My F&M

Brexit: Keep Calm and Carry On

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In an historic move, Great Britain voted to leave the European Union.  This decision caught global markets somewhat by surprise and increases uncertainty in several ways, resulting in an adjustment in global securities prices.  

As this is written, markets are reacting, and the Dow Jones Industrial average is off more over 600 points with the S&P 500 Index down 3.6%.  Gold is up nearly 5%, oil is down, and the dollar is up.  The EAFE international Index is down over 8% while the emerging markets index is off about 6%.  U.S. 10 year Treasury rates are 1.55% (0.19% lower on the day).  

What does all this mean?  The biggest near term economic impact will likely be transmitted through adjustments in foreign currency exchange rates.  A weaker British Pound and a weaker Euro mean a stronger U.S. dollar.  The economic impact of a stronger dollar is an increase in the costs to foreign buyers of U.S. exports and a decrease in the costs to U.S. buyers of imported goods.  Other things being equal, these price changes reduce U.S. exports and increase U.S. imports.  Fewer U.S. exports somewhat reduce U.S. economic activity while cheaper imports tend to reduce U.S. inflation.    

Intermediate term implications may be political.  UK Prime Minister David Cameron is stepping down in the fall, the EU will be weaker, and Scotland may reconsider leaving the UK.  France or other states may be encouraged by this departure and could consider their own exit from the EU.  More broadly, this may be a boost to other populist, nationalist, or anti-bureaucracy movements and a general backlash against the status quo.  Geopolitically, a more fragmented Eurozone may encourage more opportunism on the part of Russia.   

Perhaps the most important economic trend Brexit may bolster is the backlash against free trade.  Free trade is an important component to a healthy, unencumbered economy.  But with the presumptive presidential candidates of both U.S. major political parties having staked out the most anti-free trade positions of any candidates for quite some time, this additional international anti-trade momentum could hurt earnings growth.  

Clearly, the UK’s separation from the EU will not occur for some time, and in the interim, there could certainly be other free trade agreements negotiated between Great Britain and the European Union that might mitigate the impact of this vote.  On the other hand, the EU may also seek to punish Britain for leaving and move them “to the back of the line” as our president had suggested the U.S. would do, which would not be a good outcome.  

Overall, uncertainty has increased in several areas, and that could take a while to play out.  What is not uncertain, however, is that stocks are a little cheaper today and bonds generally a little more expensive than yesterday.  Market volatility creates an opportunity for those with a long-term view to benefit by rebalancing, and that will be our reaction.   

Given the origin of this market dust storm, we’ll close with advice in the form of an aphorism generally connected to British character:   Keep calm and carry on!