Auour Initial Thoughts on Brexit

On Thursday, Britain held a referendum to decide whether or not to leave the European Union. Leave won with 52% of the vote, while Remain lost with 48%.  This referendum will likely result in the United Kingdom’s institution of Article 50, which would begin a withdrawal from the European Union.  We have provided some information below to help you put Brexit into context:

1. The UK has been in the EU for 43 years.
2. Britain, and especially London, has served as the financial center for the European continent.
3. S&P gave the UK a AAA credit rating prior to the vote.
4. Britain is a net importer from the European Continent.
5. Scotland and a large majority of young people voted Remain.
6. The continent will experience a number of political events that may impact the landscape of the European Union further. Spain has an election this weekend. Le Pen has begun asking for a referendum in France. Fringe political parties in other countries are gaining strength due to Brexit’s victory.
7. The British government has not yet determined when it will enact the Article 50 provision, which will start the clock on negotiating an exit strategy with the EU.  Negotiations will last for at least 2 years but may take as many as 5 years.

Some of our early thoughts:

1. This is not a Lehman-type event.  Lehman’s bankruptcy was also a shock to the markets but had very different and immediate ramifications.  Lehman was a global financial firm that sat in the middle of a large percentage of financial transactions around the globe.  On the Monday after Lehman’s bankruptcy, firms across the globe were taken offline, unable to do business as their letters of credit for trade, lines of credit, and cash holdings were unattainable.  The impact of the UK referendum will be quite different: there is no immediate stoppage of economic activity.
2. We believe that Brexit will not catalyze a domino effect within the financial sector.  Banks in the US and international developed world are well capitalized, and central banks have the mechanisms to backstop any disruptions.  Leverage within the financial system does not resemble leverage levels in 2008.
3. We believe that Brexit is the beginning of the restructuring of the EU, not the end.  We are witnessing the markets paying more for credit protection from France than from Britain, suggesting that people are more concerned about the instability impacting France than Britain.  We concur and see more potential issues for the continent than for Britain.
4. We are happy that we have not recently purchased property in London. Morgan Stanley has discussed the possibility of relocating a large number of their employees from London to Dublin or Frankfurt.
5. The uncertainty will likely be discounted quickly in the markets.  One thing we have learned from other episodes is that markets will likely err on the side of caution, building a consensus around a bad outcome.
6. It is unclear to us whether this will turn out to be as negative an outcome as it is being viewed.  England is more capable than Greece of negotiating with the EU.  In addition, England has always maintained more autonomy from the EU than other members (e.g. maintaining their own currency). The political forces within the EU want to punish England; they want to make an example out of Britain to discourage other countries from considering an exit.  However, the impact to their economies would be severe if leaders come down hard on the UK, so we assume that a more reasonable solution will prevail.  Historically, the leaders of the EU have avoided taking the hardline with any country.  They tend to be kick-the-can’ers and we have no reason to expect a change in their strategy now.

 

This is an unpleasant outcome and will rile markets for some time, given the level of economic uncertainty that results.  However, in the end, we believe this divorce will be amicable.

 

The thoughts above represent our initial take on the situation and may change if our stress factors move materially. We feel comfortable with our current positioning of being underweighted in both emerging and developed international markets. At this point in time, the disruption, though meaningful, appears to be limited. If we observe the signals changing, we will act accordingly, but for now, we maintain a fully invested but defensive position.