Does Brexit = Crisis?

Global markets have suddenly become volatile again as recent polling data in the UK suggest that Britons may elect to leave the European Union in a June 23 referendum. The reversal in the polling data, which until very recently had the pro-Union voters holding a firm majority, could have dramatic implications for Europe’s economic future. However, the potential implications vary widely depending on who you ask. Some believe that a British exit could be the first step to a complete disintegration of the European Union. Others believe that reduced ties to Europe could open up new economic opportunities for the UK. Regardless of the outcome, increased uncertainty will be with us for at least the next several trading days as the drama unfolds. Following the referendum, the uncertainty could potentially increase if the British people do indeed elect to leave the Union.

Those advocating to remain in the EU warn of dire consequences if Britain were to leave. In his weekly newsletter, James Meyer of Tower Bridge Investments writes, “Economically, separating from the EU would expose Great Britain to possible increased costs of trade, higher expenses, and more regulatory steps to do business with former EU partners.” The British government, for its part, has told its people that an exit could permanently damage the domestic economy. The government’s analysis, released in April, predicts that “the U.K. economy could be around 6% smaller in 2030 if it left the EU than if it remained a member”, according to an April 18 article in the Wall Street Journal (“Brexit Would Lead to 6% Drop in UK GDP, Government Warns”, by Jenny Gross and Jason Douglas). The article goes on to say that the projected reduction in GDP “would be a loss of income equivalent to $6,107 a year for every British household.”

The mechanisms through which these consequences would occur, according to the government and others, would be: 1) a reduction in trade with the remaining EU member nations; and 2) lower foreign investment into the UK by EU nations. According to the Financial Times, “in 2014, just over half of Britain’s trade was with the EU, while sales to and from 60 other countries are governed by agreements struck with the bloc.” For better or worse, membership in the EU comes with ready access to the Union’s markets, and the loss of this access could be very costly for an economy heavily dependent on European trade. Furthermore, EU nations contribute about 48% of foreign direct investment (FDI) into the UK, according to the British government. The loss of some of these investments could result in job losses and a sharp drop in the value of the British currency (pound sterling). Moreover, Britain would still have to pay for access to the European markets, as does Norway, even if it decides to exit. And finally, there “is the possibility of a sudden outflow of money from the UK, which could make the country’s current account deficit of 5% of national income difficult to finance”, according to Chris Giles of the Financial Times. Indeed, it is likely that there would, at the very least, be a near-term rotation out of British stocks and into safe-haven Gilts, and the Bank of England would need to suppress interest rates in an effort to stimulate economic growth – not an ideal outcome given the current global economic environment.

But BCA Research’s Peter Berezin says the bigger risk to the global economy is what Brexit would mean for the cause of European integration. “The main risk is that the UK’s voluntary withdrawal from the EU increases the odds that one of the euro area’s struggling economies eventually decides to abandon the common currency.” The departure, or even the threat of departure, by one of Europe’s peripheral countries could lead to a mass exodus by investors in European sovereign debt as the markets begin to price in the odds that investors may get paid back in a weaker currency than the Euro. This is exactly what happened during the Greek crisis. It’s not hard to imagine a resurgence of the European debt contagion as speculators bet on the odds of an exit by Greece or Spain or Portugal or Italy. ECB efforts to support sovereign debt and the European banking system, which is heavily invested in sovereign debt, might not be successful next time around, and the deflation resulting from the economic fallout would make Europe’s huge debt loads that much harder to service.

Those advocating for an exit from the EU, on the other hand, say that Britons would benefit from a reduced regulatory burden, a reduction in protectionist trade policies, and more control over its borders and immigration policies. The issue of immigration has become more important following the financial crisis. Many Britons do not agree with the current administration’s liberal immigration policy now that solid middle-class jobs with good incomes are harder to come by. Moreover, the Syrian refuge crisis and the potential for terrorist attacks may also be playing a role in the shift in public opinion. This is especially true following the events in Orlando last weekend. Finally, proponents of an exit say the UK would benefit from the elimination of over $5 billion in annual contributions to the EU budget as well as increased freedom to pursue trade deals with non-EU countries.

It’s hard to know who is right. It seems highly unlikely that the UK can pull off an exit without a hitch, but the consequences certainly could be less severe than some are speculating. The foundation of the European Union is the guarantee of free movement of: 1) goods; 2) people/workers; 3) services; and 4) capital. Unfortunately, many Britons are finding that the benefits of those freedoms are now outweighed by their costs. Particularly problematic are the regulatory burdens, including restrictions on trade outside the Union, the costs of membership, and the loss of border control. Most economists will say, in hindsight, that these types of problems should have been foreseen. Monetary unions and trade agreements are great as long as prosperity is widespread. When the going gets tough, though, there are bound to be problems. The better performing countries/economies will always be resentful for having to carry around the “dead weight” within the Union. Obviously, many Britons feel they are being disproportionately taxed to be a part of the EU. Time will tell if these voices prevail and if other countries follow suit.

Events with binary outcomes such as the Brexit referendum pose a near-term challenge for investors. Almost without fail, there will be rhetoric from the various talking heads on TV predicting the worst possible scenarios. This happened with Y2K, 9/11, the US invasion of Iraq, the Greek crisis, the Ukraine crisis, the Syria crisis, and many, many more crises throughout the past couple of decades. Yet here we stand, still within spitting distance of all-time highs for the major stock market indices. The astute long-term investor is able to put various external risks into context and maintain a disciplined course. Could a ‘yes’ vote for Brexit cause some economic problems in Europe? Oh course. But is it likely that a British exit will be the difference between reasonable market returns and massive losses over the next decade? Probably not. We believe client portfolios at Farr, Miller & Washington are well-positioned to withstand a wide range of macroeconomic scenarios and external shocks, such as the Brexit vote. We remain defensive but fully invested.