In this first of a two-part series we look at what Brexit really means and how the decision that shocked the world may impact us.
- Why do share prices fluctuate?
- Winners and losers from the oil price tumble
- How will the 2016 Budget affect you?
What does Brexit mean exactly?
The United Kingdom (UK) has voted to leave the European Union (EU) in a shock 52%/48% decision that has signalled potentially the beginning of a lengthy period of uncertainty and volatility. The victory by the Leave campaign has shocked most pundits because opinion polls leading up to the referendum indicated a strengthening remain position.
It was evident in the polls that the referendum was creating confusion due to the large number of undecided voters (~10%). It was anticipated that these voters would side with the status quo Remain, and therefore the swing to Leave truly emphasizes the level of unrest in Europe.
Cameron believes that the country requires new leadership to take it in this new direction
What is the political risk?
In a statement following the result, David Cameron, the Prime Minister (PM) of the UK announced his retirement, and indicated that the UK should have a new PM in October. Cameron believes that the country requires new leadership to take it in this new direction and that stability needs to be maintained. We believe that the decision to leave the EU marks a period of instability and this begins with political turmoil in the UK as seen by the leadership battles in its two main parties.
British Prime Minister Cameron addresses parliament on Brexit
Cameron has stepped down as the leader of the Conservative Party, whilst the opposition Labour Party led by Jeremy Corbyn is in disarray with a number of his shadow cabinet resigning. We are yet to see the unity that is required within UK politics in order to navigate the uncertainty associated with Brexit.
It is likely that the new PM will come from the Leave camp and it is evident from the 52%/48% margin that unifying the UK will require a lot of work.
The narrow victory for the Leave campaign has sparked discontent within the UK and has triggered a petition for a 2nd EU referendum. The petition currently allegedly has over 3.5 million signatures and will be considered for debate in parliament. It is however unlikely that a 2nd referendum will be held because it requires retrospective legislation.
The vote to leave will likely strengthen the separatists in Scotland because 62% of the country voted to remain within the EU. This may trigger a breakup of the UK because it is likely that a second Scottish Independence Referendum will be held.
Brexit is the most recent example of the unrest in Europe and it raises questions over the possibility of an EU breakup
Geopolitical risks in Europe have dominated markets because right wing parties have been gaining support due to the influx of migrants (1.3m EU asylum claims in 2015) and a prolonged period of high unemployment and low growth. Brexit is the most recent example of the unrest in Europe and it raises questions over the possibility of an EU breakup.
Right wing parties in France, Italy, the Netherlands, Sweden and Denmark have expressed interest in holding similar referendums which highlights the real threat of the disintegration of the EU. The demand from other member states to leave the EU will likely rise, especially if the fallout from Brexit is not as significant as most predict. It is evident that there is a significant political risk in Europe, to the extent of the European Central Bank (ECB) explicitly stressing that rising political risks in Europe may lead to the delay of much needed fiscal and structural reforms.
What is the potential economic risk?
A UK withdrawal from the EU has a 2 year negotiation deadline under Article 50 of the Lisbon treaty with the possibility of extension, so it should be noted that the UK is not leaving the EU immediately. This however creates a prolonged period of uncertainty which will weigh on equity markets and the European economy.
The greatest impact is on market sentiment rather than the economic effects of an exit. This impact has been felt in global equity markets which have experienced significant falls. The currency impact has also been significant with the GBP depreciating over 10%. The immediate economic impact will be on business confidence, investment and consumption which will experience falls in the short term.
The two year negotiation deadline gives the UK time to deal with issues including trade barriers and the free movement of labour. There will undoubtedly be a period of adjustment but the UK and Europe are too interdependent to allow an economic breakdown within the region. Whilst a less open economy will reduce the UK’s potential for growth, the economic implications will likely be less problematic than most envision because both the UK and EU will want to reduce the economic implications of Brexit. As such, the world economy should be able to weather the storm particularly well.
Growth in the EU has been sluggish since 2011, and whilst the economic impacts are difficult to assess, it is highly unlikely that the EU will hit its 2016 and 2017 growth forecasts of 1.4% and 1.7% due to the uncertainty associated with Brexit. The EU is less exposed to the event because trade exposure to the UK is only 3% of EU GDP.
The UK however is deeply integrated with the EU which is the UK’s largest trading partner so renegotiation of trade agreements will create relatively more drag on UK growth. The Bank of England’s (BOE) growth forecast of 2% and 2.2% for 2016 and 2017 are unlikely to be met. Inflation has also been well below the target of close to 2% over the medium term, reflecting the sluggish recovery. The GDP has however depreciated ~10% which will benefit UK exporters and subsequently improve the UK’s trade balance. The currency depreciation will also likely increase inflation by 1-2%.
The narrow victory for the Leave campaign has sparked discontent within the UK and has triggered a petition for a 2nd EU referendum
What is the monetary policy?
Europe has been characterized by weak growth and low or negative inflation for an extended period of time and this has not only required expansionary monetary policy, but also structural reform to rebalance saving and investment in order to drive consumption and growth.
The implementation of structural reform is likely to be challenged by the increasing number of right wing parties across Europe who are seen to be less reform oriented. This will put pressure on central banks to adopt additional monetary policy measures to attempt to counteract the fallout from Brexit.
Whilst we believe that central banks are unlikely to change their monetary policy stance in the immediate aftermath of Brexit, there are a number of measures they can take to cushion the impact. The ECB could increase the amount of monthly asset purchases (currently €80 billion), reducing the deposit rate (currently -0.4%), widen the universe of asset purchases or lengthen the quantitative easing past the intended end date of March 2017.
The ECB could also extend its Long Term Repo Operations or implement a new program with the aim of offering attractive long-term funding conditions to banks.
The BOE will likely disregard the inflationary impact of a depreciating GBP by easing monetary policy in the form of an interest rate cut (current bank rate: 0.5%) or expanding its €375 billion quantitative easing program.
The US Federal Reserve has been cautious in raising rates too quickly in an environment of geopolitical uncertainty because they are wary of triggering a downturn. It is now likely that the Fed will hold off until 2017 to hike rates, with the probability of a 2016 rate hike all but ruled at 15% for December.
What are you most concerned about regarding Brexit and your personal finances? Let us know in the comments section below.
Research Analyst – Jake Bowmer, Eric Chim, Alex Harris, Elan Miller, David Pobucky Approved By – Paul Saliba
Research Analyst Disclosures
I, David Pobucky, Elan Miller, Jake Bowmer, Eric Chim, Alex Harris hereby certify that all the views expressed in this report accurately reflect my personal views about the subject investment theme and/or company securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report.
I, David Pobucky and/or entities in which I have a pecuniary interest, have an exposure to the following securities and/or managed products mentioned in this report: HGG
I, Elan Miller, and/or entities in which I have a pecuniary interest, have an exposure to the following securities and/or managed products mentioned in this report: BHP, RIO,
I, Jake Bowmer, and/or entities in which I have a pecuniary interest, have an exposure to the following securities and/or managed products mentioned in this report: Nil
I, Eric Chim, and/or entities in which I have a pecuniary interest, have an exposure to the following securities and/or managed products mentioned in this report: HGG,
I, Alex Harris, and/or entities in which I have a pecuniary interest, have an exposure to the following securities and/or managed products mentioned in this report: Nil
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