THE market reaction to the Brexit vote has been swift but not unexpected given the circumstances. In the week prior to the vote the consensus view was that the "stay campaign" would prevail, hence the surprise outcome is largely to blame for the violent reaction of global markets on Friday. The challenge will be to extrapolate this event and determine its significance, if any, in the investment landscape over the medium to longer term.
What happens next? The Parliament has to ratify the vote. Following this will be two years of painstakingly slow progress on unpicking the European agreements. Indeed most trade agreements take years longer than this to negotiate. To reiterate – the UK Treasury has predicted that: The UK economy is likely to fall by 3.6pc over the next two years; Inflation is expected to rise a bit over 2pc; With such a large fall in the currency – the Bank of England will be caught between easing for liquidity and tightening for imported inflation.
On the medium term, the trade agreements linked to EU membership would be void and would need to be renegotiated. This leads to the two main fears attached to Brexit: The financial strength of the City of London would be questioned as the ECB has already voiced concerns about the fact that most Euro-denominated paper is traded outside the Euro-Area. The financial sector is likely to be the main sector to suffer until the uncertainty is removed, which will take time; and a Brexit would be a mixed blessing for the exporting stocks (remember that 70 to 75pc of the top line earnings of the FTSE 100 are sourced outside the UK). The depreciation of the Pound would be a tailwind while the trade re-negotiations would be a headwind. Overall, the market takes a pessimistic view on these sectors.
While the initial market reaction has been extreme – I would expect some stability to come into markets over the next few trading days. However – this is a clear vote against the European Union – and plays to a theme which is playing across the broader Europe and US. Economic nationalism is rising and fears over immigration and border protection have been dominating election campaigns. Investors will be speculating that this is the canary in the coal mine for the end of the EU – and this is likely to be highly disruptive for markets for many more months to come.
I think the tug of war between risk off and on behaviour will continue as the year continues and for this reason having appropriate weightings in cash and fixed income are important. The returns from either asset class are at historical lows, but an allocation to cash in particular will allow a level of optionality that is very useful in these types of environments. Equity exposures will require increasingly active management to accommodate the opportunities that are created under this scenario.
Europe has not been a significant contributor to global growth for some time, even before the financial crisis. The Union is however a significant trade partner with Australia but by far the greatest impact of the Brexit episode for us is the part it plays in a series of destabilising events this year such as the precipitous fall in commodity prices and the renewed focus on Chinese growth and debt management. Ultimately global growth will be determined by the extent of economic recovery in the United States and China, so it is important to follow impacts of the Eurozone on these economies.
- This article does not take into account the investment objectives, financial situation or particular needs of any particular person. Accordingly, before acting on any advice contained in this article, you should assess whether it is appropriate in light of your own financial circumstances or contact your financial adviser.