When a Client Asks, “What is Brexit?” Here’s Your Quick Guide

As we discussed in a post on Market Psychology and the Investor Narrative, the markets get very volatile when a new, large and unfamiliar risk surfaces. Brexit, or the possibility that the UK will decide to exit the European Union, is one such risk. Will it happen? Right now opinion polls are roughly 50-50, and market participants are putting the probability at 40-50% of a yes/Brexit vote on the upcoming referendum on June 23, 2016. So, when a client calls and asks for an explanation, here’s your short primer:

Basic points:

  • The European Union consists of 28 member states. Member states give up some political and economic authority in order to benefit from free trade in a market with over $18 trillion in GDP and 500 million people.
  • Note that only 19 of those member states use the Euro as their base currencies – this subset is called the Eurozone. The UK is one that doesn’t (British Pound). See our video here on why many investors have been short the Euro.
  • The UK has been part of the EU since 1973, so the prospect of an exit is a historically big deal.
  • The UK will have a referendum on June 23, 2016 on the question of whether the UK should remain in the EU.

Why now?

  • Critics have argued that the EU brings too much regulation with too many issues, like open borders.
  • The UK Conservative Party promised a referendum after it was elected; they won and scheduled it for June.
  • Public opinion of the benefits of being part of the EU, with anemic growth and a growing migrant crisis, is at a low.

Is Brexit good or bad for the UK?

  • Most economists think it’s bad – some companies might relocate headquarters to the Continent, foreign capital inflows might slow. The UK would need to negotiate new trade treaties with the EU, which could be a lot less favorable than those available to EU members (the prime benefit of EU membership).
  • The markets are concerned: The GBP has already declined close to 10% as fears of a yes vote have risen recently and Goldman Sachs thinks a 20% decline is possible in an exit scenario. Morgan Stanley thinks the FTSE 100 will underperform by 20% with a yes vote.
  • The pro camp thinks fears are overblown and that lifting burdensome EU regulations would boost growth. An EU-less UK, they argue, is an even more attractive place to have your headquarters or invest, and the UK will have no issues negotiating favorable trade deals when German auto companies and French wine manufacturers pressure politicians to keep trade flowing freely.

Will it happen?

  • Too early to tell. Opinion polls last year consistently favored staying, but it’s been close recently. Also, the percentage of “undecided” is high, so campaigns are ramping up to sway the middle.
  • That said, PIMCO puts the probability at 40% today. JPM estimates the fixed income markets think it’s a coin toss.
  • Remember that a yes/Brexit on the referendum would not cause the UK to exit – it presumably would kick start negotiations between the UK and EU on the mechanics, terms, etc. This is uncharted territory.

How does Brexit compare to Grexit?

  • Greece is economically insignificant (1.5%) in the context of the EU economy; the UK is huge (15%, behind only Germany).
  • It’s much easier for the UK to exit – having your own currency is like having one foot out the door.
  • Grexit raised concerns about cascading defaults at banks and then subsequent exits by Portugal, Spain, Italy, etc. Brexit doesn’t create credit risk.
  • Both Grexit and Brexit call into question the whole EU concept. The fear is less about a single country than whether it leads to an unravelling. A Brexit would create a precedent for “strong” EU countries to exit, so attention would turn to Northern European countries.

What happens now?

  • Media coverage should pick up as both pro and con camps build momentum. Updates on polling will be frequent – but remember that polls at this stage are going to be highly unreliable.
  • When experts weigh in, remember that they often have skin in the game. Think of it as listening to two political parties more than a rational debate about the merits.
  • Most large companies will publicly throw their weight behind the no-Brexit camp. There’s little upside for multinationals in a Brexit scenario. US companies have made big investments in placing regional headquarters in the UK as the launching pad into the EU market.
  • The British Pound will be volatile and, if a yes/Brexit vote looks more likely, both the GBP and Euro should be under pressure relative to the US Dollar. Expect people to draw conclusions from small moves – the overall trend is going to be more important than daily noise. If Brexit looks more likely, it’s probably negative for the Euro as well.
  • If opinion polls start leaning toward Brexit, expect a scramble of concessions/negotiations/etc. between the pro-EU forces in the UK and counterparts in the EU – they all have a huge incentive to avoid this outcome.
February 25, 2016

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