The UK is set to leave the European Union despite pre-polling indicating the ‘stay’ campaign would win. While it’s too early to predict the long-term economic impacts; the European markets have fallen sharply as uncertainty prevails. The decline in other equity markets have so far been contained.Market volatility is expected to remain elevated until further clarity is received on the UK’s exit mechanism and future trade model with the EU. Both these factors will influence the extent to which the exit will impact the UK economy.
The overall impact on the global economy is expected to be limited. Global central banks and other authorities remain on standby, should support be required. Volatility is expected to decline as more information becomes available and market participants shift their expectations.
We must remember that concerns regarding Europe are not new. The European sovereign debt crisis and Greece debt drama were successfully navigated by financial markets. On this basis we do not anticipate making any immediate changes to the investment portfolios of William Buck’s clients which are appropriately diversified.
The past week was dominated by uncertainty surrounding the ‘Brexit’ referendum vote. The final poll released prior to the official vote, indicated that the UK would remain part of the EU. Financial markets responded accordingly with a strong rally towards the end of last week.
The rally reversed sharply as early results from the official poll indicated the ‘leave’ campaign was heading for a win. The reversal has continued well beyond the official result confirming the leave campaign won by a margin of 52% to 48%.
Despite the volatility, the majority of global markets remain above the lows reached earlier this year, with many simply retracing the sharp rally which occurred immediately prior to the vote.
A period of political and economic negotiation will need to occur before the UK actually leaves the EU. This process may take up to two years to formally negotiate and implement based on the currently available information.
The ultimate economic impact will depend on the trade model adopted by the UK post-exit. Free trade access like Switzerland or Norway would provide the most favourable economic outcome. This would still require compliance with EU rules and regulations and it is unclear if the UK would agree to that.
The World Trade Organisation model will be the default if no free trade agreement is reached. This would provide reduced EU market access and would be least preferable from an economic perspective.
There are also concerns that the outcome in the UK may influence other countries to leave the EU. A number of political parties across Europe have already used the UK result to agitate for change. It remains to be seen if this translates into action.
The Brexit issue remains a political and economic shock, rather than the start of a crisis that could threaten the global financial system. In the short term, the UK and Europe risk a contraction in economic growth due to the immediate uncertainty.
Any threat to the global economy is unwanted given growth is currently below trend. However, the overall economic impact from the Brexit is expected to be limited. The EU accounts for only 3.9% of global output and 4.9% of Australian goods exports.
There is, however, expected to be some impact on Australian service exports such as tourism. It will now be more expensive for UK tourists to travel overseas given the plunge in the Pound. Companies which rely on the UK or Europe for a large part of their revenue will also feel an impact.
Commentators have called for ‘cool heads’ from politicians post the referendum result. This is also good advice for long term investors. Sentiment is expected to drive short term market movements, whilst fundamentals will prevail over the medium to long term.
One of the key tenants of William Buck’s investment philosophy is to maintain diversification, and the value of term deposits, bonds and cash is highlighted in times of volatility. Also international exposure is predominately unhedged, which means a falling Australian dollar protects downside movements from global share markets. Importantly income in portfolios is expected to remain consistent.
The recent increase in volatility reflects the current uncertainty about the way forward. In the absence of any direct precedent the media will make predictions ranging anywhere from overly pessimistic to overly optimistic.
Despite the current uncertainty, significant geopolitical events are nothing new. In recent years we have successfully navigated uncertainty surrounding the Europe sovereign debt and Greece’s own position in the EU. The main point is that financial markets tend to recover from the initial uncertainty over time. Global central banks remain on alert and are ready to provide additional assistance to financial markets should it be required.