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Investment e.Perspective

Current Issue | April 27, 2017

Avoid the Temptation to Overreact

By: Brendan O'Sullivan-Hale, MBA, CFA, Senior Investment Strategist & Oxford Investment Fellow


In the spring of 2004, the George W. Bush administration initiated talks with Colombia to negotiate a free trade agreement. The bilateral trade relationship between the US and Colombia is not particularly large. At the time talks began, trade between the two nations totaled a little less than $12 billion. The agreement was signed in 2006 and President Bush sent it to Congress for ratification in 2007. The agreement languished in Congress for four years, until parts of the agreement were renegotiated and the House and Senate finally signed off in late 2011.

That's a lot of trouble for a trade relationship smaller than the annual revenues of J.C. Penney.

With last week's historic vote to leave the European Union, the United Kingdom is entering uncharted territory. No other nation has left the European Union, though the Union's governing documents contemplate the possibility. Article 50 of the Lisbon Treaty allows a member state "to withdraw from the Union in accordance with its own constitutional requirements." The process of withdrawal will begin with official notification by the United Kingdom's government to the European Council of its intention to withdraw. At the soonest, this will not occur until David Cameron's successor takes office.

At that point, a two-year clock starts ticking. This is the maximum time frame the treaty allows for negotiations of the arrangements of the UK's withdrawal, and establishment of new political and trade agreements. Simultaneously, the UK will have to negotiate new trade agreements with all of its other trading partners, as the agreements under which it is currently covered – those that its trading partners have with the EU - will no longer apply. The treaty does allow for the possibility that a diplomatic feat of this complexity will take longer than two years, but only if the 27 other heads of government of EU countries unanimously agree to extend the time frame. With the EU keen to show other would-be departers that leaving is no easy task, they may not be favorably disposed to do so.

The economic linkages between the UK and the EU, to say nothing of the links between the UK and other key trading partners, including the United States, are far larger and more complicated than the modest relationship between the US and Colombia. It took the US and Colombia seven years to come to terms; this task is considerably more urgent.

The vote to leave the EU was a surprise to most outside observers, including me. What is not surprising is the subsequent chill that has infected markets and the UK economy, and the chaos that now plagues the UK's political system. The financial shocks have been widespread – with financial stocks declining on the anticipation of costs related to relocating parts of their operations from London, as well as declining profits as the free movement of capital is inhibited. An anticipated decline in the free movement of people across European borders also hammered airline stocks to a similar degree.

Though it will be some time before Britain actually exits the EU, the vote is already impacting the real economy. Among the Leave campaigners' promises was that departing the EU would improve the UK's export competitiveness; however Siemens this week announced that its plans to export wind turbines from a facility in Hull are on hold. Vodafone, a global telecommunications company based in London but earning a majority of its revenues overseas, has publicly indicated its willingness to relocate its headquarters.

With David Cameron stepping down as prime minister and Boris Johnson, until very recently viewed as his most likely successor, forced out of the race, the country is in a leadership vacuum. This is further exacerbated by disorder in the opposition Labour Party – best exemplified by party leader Jeremy Corbyn's refusal to resign (at this writing) after a resounding loss in a no confidence vote. Cameron has indicated that he will not be the one to issue official notification to the European Council of the UK's departure. He will leave that to his successor, who will be elected in early September. As long as the EU sticks to its guns about not beginning any negotiations until that formal notification is received, uncertainty will haunt the British economy and global financial markets.

Stock markets at the moment are forecasting some version of the worst: that in exiting the EU, the UK will leave behind most of the economic benefits of EU membership. These include a free trading relationship with the largest trade bloc in the world, ease in cross-border movement of capital that has made London a global financial powerhouse and ease in the movement of people, which despite its obvious cultural strains, has created a dynamic labor pool with an unemployment rate far below the EU average.

Broadly speaking, markets are not yet forecasting a truly cataclysmic outcome – that the exit vote will so embolden anti-European parties throughout the EU the entire Union will soon come crashing down. However, extreme drops in the peripheral European markets of Greece, Spain and Portugal show that some market participants are alert to that possibility. An EU breakup is not likely but its consequences would be so severe that it warrants continued attention and monitoring.

There is yet another possibility the markets are not yet considering, which is that cooler heads will prevail. In that event, the present market turmoil may more closely resemble the volatility surrounding the 2011 downgrade of US debt – an important event that markets nonetheless found a way to work through.

Reporting on Prime Minister Cameron's arrival at the EU summit in Brussels this week, the Financial Times quotes an unnamed senior UK diplomat saying, "Ultimately Brexit won't happen." It is possible that the widely reported (though statistically unverified) voters' remorse within the UK could lead to a scenario where there is a second referendum. There is precedent for this type of thing happening in Europe, notably the two referendums it took to ratify the Maastricht treaty in Denmark in the early 1990s. Still, it is not very likely – at least not soon, since it would be perceived as a divisive repudiation of the democratic process. A much more likely scenario is that the UK could pursue membership in the European Economic Area (the so-called "Norway Option"). The EEA would continue to provide free access to the European market, and importantly would allow London to continue to function as Europe’s financial nerve center.

Membership in the EEA comes with a price, though – accession to many EU regulations and a requirement to allow free movement of labor from other EU member states. Both of these would compromise some of the major promises of the Leave campaign. Considering that the campaign's leaders are already walking back promises that savings from paying into the EU budget would be used to support the UK health care system instead, perhaps a further erosion in the Leave campaigners' credibility is to be expected.

Investors should avoid the temptation to overreact. Whatever the merits of the Leave campaign's appeals to a desire for political self-determination and local control of immigration policy, UK voters have inflicted meaningful damage on their own economy. While that damage can be contained – and the EEA option offers one such possibility - there is no guarantee that it will be. Even in that instance there will be winners in the aftermath: Dublin, Paris and Frankfurt will be the cities to watch in a hand off of financial leadership. And the UK itself remains one of the world's largest economies. Its upheaval will last for perhaps a long while, but it is too soon to count it out.

The above commentary represent the opinions of the authors as of 6.30.16 and are subject to change at any time due to market or economic conditions or other factors.