For most, the talk of a “Brexit” over the last few weeks was background noise. Well, to the surprise of the markets, it just happened. Let’s break down the latest crisis de jour.
First, to explain Brexit, we need to have a 30 second review of history. From World War II to the present, Europe has tried to work together, forming a variety of treaties and alliances, starting with coal and steel treaties and progressing from there. Fast forward a bunch of treaties, alliances and decades later and we get to the modern era. On November 1, 1993, the European Union was formed and is presently at its peak membership, with 28 nations (don’t try to match the yellow star count on the blue flag of Europe to the member nations, as unlike the U.S. flag, the stars are purely symbolic). The EU represents the strongest alliance among European nations in history (to be specific, this refers only to willing alliances). The idea was simple and can be summed up as, “Hey, let’s stop fighting with each other militarily, economically and socially and agree on some basic principles.” Today, the EU operates as a single market allowing for money, services, goods and people to flow freely from country to country. Sounds so nice.
In Many ways, this set up was wonderful for the United Kingdom. Every union needs a financial center, and the U.K. most certainly serves that role in the European Union. London’s largest industry is finance, and London serves as the largest financial exporter in the world. To give you an idea of London’s reach, it is also the leading issuer of international bonds and the center for international bank lending and money markets. More dollars are traded in London than New York and more Euros are traded in London than all of the rest of Europe’s cities combined. Banks around Europe and the world coordinate with London’s financial center to make the international monetary system work. This is all great for the U.K., which gets an enormous lift to its economy from its dominance in this area. Of course, if you are in London right now, you are having a classic “What just happened?” moment. You see, all of this is possible because of the U.K.’s inclusion in the EU.
So why in the world would they vote to leave? First, you may have noticed that the entire world is a bit of a mess right now, and the epicenter of that mess is in Europe. The Reader’s Digest version goes like this: To be in the EU, a nation gives up part of its identity. You share decisions with other countries, subjecting yourself to decisions that may not help your country at times. Well, nationalism tends to rise when a country feels like it is getting pushed around. As the world came out of the Great Recession, Germany owned monetary policy discussion and emerged as Europe’s dominant nation. That was hard for the Brit’s to swallow, and anti-EU sentiment began to rise. Many in the U.K. began to advocate for the U.K. to exit the EU. The straw that broke the camel’s back was immigration, but not the kind you may think. EU rules require member nations to accept any immigrant from another EU country. Western Europe has been invaded by immigrants from poorer Eastern Europe, creating a cultural bbacklash and pressure on social services. This became the real reason the minority pushing for a Brexit gained so much support. This all peaked while Prime Minister Cameron was running for re-election. To maintain his path to victory, he promised a referendum on the issue if re-elected. He was re-elected, put up the referendum and the vote closed a few hours ago with Brit’s voting, just barely, to exit the EU. Prime Minister Cameron, a supporter of the “Remain” camp, announced his resignation hours later, citing a need for fresh leadership to pave the way forward.
Now, why would they vote to exit the EU when they know the U.K. stock market basically trades like a financial stock? So the financial industry goes, so goes the U.K. market. First, lots of people do not have investments, do not care about investments, and do not understand the positive impact the financial services industry has on the U.K.’s economy. Second, some do care, but care more about other issues like immigration and nationalism.
So what does this all mean? The EU could propose a compromise, but that would cause issues with the other 27 member nations, so major adjustments are unlikely. The worst case scenario is the entire EU falls apart with Germany, France and others heading for the exits and creating turmoil while the global economy reconfigures itself.
The most likely scenario is that the U.K. begins negotiations to reach agreements to untangle itself from the EU. This process is estimated to take a few years (they do take lots of long vacations). The U.K. itself will likely see its market get hit very hard, and the damage there will likely linger a while. The permanent damage is self-inflicted. The financial center of Europe will likely move elsewhere (Amsterdam and Frankfurt are popping corks right now). The pain will be harsh throughout the EU as many entities and economies will be impacted by the re-aligning of nearly everything. And, because we live in an inter-connected world, the pain will be felt in Asia and the U.S., though it will likely be swift and short lived, not as severe as overseas, and will present great buying opportunities for the disciplined investor. Markets throughout the world do not like uncertainty, and this is a classic case of financial uncertainty. On Thursday, markets rallied, believing the U.K. would vote to stay. Today, expect quite the opposite as the new reality is immediately priced into the market open. Over the short run, we expect market volatility and buying opportunities ultimately followed by stabilization as the losers in the U.K. are replaced with winners elsewhere. Ultimately, the untangling of the U.K. from the EU will not end the world and after nerves settle, markets will stabilize. In the meantime, consumers will continue to consume, the world will continue to turn, and you can forget about a fed rate hike any time soon And for international travelers looking for a bargain, the U.K. just became very attractive.