In the wake of prereferendum polling results indicating a slight edge for the remain side, the United Kingdom's June 23 Brexit vote to leave the European Union (EU) came as a surprise to many observers.
The morning-after financial market reaction was predictably volatile. The consequences are likely to be far reaching, whether viewed over the short-, medium-, or long-term. As global equity managers, here are the potential impacts that we see, the morning after the vote:
Near term—uncertainty, volatility, and less investment
We expect significant market turbulence, a weakening British pound, some stalled merger-and-acquisition activity, and a general flight to investments perceived to be high in quality, both within the United Kingdom and possibly globally. For U.K. equities, large and global companies are likely to perform best in the short term, especially those with sustainable cash flow and solid shareholder yield, while shares of banks and retailers could be among the most challenged. That said, the market implications are difficult to quantify, and a number of factors could shift the impact of the Brexit.
Medium term—U.K. recession risk, modest U.S. impact
The U.K. economy could flirt with a recession; we expect GDP could decline by a cumulative 2 to 3 percentage points, roughly speaking. In addition, U.K. investment activity and foreign direct investment are likely to fall significantly, at least until the level of uncertainty normalizes. U.K. exports are likely to be lower than they would otherwise be, but not until 2018 or 2019; the impact is likely to be the most significant on services industries, such as financial, legal, and marketing. Finally, we expect a modest cumulative decline in European GDP of around 0.2 to 0.4 of a percentage point.
The impact on U.S. fundamentals is likely to be modest. Broadly speaking, U.S. companies do not have a lot of exposure to the U.K. economy; the aggregate revenue exposure of the S&P 500 Index to the United Kingdom is 2.9%.1 At the sector level, the energy (6.4%), information technology (4.0%), and materials (3.7%) sectors have the highest revenue exposures to the United Kingdom. This suggests that while the Brexit will create serious market dislocations in the United Kingdom and roil European markets, its impact on U.S. fundamentals and markets is likely to be modest.
The vote could, however, act as a catalyst for political uncertainties. Within the United Kingdom, another referendum on Scottish independence may resurface, after voters rejected such a measure in 2014. In Europe, populist movements in France, Italy, and other countries may gain momentum. The Brexit also sets up rounds of decisions and negotiations that will begin as the United Kingdom seeks to spell out the terms of its departure from the EU. Given the uncertainty inherent in political negotiations, it is impossible to know where the United Kingdom will end up.
Long term—dashed hopes for the "United States of Europe"
As for the long term, in our view, there is no merit to claims that the United Kingdom, freed from EU rules, could achieve spectacular economic growth via deregulation. This is pure economic nonsense. On the other hand, it is also best to discount claims about an impending financial crisis. The value of the British pound may fall, but for a country that borrows in its own currency and has an excessive current account deficit, that's a good thing; that is, unless the currency decline is disruptive, creating losses to some households and businesses, and increasing uncertainty even more.
In addition, the Brexit is likely to weaken the long-term goal of a “United States of Europe.” That goal never made much sense, in our view, as Europe has a monetary union, not a fiscal one. In any case, the former is struggling at the moment. One might expect that the Brexit vote would act as a wake-up call for the EU elite. However, there have been many such calls in recent years, yet nothing seems to happen; the EU leadership appears impervious to the dissent. The EU system desperately needs reform but has shown little inclination in that direction. The Brexit greatly damages the European unification project, and calls the whole project into question, as there is a widespread view on the Continent that Europe is failing to deliver economically.
1 FactSet, 2016.