June 24, 2016– Financial markets were rocked on Friday, June 24, by the results of the British referendum on membership in the European Union. Polls had indicated that the vote would be very close; the actual results were a surprisingly strong vote for exit. Across the United Kingdom, 52% of the votes cast rejected membership in the European Union, reversing the United Kingdom’s participation in the European Union, formerly known as the European Communities, or the European Common Market, which Britain joined in 1973. Immediately after the vote results were out, financial market participants looked for safety, wherever it might be found. Yields dropped across all maturities on bonds perceived to be safe havens, such as those of the U.S., Germany, and Japan, as well as in the U.K., in anticipation that central banks would be providing liquidity to shaken stock markets. Conversely, yields on 10 year government bonds rose 0.15% for Italy and Spain, 0.25% for Portugal, and 0.75% for Greece. The British pound fell by 8.5% against the dollar; the Euro fell by 2.3% against the dollar. Overnight, the Nikkei fell by 8%; other Asian markets fell between 1.5% and 3%. The Group of Seven issued a statement that the G7 stand ready to use existing liquidity tools to support economic and financial stability. Stock markets dropped worldwide, with the biggest drops in more economically challenged members of the European Union: over 12% drops in the Spanish and Italian markets, nearly 7% in Germany, 8% in France, and only 3.2% in London. U.S. stocks are broadly down, with the S&P 500 down 3.5%, with the biggest declines in more cyclically and interest rate sensitive sectors of financials, materials, technology, and industrials.
What are the implications of the UK’s vote to leave the European Union? Notably, the United Kingdom was not a party to the 1992 Treaty of Maastricht, which established the European Monetary Union, and led to the creation of a single European currency, the Euro, in 1993, so this vote does not immediately affect the status of the Euro. The vote to leave will take the United Kingdom out of the European Common market. From the perspective of the Leave campaign, this will allow Britain to restrict immigration and eliminate interference in U.K. policies by E.U. bureaucrats in Brussels, and the campaigns for the Leave vote emphasized fear of immigration and the benefits of controlling Britain’s borders. From the perspective of the Remain campaign, the vote to leave will be economically costly, disrupting trade and restricting economic growth, and will be particularly challenging for the City of London’s status as a premier financial center for the world. The EU has already made clear that the EU will require that the formal process of leaving the union, known as Article 50, be followed, which will leave the UK with very limited negotiating ability on the terms of any future relationship. The EU has also stated that any future relationship will need to be “balanced in terms of rights and obligations,” in the words of the European Commission President Juncker, which means that the United Kingdom will not be able to participate in full single market access to Europe without accepting the free movement of people across Europe or without participating in the various stabilization funds mandated by the EU. Our interpretation is that the contractionary effect on the UK economy will be much greater than anticipated by the Leave campaign, over both the short term and the long term.
Over the intermediate to longer term, we are concerned about the possible transmission or contagion routes from this vote. We are likely to see other referenda on political unions. For example, Scotland voted in September 2014 to stay in the United Kingdom as a way to stay in the European Union, and may have another referendum as to whether to quit the United Kingdom and rejoin (or stay in) the European Union. Stock market drops and bond yield increases in Italy, Portugal, Spain, and Greece also signal increased risks from potential European Union disintegration.
We are watching these developments carefully. We anticipate that the U.K. vote to Leave will further extend the time table for returning to historically normal interest rates. We will continue to monitor the effects on economic growth and market valuations. In the short term, we expect markets to be very volatile, as investors globally sort out the implications and watch for the political ramifications to develop. We continue to believe that our investment philosophy of looking for high quality companies at reasonable valuations will yield consistent and attractive risk-adjusted returns. Companies that have strong balance sheets, strategic leadership in their products and markets, and strong environmental, social, and governance policies will have the financial flexibility and the leadership wisdom to navigate choppy and volatile economic conditions.
For more information: Molly McEachern, Trillium Asset Management, email@example.com, (617) 532-6689
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