U.K. Vote to Leave European Union Roils Financial Markets | Capital Group


Investment Insights

June 2016

U.K. Vote to Leave European Union Roils Financial Markets

But Process Will Be Lengthy and Outcome Likely Not as Bad as Markets Fear

  • Stock markets slide in response to Brexit vote in an orderly decline
  • British pound suffers big loss, euro also slides against dollar
  • Market volatility to remain elevated as Britain and Europe reach new agreements
  • A long-term investment horizon remains key to successful investing

British voters surprised the world on Thursday by approving a proposal to abandon the European Union, with 51.9% of the vote in favor of leaving and 48.1% in favor of remaining. Global markets and currencies reacted negatively to the news, evidenced by a spike in volatility and declines across all major equity markets. Stocks gave up ground after rallying the prior week in the run-up to the vote.

The British pound fell to a three-decade low against the U.S. dollar, its biggest one-day fall on record, while the euro slipped 3%. David Cameron announced he will resign as prime minister by October. Markets are likely to remain volatile until it becomes clear what a Brexit scenario means for the U.K. and the rest of the EU.

Brexit and the Tumbling Pound Sterling

Sources: Bloomberg Finance L.P., RIMES. 6/24/16 Data as of 11:30 a.m. PST.

The exit of a large, established member from the EU has never been tested. It could take at least two years for the U.K. to formally leave the 28-nation bloc, and it is unclear how much the country’s relationship with the EU will change during that period. This uncertainty is likely to have an immediate effect on areas of the U.K. economy such as business investment, consumer and business confidence, the currency and foreign direct investment flows, among others.

“The key point to remember is, this referendum is the beginning of a process, it’s not the end,” says Capital Group portfolio manager Rob Lovelace. “The market has interpreted this as a bimodal event and it isn’t. Now that the referendum has passed, we start a two-year process of negotiations.”

“Markets are reacting negatively to the uncertainty,” he said. “U.K. equity prices may continue to decline and the economy may suffer in the short-term. But as someone who can take a long-term view, I would regard it as a buying opportunity,” said Lovelace, who is a manager for New Perspective Fund. “We continue with our in-depth research in our efforts to identify investments that can reward investors over the long term and capitalize on short-term market uncertainties.”

Economic Implications

Over the next few weeks and months, the feedback loop between financial market reaction and the global economy will play an important role in how long-lasting the impact will be. The U.K., which has thus far been one of the stronger economies in Europe, could face a mild recession. “As the second largest economy in Europe, a slide in the U.K.’s economy will have an impact on broader Europe,” said Thomas Hogh, a portfolio manager for Capital World Bond Fund. Against this backdrop, major central banks will stay committed to accommodative policies and the Federal Reserve will in all likelihood withhold any rate increases, he said.

Meanwhile, stock markets, especially in Europe, appear to be pricing in a weak economic environment. “Stock values in Europe have remained very attractive and continue to be so,” said Mark Denning, a portfolio manager for EuroPacific Growth Fund. And at the end of the day, even as the U.K. negotiates new agreements, a lot of business will go on as usual.

“The market is interpreting this event as perhaps the beginning of the end for the European Union. If that happens, it won’t happen overnight. A process like that takes many years,” said David Riley, a portfolio manager for Capital Income Builder.

“There is far too much panic centered on this vote. It’s not the end of the world. European trade will not cease to exist. Mercedes Benz and BMW will still want to sell cars to the U.K.; it’s the second-largest economy in Europe and it’s not going to disappear,” said Riley.

Despite Brexit Worries, U.K. Equities Have Outpaced Their European Peers

Sources: Bloomberg Finance L.P., RIMES, MSCI. Data as of 6/24/16.

Status Quo Upended

U.K. voters were asked a simple, straightforward question: “Should the United Kingdom remain a member of the European Union or leave the European Union?” Those who wanted Britain to leave the EU had argued that the U.K. would benefit by ridding itself of costly EU regulations and by restricting the ability of immigrants to enter the country. Brexit opponents warned that abandoning the EU would damage the U.K. economy by voiding long-held trade deals and other agreements that provide for the free flow of people and capital in the 28-nation bloc that stretches from Finland and Sweden in the north to Italy and Greece in the south.

