or United Kingdom (UK from here on) “Leave” voters were motivated by economic dissatisfaction (they perceive themselves to be net losers), discomfort with immigration from other parts of the European Union (EU), and resentment of decision-makers in Brussels (the EU capital). There were not enough economists, economic winners, and cosmopolitan citizens (Londoners voted to stay by 60% to 40%) to outvote the “Leave” supporters.

With all that as prologue, let’s consider the investment implications. As stock investors, we are interested in the implications for current and future public company profitability. As bond investors, we are interested in credit quality or default risk and interest rates.

Companies and bond issuers function in economies, so we are also interested in the implications for economic activity as a whole. Let’s start there.

First, this is a peaceful dissolution. There has been no saber rattling from the EU or any member country about using military force to keep the UK in the EU. Contrast this with the American Civil War or the use of Russian troops to keep Hungary in the Soviet Union.

Brexit will affect the UK more directly than it will any other country. There will be a change of government (Prime Minister David Cameron has said he will resign). The UK will also have to negotiate both the terms of its leaving the EU, and the new terms under which it will engage. As the EU is the UK’s largest trading partner, these terms will have a significant impact on the UK’s economic performance.

[Side note: “Brexit” is not well-defined. Britain is leaving the EU and will make new agreements with it. If those customs and migration agreements are very similar to the current structure, the economic impact on both the UK and the EU economies will be slight (“Brexit” in name only). If the agreements are radically different, with high trade and immigration barriers, both UK and EU economic performance will suffer.]

Despite its significant presence in American consciousness, the UK represents only 4% of the world economy. Even a UK recession would have little impact on global economic activity.

For the EU, the economic effects will be smaller than they are for the UK. The UK is only one (albeit very large and prosperous) of many EU members. Each EU member trades with all the others as well as with the UK. Any decline in UK economic activity with the EU will be shared by all of the other members, and they will still be trading with each other. Importantly, trade with the UK may ultimately diminish, but it will not vanish.

UK companies may see a decline in profitability, and so may companies in the rest of the EU. They may have less business, and it may be more expensive to conduct. So, we’d expect the share prices of the affected companies to fall. Most US companies will be much less affected than UK and EU companies, because only part of their business is in the UK or the rest of the EU. We would expect stock markets to be more volatile until details of the new UK/EU agreements are finalized, and the new rules are known.

Sovereign government bonds, as “safe havens,” are likely to rise in price (and their interest rates will fall), as investors seek a refuge from stock volatility. We’d expect to see this both for UK and other EU bonds, and also for US government bonds, which attract investors from around the world.

In the long term, we’d expect relatively small effects on stock prices, with UK stocks most negatively affected if the impact on the UK economy turnsout to be negative, then EU stocks, and finally stocks in the rest of the world slightly negatively affected if at all.

Now wait a minute. Didn’t stocks fall a lot on Friday? They did. The table below shows the change for various markets Friday, June 24 (since 23-Jun), Thursday and Friday (since 22-Jun), and since February 11, which was the market low just before the date of the Brexit referendum was announced.

The large drops Friday in part reflect surprise – the markets thought that the Stay side would win, and markets advanced Thursday based on that assumption. As our earlier discussion suggested, the effect was largest for the UK market, then for France and Germany, and smallest for the US. Furthermore, since just before the referendum was announced, stock markets are up, even if only marginally, and even for the UK.

Going forward, we’d expect a similar pattern, but in smaller amounts, if the new agreement, once settled, is deemed to be more restrictive than the market currently expects, and we’d expect stock market increases if it’s less restrictive.

All in all, for US investors, Brexit is much more likely to be a blip than a disaster. For the world at large, it may direct more concern and attention to the concerns and interests of the constituencies who have not benefitted from increasing global economic and political integration. That is likely to result in more measured, and more sustainable, economic and political advancement.