Brexit

Monday 06/27/16

    Last week the United Kingdom held a referendum to vote on whether or not they should stay in the European Union. Although the United Kingdom does not use the euro, they are still an EU member. The vote split the country almost evenly, but in the end the decision to leave the EU won. On Thursday night as it became clear that “Leave” would win, the pound began to sell off hard. Figure 1 shows the selloff in the pound versus the dollar. A nearly 12% move in a major currency pair is not good for the stability of the financial markets. By the end of the day, global financial markets erased over $2 trillion in value. This week I'll take a look at some of the consequences of Britain leaving the EU.

Why all the Brexit panic?

    The market hates uncertainty. Anytime there is uncertainty looming, markets have a tendency to overreact in a negative way. It will take a long time for the Brexit to actually happen. In the meantime, trade deals will need to be renegotiated with the European Union. It is possible that the EU will be vindictive and not offer good terms or that Britain will opt for protectionist policies.

    The swings in the currency alone are enough to create problems. Currency trading is a leveraged endeavor and violent swings like this can lead to the failure of major firms and potentially spread contagion in financial markets. The Japanese yen has benefited from a knee jerk reaction into the yen which is (mistakenly in my opinion) viewed as a safe-haven currency. This has caused the Japanese government, which has been pursuing a weak yen policy in an attempt to boost exports, to consider direct intervention to weaken their currency. Japanese stocks fell sharply as shown in figure 2, because a strong yen means weak Japanese exports. The US dollar has also surged as a safe-haven currency (see figure 3). This makes it less likely for the fed to raise interest rates this year.

    I do not think the direct implications of the Brexit are nearly as consequential as the speculative currency fluctuations. I suspect that Britain will be able to negotiate similar trade deals to those of Norway and Switzerland. If the EU decides to play hardball, it would most likely backfire and the United States would be the major beneficiary, while the EU and Britain would be the losers.

European Financials
    One of the worst performing sectors was European banks. European banks have been in pretty miserable shape ever since 2008. It has long been my opinion that it is only a matter of time before many of these banks will need to be recapitalized or bailed out in some form. Figure 4 shows the price of a European financials ETF, EUFN. It is possible that this event will be enough to finish off some of the struggling European banks. If Europe finds itself in the position of having to bail out banks, this would add to Euro-skepticism in many countries and could lead to even more fracturing of the European Union.

    While I tend to agree with the idea of Britain separating itself from European control, I am concerned about the reasons why many voted for the Brexit. One reason was growing nationalism and anti-immigrant xenophobia. I wouldn't want to be governed by unelected Bureaucrats, but at the same time I would want to maintain the free trade agreements and the freedom of movement associated with the EU. If the Brexit gives rise to nationalism and protectionism it will be a major negative for the global economy.