Market Insights: Brexit - Some perspective

Brexit - Some perspective

The result of the recent referendum definitely came as a surprise to many, resulting in a major two day slide in global equities and a sharp spike in short-term volatility.  However, we need to stay calm and assess the situation with a long-term perspective.  In our view, we don't believe this is a trigger to a new bear market, nor will it cascade into something in the order of the 2008 banking crisis (this is likely not a Lehman moment!), or likely even a 2011 type correction here in North America.  

Firstly, we need to contemplate that this was indeed a referendum and not legally binding for the British government.  Although Prime Minister David Cameron has announced that he will be stepping down, he was very clear that he would not invoke Article 50 and that this would not occur until a new PM replaces him in the next election in October.  Article 50 is part of the Lisbon Treaty, and must be invoked for the withdrawal process to even commence.  This Article states that the E.U. will negotiate the terms of the withdrawal with the country over a two-year period.  It would be a fair assumption to say that David Cameron did not invoke this Article 50 with the hope that a deal can still be reached at some point.  This is somewhat promising.  It is also not overreaching to say that there may be some chance of a second referendum on the exit.  In fact, at the time of this writing, there have been in excess of 4 million signatures to a petition demanding just that.  We realize that the result of this recent referendum could have a cascade effect with regards to the rest of the E.U.  Frexit (France)?  Nexit (Netherlands)?  However, this could perhaps also result in the E.U. coming together and becoming stronger.  No one knows, of course, and there are many possible scenarios that could play out.  

From a global economic view, let's put the Brexit in perspective with some keen observations from Canaccord's North America Portfolio Strategist Martin Roberge:  

"The UK and European economy account for 1.4% and 7.9% respectively of world GDP growth. India’s and China’s contributions are 2x and 7x bigger. The UK represents only ~3% of US and Chinese exports (Europe ~20%). Our point is that investors should not overstress Brexit as a tail risk to the world trade ecosystem. For investors, it is all about weighing short-term clarity against long-term uncertainties such as Europe’s fragmentation. In the near term, Brexit increases clarity on a few fronts. First, turbulence in a small economy like the UK will likely allow monetary policy to remain softer for longer in larger economies. Second, the depreciation of the pound sterling and the euro is a positive shock absorber for Europe while the US$ appreciation possibly sidelines the Fed for the balance of the year. Third, should Brexit paralyze global growth, this could be the catalyst for governments to issue cheap sovereign debt and front-load fiscal stimulus. Last, should global funding risk escalate, the BoE, ECB and Fed appear willing to do more than is needed to provide liquidity backstops to banks and corporations. All of the above may explain why global financial conditions have barely tightened since last Friday with bond yields falling across the risk spectrum. Thus, it could well be that Brexit leads to over-stimulative conditions not needed in the first place. Meanwhile, dividend-to-bond yield spreads flash green for stocks (Figure 1).

 

 

Plainly, we agree with these comments.  That being said, we are keenly aware of the current situation and will be keeping a close eye on any developments with the aim of making proper adjustments, should this become necessary.  We will continue to assess the situation over the coming days and weeks and look for more clues into how this will all play out.  Our internal Milestone Recession Risk (MRR) indicator has recently had a slight uptick in risk; however, it is not currently at a level where we would make any significant strategic asset allocation adjustments.  For the moment, it's best to simply stay calm and take a breath.  Once the immediate emotion settles, we will let the market get back to assessing the fundamentals, which, at least on this side of the pond are starting to look better.