Brexit – A Leap of Faith

A fantastic summary of the current British economic situation, courtesy of Darryl Conroy (Financial Markets Research, Investment Research & Economics; Suncorp Group).

 

UK Referendum

In the aftermath of the UK referendum, it’s difficult to find an adjective that suitably describes the magnitude of the mayhem wrecking its way through the world’s financial markets.

The UK referendum asked a simple enough question, “Should the United Kingdom remain a member of the European Union or leave the European Union”? The shock result of the vote, was of course, to leave the European Union.

I must confess, I personally got the result wrong and thought the strong opinions from the likes of George Soros were overblown. I now find myself frantically digging around for his every prophetic word. For this reason the examination into why the vote fell the way it did is all the more fascinating to understand. The UK referendum descended into a bitter and divisive campaign that invoked talk of war and images from World War II. The fact that MP, Jo Cox was sadly murdered underscored the acrimony.

It seems the referendum arose from a desire by Prime Minister Cameron to galvanise his Conservative party, and at the same time quell the uprising surrounding UKIP (independent and eurosceptic party). With the benefit of hindsight, it is fair to say Cameron failed and has subsequently tended his resignation.

But why did the United Kingdom vote to leave? From my perspective, it seems the decision revolves around immigration, inequality and fear. Immigration has become an intense and divisive point of debate, with some resenting immigrants for taking their jobs. On the other hand, others see the benefits of higher living standards and the creation of more (lower paid) jobs. Ever since the GFC, the developed world is mired in fear and insecurities around jobs and financial security.

It is fascinating that these issues are very much global, with exactly the same rhetoric giving rise to Donald Trump and resulting division in the US. Furthermore, protectionist and populist policies are gaining traction throughout the developed world.

“A ground swell of disenchantment amongst the voting public is a growing challenge the world over!”

 

Stability

The United Kingdom is the world’s fifth largest economy and the second largest within the European Union. The UK has been a pillar of economic and political stability for many decades. In the short-term at least, the vote to leave brings enormous turmoil as the painful process of extraction commences. This is because the EU is an inherently bureaucratic beast and a two year process. It is also unchartered waters, as no country has ever left the EU.

Brexit is not yet 48 hours old and already there is talk of Northern Ireland and Scotland reinvigorating their own referenda to leave the United Kingdom. Furthermore, market speculators will press for weakness in places like Denmark, the Netherlands and the weaker economies within the EU. Thereby, exerting enormous stresses and uncertainty upon the United Kingdom and European Union.

Although voters have had their say, Great Britain is left leaderless and the closeness of the vote only highlights the bitterness and the voter division. For instance, Brexit was favoured by older voters and those outside of London. Younger voters enjoyed the freedom and access to the European Union for work and play, and are now left with the bitter taste of discontent. This places the notion of stability at risk of greater uncertainty and volatility in the months and years ahead.

 

Implications for Financial Markets

What are the implications for the financial markets? Enduring uncertainty is likely to generate significant volatility within the financial markets. If inequality was one of the drivers behind the UK’s vote to leave, then the $5.5 billion wiped off the UK’s FTSE may well bring the rich and the poor closer together. It is brings financial consequences.

Such an erosion of capital heightens the risk of recession in the UK, at least in the short-term, and dislocations in other markets such as credit, currencies and commodities. Hence, we can expect further monetary stimulus from the Bank of England in attempt to stabilise markets and engender a sense of confidence. Working in the other direction to a rate cut, is the thirty year low in the British pound. Whereby, rate hikes typically help to stabilise a depreciating currency. Although the BoE have a number of tools to stabilise the pound. A longer term benefit of a lower currency is to narrow the current account deficit, currently 5.2% of GDP (Australia is 5.1%).

Markets reveal a distinct shift into safe-havens such as bonds and gold, and away from growth assets such as stocks and commodities. This is likely to settle down over time, nevertheless a negative impact for the Australian economy and for markets in the immediate future. Rate cuts are increasingly likely in the UK and Europe, whilst the much anticipated rate hike in the US is off the table. Amongst the malaise there will be opportunities for those with enough intestinal fortitude to stomach the market swings.

A small and open economy such as Australia is likely to get caught up in the apprehension. Whilst adjustments to the RBA cash rate are less certain, the risks are to the downside. One risk worth considering is if dislocations in credit markets do surface, this will negatively impact upon Australia’s credit markets. Especially so, given the record high levels of leverage in household balance sheets and rising debts within the government balance sheet.

The key to moving beyond the near term uncertainty and volatility is to affect fiscal reform so as to keep up with a fast changing global economy. Without reform we rely upon monetary wizardry from central banks, and risk even further disenchantment from voters.

With a federal election just around the corner here in Australia, there are salient lessons about inclusion and much needed reform. Whilst it’s too late to address these issues for July 2, they require action and leadership in the not too distant future.

Personally, I can draw lessons from Margaret Thatcher, “expect the unexpected”. More broadly, the words of Tim Kaine, “my sense is that economic anxiety means political volatility”, ring loud, but I dare not think what lies beyond the immediate volatility!

 

If you are concerned about Brexit, or interested to understand more, please call our office on 07 4646 4970 or contact us on info@fortressfs.com.au.

Article courtesy of Darryl Conroy (Financial Markets Research, Investment Research & Economics; Suncorp Group).

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