Our view on BREXIT

Our view on BREXIT

The votes are in, and the UK people, across economic/social lines, were willing to take the risks of a BREXIT and have voted to leave the European Union by a vote of 51.9% to 48.1%. The short-term market impact is severe, as global equity markets are booking losses between -3% and -10% all over the world. U.S. bond markets are rallying, with the 10-year Treasury yields dropping from 1.73% to 1.54% in early market trading. As of this writing, the pound and euro have fallen to £1.32 and €1.09, and the yen and dollar are rallying on a flight-to-safety. Oil is off by over $3 to $47 and gold is up by $58 to $1,321. Here is a summary of the impacts:
Impact to the UK economy 

The UK had survived and prospered for nearly 400 years before its membership in the EU. England, on its own, had a pretty solid run for over 1100 years without any form of "EU membership". There should be no doubt in anyone's mind that the British have built up the institutional fortitude necessary to establish a prosperous path forward without policy guidance from the "experts" in Brussels. Furthermore, nothing happens immediately: Article 50 of the EU Treaty allows 2 years to negotiate the terms of their exit deal. That said, it is estimated the U.K.’s GDP will be cut by 1.5% to 2.5% in the short-term. As of this morning, David Cameron has resigned as Prime Minister. The Bank of England Governor Mark Carney sought to reassure global markets with a statement that there is £250 billion set aside to ensure liquidity, and implied the BoE will maintain accommodative monetary policy for longer. Defending London’s banking industry will be a key priority for the UK government.
Impact to the EU

Great Britain was one of the most economically advanced countries in the EU. It was an "elite" member of the club. With the Brits paving a successful path for exit, it clearly opens the door for other disconsolate members to do the same (Itexit, Spexit, Swexit). Membership in the club, as well as in the Eurozone, has of course been purported to be irrevocable by the Brussels establishment. But clearly the past events in Greece, and the current Brexit initiative, show it is not. The greatest worry from Brexit comes from a renewed questioning of the integrity of the entire EU project. Dark clouds are forming once again over Europe as markets begin to price in the risk of further referendums and exits, and the euro, as a reserve currency, has come into question. European Central Bank President Mario Draghi has sought to throw support to financial markets this morning by assuring that the ECB is standing ready to use all the instruments available within their mandate. 
Beyond the EU

For the U.S. and Asia, this is a market volatility story; exports and investment to UK from the US and Asia are small and likely to be unaffected. That said, the present detente agreement in currency markets for a steady USD has been ruptured. We are watching carefully whether the rising dollar rattles the Chinese, raising the specter of Chinese currency decoupling risks. 
What Happens Next?

Article 50 of the EU Treaty will not be immediately triggered, and, as mentioned, the UK has 2 years to negotiate a deal, which can also be extended. History shows us these could be ugly negotiations with many last-minute, emergency meetings, especially as the deal has to be ratified by all 27 member states. While EU leaders may want to “punish Britain,” both Eurozone and UK leaders both have strong incentive to keep close economic ties, including: 
  • EU accounts for 45% of UK exports 
  • UK accounts for 8% of EU countries’ exports (3% of GDP) 
  • 1.2 million British citizens living in other EU countries 
  • 3.3 million EU citizens not from the UK living in the UK 
  • Foreign direct investment and services trade between EU and UK both very high 
If Brexit takes the form of the UK remaining in the European Economic Area and Free Trade Agreement, keep in mind they are likely to still be forced to comply with rules and regulations from Brussels, but key issues and points of negotiation will be migration, financial regulations, and UK contributions to EU budget.
What this means for you

In both February and May, the Ropes Wealth Investment Team made trades to reduce risk in many of your portfolios (reducing non-U.S. large cap equities to buy U.S. large cap equities, reducing U.S. small cap equities and consolidating to a more “mid-cap” exposure, reducing high yield bonds to purchase investment grade bonds).  These moves were made to improve the quality of our portfolios given risks including Brexit that implied higher than normal market volatility. While your portfolios will be impacted by these market moves, we have strived to blunt the full impact of the risks with our tactical positioning, without going to the extreme of moving to cash with an event that had such a binary outcome. 

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