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Brexit: Slow, Steady Grind Down

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Advisors and institutional investors continue to ask me what the implications of Brexit will be. My answer: Don't think of it as a crisis—a massive collapse followed by a sharp recovery, which is how the market has reacted—but a slow and steady grind with some notable implications.

Limited New Investment

First, much investment in the United Kingdom will be foregone as a result of leaving the European Union (EU). I'm not saying a host of large companies will suddenly pack up and move elsewhere tomorrow; that's a costly decision, and one made with much consideration over time. But companies won't likely expand in the United Kingdom; they'll expand elsewhere.

Consider a mid-size company looking for a supplier in Europe and choosing from a short list of companies—one in Spain, one in Sweden, one in Austria, and one in the United Kingdom. The U.K. supplier could be every bit as good as some of the other others on the list, but why would you choose it for a long-term partnership? The uncertainty of how Brexit will impact the supplier presents a level of risk that doesn't exist with the other suppliers.

No Rebound for the Pound

Second, while the U.K. equity market might continue to rebound, the currency likely will not. The pound is significantly lower today than it was on the eve of Brexit—approximately $1.30 now vs. $1.45 to $1.50 before.

Now, this is theoretically good for U.K. businesses that sell products overseas. A lower pound makes exports cheaper, so U.K. exporters should be more competitive in global markets. That's why many proponents of Brexit cited the potential competitive gains that could come from it.

But there will likely be no long-term competitive gains. Why? Because 50% of U.K. exports go to Europe, and if there's weaker final demand from Europe, it doesn't matter how cheap or how expensive an item is. When 50% of your total pie suddenly decelerates, it has an adverse impact.

This was tested in the United Kingdom in 2009, when the pound fell in the aftermath of the global financial crisis. Everyone expected an export move, but it didn't happen. It's also been tested across Europe; in fact, it's why European countries decided to abandon their individual currencies to join together in the euro.

Still Too Early To Tell

While these are two of the major implications of Brexit, a number of other things could happen, and it's worth watching how they play out.

First, there's been a lot of talk about trade barriers since the EU is the most important market for U.K. goods. The theory is that any competitive gains from a cheaper pound would be negated by trade barriers that result from Brexit. It's unlikely, however, that trade barriers will be the United Kingdom's biggest problem. Even if the United Kingdom doesn't negotiate well for access to the EU and reverts to World Trade Organization (WTO) rules, most goods would still be protected.

What is problematic is services. They're not covered by current WTO rules, and they dominate U.K. exports, which, as I've noted, will likely decline. The uncertainties are asymmetrical, to say the least.

Also problematic is regulatory uncertainty. While the United Kingdom wasn't a part of the euro, it was part of the European single market. As a result, many regulatory bodies, such as the European Banking Commission, are domiciled in London. Now, imagine what happens when a community's banking regulator is not part of that community. It's like the Federal Reserve setting monetary policy but entrusting Sao Paulo to execute it. That probably isn't going to work well.

Finally, how does this all take place? As the United Kingdom unwinds its legislation, it then has to rewrite it, chapter by chapter. And debate it in Parliament.

It also has to negotiate trade deals, and the United Kingdom hasn't had to do that since 1973 because the EU has done so. Now the United Kingdom has to build an entire department, staffed with experienced people, and do so quickly, because it's going to have to negotiate at least 53 bilateral trade agreements (how many the EU has).

And all of this has to happen within the next two years. That's a very tall order when you consider that the EU-Canada trade agreement now in effect took seven and a half years to negotiate.

In fact, it's nearly impossible that this will all happen in two years. What will most likely happen is that the United Kingdom will seek to replicate EU legislation, which leads to the somewhat obvious question: Why leave the EU in the first place?