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Beutel Goodman: Views on Brexit

June 24, 2016

The ramifications of the referendum vote are expected to play out over the long-term.  Immediate market reaction to the referendum results has been visceral, with a massive flight to quality trade, with stocks plummeting, bond yields spiraling down, gold up, oil down, the euro and pound free-falling and the U.S. Trade Weighted dollar increasing. Credit spreads are wider with the greatest impact on the financial sector. The markets had largely discounted the closeness of the poll results, but put more faith in the betting markets which favoured “Remain”. The markets were thereby improperly set up for the results. Initial reactions to contagion events such as Brexit are always volatile and it will take a while for the dust to settle. The whole exit process will take a long time to play out, as Great Britain has two years to negotiate the terms of its exit with the European Union, once it formally announces its intention to Brussels. Prime Minister David Cameron has announced his resignation and has stated that he will leave it to his successor to trigger Article 50 of the Lisbon Accord (the mechanism to leave). This will likely not happen until the fall, as Mr. Cameron also stated he intends to remain as leader until October. There are a web of issues around regulations and trade and how to handle Brits working abroad and foreign EU workers within Britain. The UK is a significant part of the global economy and the impact on trade, investment, asset prices and banking stability in Britain will likely be significant. Although Brexit is having global reverberations, we do not put it on par with a systemic shock to the financial system such as the Lehman Brothers’ bankruptcy. Brexit creates uncertainty and markets hate uncertainty.

Economic Overview

  • The EU is the source of £500 billion pounds of direct investment into the British economy. With a large current account deficit, the UK is reliant on capital flows and there is fear that foreign direct investment will dry up post-referendum.
  • 45% of Britain’s exports and 50% of its imports are with the EU.
  • The result puts Britain’s AAA credit rating at risk – already credit cautious comments have been released by Moody’s and S&P.
  • The City of London’s future as a global financial centre is now in question and a number of global banks could relocate their European headquarters elsewhere in the euro zone. Financial services makes up 8% of British GDP.
  • The British economy may slip into a recession in the second half of this year and the euro zone economy will likely take longer to recover.
  • There is a range of estimates of what the direct economic hit to the UK economy could be: the UK Treasury calculates that GDP will be 3.6% lower in two years, the OECD forecasts a 3% GDP loss by 2020 and the IMF most pessimistically expects a 5.5% decline in GDP by 2019.
  • For North America – the UK accounts for 3% and 2.5% of total U.S. and Canadian trade, respectively, therefore there will likely be no direct economic impact, but the risk is contagion as a result of financial market uncertainty.

Monetary Policy Implications

  • The Bank of England will most likely cut rates, moving away from its tightening bias and will be prepared to expand QE, extend swap lines, provide life lines to the banks, essentially utilizing any tools at its disposal to stabilize the financial markets.
  • The European Central Bank is likely prepared to offer more credit easing if necessary. The Bank will likely be reluctant to take the deposit rate any further into negative territory.
  • The markets have completely priced out any chance that the U.S. Federal Reserve hikes the Fed Fund rate in 2016. The strength in the U.S. Trade Weighted dollar stemming from the declines in sterling and the euro will negatively affect the U.S. economy and be of utmost concern to the Fed. Chair Yellen stated in her recent press conference that one of the reasons that the Fed paused in June was concern over Brexit.
  • The Fed’s macro outlook will be affected by tightening financial conditions.
  • A stronger U.S. dollar is problematic for China and other emerging markets.
  • We could see a global coordinated central bank announcement similar to what occurred during the credit crisis.

Contagion

  • Scotland and Northern Ireland overwhelmingly supported staying in the EU, so this may ignite the fires of independence in those two countries. Political leaders in Scotland have already stated that they plan to reintroduce a referendum for Scottish Independence.
  • The EU could make it very painful for Britain to leave, so as to discourage other countries from embarking on a similar path.
  • Looking beyond Brexit, and taken together with the popularity of Donald Trump in the U.S., the referendum success signifies a rise of populism, and anti-establishment movements that are nationalistic, anti-immigration, anti-trade and anti-globalization in spirit.
  • Brexit could lead to the increasing popularity of anti-euro movements in other euro zone countries, such as Italy, Spain and France.
  • There are big elections coming up which may witness the rise of the right - Spain on June 26th and France, Germany and the Netherlands in 2017.
  • Could possibly upset the balance of power within the European Union as Germany and Britain were united in offsetting protectionist movements, and France perceived Britain as a counterbalance to German influence.

Implications for Bond Strategy

  • Our duration positioning was neutral to the Index going into the referendum due to the immense uncertainty around the outcome of the vote. We felt it best served clients to be cautious.
  • Credit spreads are wider and this will likely create opportunities for certain high quality credits to be mispriced of which we will take advantage.
  • Interest rates will stay low, likely for a long time. The chances of monetary policy tightening in Canada and in the U.S. in 2016 are remote. The next move by the Bank of Canada could very well be an ease if non-energy exports do not lead growth and if the Canadian dollar appreciates.
  • Flows into safe haven bond markets such as Canada and the U.S. will continue placing downward pressure on the yield curve.

Implications for Equity Strategy

  • World equity markets were clearly surprised by the victory for the “Leave” side in the British referendum on membership in the EU.  As with any surprise, we expect an initial period of volatility, as investors sort out exposures and adjust positions.
  • As fundamental value investors, our equity investment process does not rely on making macro or event-driven calls.  Our view is that the value of quality investments, well supported by sound financials and fundamentals, will be realized over the longer-term.  As a result, short-term volatility can produce pricing anomalies that represent good entry points.  We expect this may be the case in the current situation.
  • With respect to our individual holdings, we do not think the developments out of Britain represent a material risk to longer-term valuations.  While there may be some drag on global growth, the assumptions we use in valuing our economically-sensitive positions are already quite conservative.  In establishing upside targets for our stocks, we do not rely on unduly optimistic forecasts for inputs such as commodity prices or measures of demand.  Our focus on downside protection is largely based on testing valuations against situations that are quite pessimistic.
  • While downside volatility is never pleasant, it can be a good opportunity for investors who have done their homework to be prepared to take advantage of market inefficiencies.

Should you have any questions, please direct them to Bruce Shewfelt, Managing Director, Client Service & Marketing at (416) 932-6345 or your Beutel Goodman relationship manager.