Brexit is a Reality

By Richard N. Croft

Brexit is a reality! Despite the betting odds, despite the financial markets’ expectation that we would see a “remain” outcome, the British electorate knowing for bucking the odds voted to exit the European Union.

And now we face the inevitable fallout. Unfiltered headline noise will set the stage this week. Witness the latest hot off the press headline noise; “Financial Markets in Free Fall;” “Volatility is Spiking;” “Gold is Surging;” “Currencies are in Disarray!” Remember this is noise and not what you should focus on when making investment decisions.

Fact is Canadian equities as measured by the iShares S&P/TSX 60 Index Fund (symbol XIU) fell 1.93% on Friday which puts the index back to where it was a week ago. The so-called spike in volatility is well below levels in February (the MX VIX Index closed Friday at 20.06, it closed as high as 31.99 in February this year). Gold is higher but not as much as you might think and is still well below levels from 2012 through 2014. Gold bugs are not seeing this as the global crisis that financial writers and doomsayers like to espouse.

The currency market is another story. The decline in the British Pound was monumental, clearly uncharted territory! And there may be more to come. Britain will most likely slip into a recession which may prompt Mark Carney head of the Bank of England to cut rates. Best guess is a snap 25 basis point cut which may further weaken the pound.

I believe the longer term implications will be political than economic. British Prime Minister David Cameron orchestrated this vote based on a promise he made to parliament in 2013. It was designed to appease members of his own party who felt that Britain gave up too much in negotiations with the EU. The lesson from this is that referendums don’t work well when dealing with complicated positions. Too often the economic message gets lost under the weight of political biases that gravitate to the lowest common denominator. In this case the leave camp played on the electorates’ xenophobia about lax immigration policies, unprotected borders and jobs. If you think that’s not the case watch closely as the US Presidential race heats up. It will play to the same storyline.

The trick in the weeks ahead is to separate the political meat from the skeleton. For example, the Scottish Parliament fresh off their own referendum that voted to remain within Britain mainly because doing so allowed Scotland unfettered access to the Eurozone, will probably introduce legislation to prevent the British parliament from enacting article 50 (the article that provides the process for exiting the Eurozone) with Scottish consent. It won’t matter but that will likely lead to another Scottish referendum to leave Britain which may well pass.

Northern Ireland will attempt to succeed from Britain to join Ireland which is an EU member. That will not likely pass muster with the Protestant majority in Northern Ireland, but will nevertheless be fodder for more headline noise.

Conspiracy theorists will say that the British exit will lead to more separations within the Eurozone. That’s not likely with the possible exception of Hungary. But that will have more to do with the political system. Hungary is a dictatorship and under the rules, only democracies can be members of the Eurozone. As for Italy, Spain or Greece, if they were going to leave they would have done so already.

I suspect that reality will begin to set in by mid-week. Any exit plan will take two to three years to implement. Most likely Britain will negotiate a partial union much like currently exists for Norway which pays about US $1 billion in annual dues to have access to the Eurozone. Norway must follow Eurozone rules but as a country remains independent.

As cooler heads prevail we may well see a rebound in equity markets once hedge funds and institutional portfolio managers have reset their portfolios based on revised earnings expectations. Which by the way will start to replace the headlines starting in July.

At this stage I would avoid committing serious money to hedging strategies. I think most of the damage has already occurred. Wait for opportunities to begin nibbling at new positions which could come as early as mid-week.

By Richard N Croft