“Markets have underestimated the willingness of populations to upset the status quo. The likelihood of additional anti-globalization events, given similar movements across developed economies, could be higher than previously thought,” said Denning.

The U.K.’s exit could possibly encourage some political parties in several European countries, for example Front National in France, to promote similar actions in their respective nations. A Greek exit could be put back on the table, while polls in other countries, including the Netherlands and the Czech Republic, have suggested that their populations might want to follow suit with similar referenda. Elections in Spain are slated later in June.

A Question of Sovereignty

Great Britain joined the European Economic Community in 1973 — before the “European Union” name was adopted and its regulatory powers expanded. Even at the time, it was a controversial decision. Some loyalists complained that Britain was giving up a measure of its sovereignty to continental Europe. Years later, when the euro was adopted, the U.K. refused to join the common currency, opting to stay with the pound instead.

“The bitter campaigning around the referendum has exposed issues related to immigration and demographics that the political system will need to address. While no one ever likes to know that there are more problems than you realize, you can't start solving the problems if you don't know what they are. We know what the problems are now and those problems will continue to be a challenge for the U.K., both internally and externally,” Lovelace said.

On the other hand, areas of the economy that may get through Brexit relatively unscathed include consumer staples — particularly tobacco companies — and utilities with strong balance sheets and attractive dividend payments, Riley said. “Defensive sectors are well positioned,” he added. “Tobacco, utilities and even pharmaceuticals — their products will continue to be in demand, no matter what happens between Britain and the EU.”

A Domino Effect in Europe?

The bigger question in front of markets is the implications this will have on the future of the European Union. Portfolio manager Mark Brett says “this isn't just about the U.K. leaving. Ultimately, the U.K. should be able to devalue its currency enough into a competitive position. The bigger question is how the other 27 EU members deal with their problems now.”

Portfolio manager Hogh notes, however, that “Brexit could do the reverse and propel the EU towards a greater political and fiscal union, including common bank deposit insurance. History suggests that a crisis may be what is needed to propel the EU into making structural reforms.”

Even when markets are falling, it is not unusual for equity, bond and exchange rate markets to overreact and these kinds of market pullbacks can create opportunities for active managers. Hogh notes that “most of the adjustment necessary to rebalance growth and finance the current account deficit in the U.K. is likely to come through a depreciation of the British pound and we could see the pound overshooting amid capital flight.”

Short and Long-term Outlook

The pound sterling and the euro are likely to remain among the weaker currencies and the U.S. dollar and Japanese yen among the stronger ones, Hogh said. In European bond markets, the yield difference between the bonds of smaller southern European nations and those of German bunds could remain elevated.

“Once the situation becomes clearer, we can focus on our in-depth company and security research in an effort to identify valuation opportunities that may have been overly impacted by short-term market fears,” he noted. 

One factor that is often overlooked by the markets in these volatile periods is how international many companies are these days, especially with increasing integration of global markets and economies over the past decade. In fact, almost 50% of revenues from companies in the MSCI Europe Index come from outside of Europe. This figure is even higher for companies represented in the MSCI U.K. Index– they earn more than 70% of their revenue from outside the U.K. The British economy and markets are among the most globally integrated.

“When it’s all said and done, do I think fewer people and fewer businesses are going to want to be in London? I really doubt it,” Lovelace said. “I think London will continue to be one of the most important cities in the world, and it could even be a better business hub without EU regulations.”

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Terms and Definitions
MSCI Europe Index is a free float-adjusted market capitalization-weighted index that is designed to measure results of more than 10 developed equity markets in Europe.
MSCI United Kingdom Index is a free float-adjusted market capitalization-weighted index that is designed to measure the equity market results of the United Kingdom.