Making Sense of “Brexit”

April 6th, 2016 | posted in: Insights, Investing

While the US has been focused on political issues of its own, a meaningful tempest has started to brew across the pond, as the United Kingdom hurtles towards a long awaited and long promised up-down vote on EU membership.

What is it?

Current Prime Minister David Cameron had as a campaign promise in the last election that if elected, which he was, that he would allow the United Kingdom to vote on EU membership for the first time in a generation. The question that will be posed to voters on 23 June 2016 is “Should the UK remain a member of the European Union or leave the European Union?” The idea of the British leaving/exit is a “Brexit.”

What is happening?

The Prime Minister, and most of his government ministers, are publically supporting the “stay in” side of the debate. However, many are supporting the “go out” side, including, most notably, the hugely popular mayor of London, Boris Johnson. Current polls are very close, with the “stay in” campaign generally winning (with on average 65% support). The momentum appears to be on the “go out” side, however, with a number of meaningful organizations getting media attention by assuaging fears of an economic or tort apocalypse following a Brexit. But the British stiff upper lip may make them poor subjects of polling—we recently had a general election and several years ago a Scottish referendum that had results that were very different from the polls. As such, with unreliable past polling and increased momentum for the “go out” camp, the markets watching the result are likely to remain volatile through June. By the beginning of April, protection against a fall in Sterling, the British currency, had risen to a cost equal to the heights reached in the financial crisis. As of this article, the currency had fallen some 7% year to date on a trade weighted basis. The latest Financial Times poll-of-polls indicated that sentiment around the decision was too close to call.

What would a Brexit mean?

A “stay in” vote would leave the status quo in place, including a number of recent concessions the British have won from Europe. A “go out” vote is less clear, but would give the UK two years to exit the Union. This would mean that Britain would need new trade and immigration treaties both with the EU and with those countries that have treaties with the EU (and not an individual treaty with the UK).

From a market standpoint, there would be uncertainty for a prolonged period of time, greater difficulty trading with the Continent, and the potential that some businesses might leave Britain. In the short term the shock effect would almost certainly have an impact on the British markets, and over the medium term, many groups estimate that it could have a meaningful negative impact on the economy, with some estimates seeing as much as a 2% drop in GDP. A further fear, similar to the Grexit fear over Greece, is that if a member leaves the Union, others will follow and Europe will unravel, unleashing yet more uncertainty over the medium term. Currently, most of these concerns are being expressed in the currency markets.

What is to be done?

While the hope (and even belief) among many market watchers is for Britain to vote to remain in the Union, it likely makes some sense to have a buffer against the “Black Swan” event that could take place should a “go out” vote win. A well-diversified portfolio, not only in terms of securities, but more broadly in terms of sources of risk, should be positioned to absorb this and similar shocks if they occur. In the event that there are specific idiosyncratic British exposures (your company does substantial business in the UK, for example), it may make sense to hedge some currency exposure (as the currency has been the best barometer of the likely outcome), though, even the currency trade seems over played versus the prospect of a yes vote. It is certainly the best of times and worst of times on both sides of the Atlantic, but whatever either election brings both Britain and American will preserve and soldier on, so the “fear trade” should not occupy too much time. Staying diversified and investing consistently while protecting against idiosyncratic risks remains the best bet. And hold on to your seat for what will prove to be a very interesting summer.