In the light of the outcome of the Brexit referendum, there are some points we can consider regarding the impact on financial markets and investments.
First of all, we think it is important to differentiate between the short-term and long-term economic, financial and political consequences of the UK having decided to leave the European project.
Leaving will mean having to renegotiate trade arrangements, which undoubtedly will have short-term economic costs for both the EU and the UK. These will mostly depend on whether or not the EU decides to have a tough stance in order to set a costly precedent for other potential leavers. However, it is important to keep perspective and think that the EU is a one-of-a-kind setup, and that a large number of economically successful countries are not part of such a type of union. Therefore, the overall long-term economic impact will probably be only marginal.
On the financial front, the most important thing to realize is that as the UK has always retained its own currency and central bank, and provided that usual financial contracts do not contain clauses related to a Brexit, the first-order financial consequences (defaults, liquidity, etc.) should in principle be small. However, the uncertainty brought about by the outcome of the referendum has naturally fed into financial markets. They have been caught on the wrong foot and now need to recalibrate. This will mean volatile markets in the months to come, particularly as the actual roadmap for abandoning the union starts to emerge and its consequences can be better assessed. A major issue will be the impact that a leave will have on financial infrastructure – due to the importance of the City of London – and market access for financial services. Hence, the steep losses for some financial stocks today.
It is at a political level where the Brexit consequences will be felt most deeply. By deciding to leave the EU, the UK – which is its second biggest economy – has both inflicted a heavy blow to the project and set a precedent. The latter will permanently act as a threat to the union and fuel populist and nationalistic movements within. It is too early to say what this will mean in terms of austerity policies and the progress towards more political and economic integration. Other political spillovers may be felt in places where nationalistic movements are on the rise, but overall contagion will be very limited.
Summing all up, and thinking on the investment consequences for our clients’ portfolios, we think it is time to keep a cool head, separate facts from noise, and focus on what should be relevant for financial markets i.e. corporate profits and decisions of central banks. Increased uncertainty will affect investments and economic performance in the short-term and may have an impact on corporate profits, which will be another factor weighing on economic valuations. Hence, we advise to remain underweight on credit and equities. Central bank action will be key on how currencies and interest rates will move. The flight to quality will drive interest rates down, something central banks will not fight at this point, but will also create large swings in currencies. Here is where we see most trouble as interests amongst central banks will diverge. We expect the Fed to keep rate rises on hold, the SNB and the BoJ to fight appreciation of their currencies, and the ECB and the BoE to welcome weaker currencies whilst trying to manage their volatility.
Fernando de Frutos, MWM Chief Investment Officer
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