Galvin, Gaustad & Stein, LLC

GGS Thoughts on Brexit Vote - June 24, 2016

Yesterday, citizens of the United Kingdom unexpectedly voted to become the first country to exit the European Union. Markets around the world have reacted very negatively as significant uncertainties now abound in Europe. This is a major event for the citizens of the UK, this is a major event for the remaining 27 members of the EU, but by itself, we believe this is not a major event for the global economy and should not alter your long-term investment strategy.

What happens now and what is the global impact?  

In 2007, the EU member countries signed the Lisbon Treaty, which created a process whereby a nation would be able to leave the EU. This is a prolonged process that will likely take up to two years, during which the UK will continue as a member of the EU and will adhere to EU policies. Over that time, the UK Government will negotiate treaties with the EU to govern how the two newly separated entities will interact. These treaties will span a broad range of issues from trade to freedom of movement (currently travel is open between countries and no passport is required). It is unclear what the newly negotiated treaties will entail and how similar they will be to the current EU policies. This uncertainty is what is spooking the markets today.

There will very likely be a negative near-term economic impact in the UK and less-so the EU to this vote. The uncertainty of not knowing what the rules will be in two years will likely freeze investment and economic activity to a certain extent. The UK economy is 4% of global GDP. JP Morgan estimates a negative 1% hit to UK GDP and a negative 0.5% hit to EU GDP from Brexit, but these two impacts together would only be about 0.1% of global GDP. In addition, unlike 2008 and the Euro sovereign debt crisis of 2010-11, there is very little scope for bank failures to result from the Brexit vote and turn it into a global financial crisis. In other words, economically and financially, the impact should be mostly local to the UK and, to a lesser extent, the EU. These economic impacts can be mitigated by the new UK leaders and EU leaders by providing clarity as soon as possible to the process and desired outcome of their negotiations. In a best-case scenario, the UK simply keeps nearly identical deals to those that already exist.

The worst-case scenario is that other member nations follow the UK’s lead and vote themselves to exit the EU, eventually crumbling the entire bloc and with it the Euro currency, which then would turn this into a global financial crisis and recession. In our opinion, the worst-case scenario is highly unlikely. Few, if any, countries dissented on proposals from the European Commission like the UK, and it is much easier to remove a country from the EU that does not utilize the Euro and has maintained control of its monetary policy. Furthermore, as proven by the Greek crisis, the leaders of continental Europe have shown an incredible will to keep the Eurozone intact, and the economic harm the UK has likely just caused itself may also dissuade others from following suit.

Implications for client portfolios:

At GGS, we take a long-term approach to investing in the stock market and do not attempt to engage market timing by raising large amounts of cash when things look bad. Indeed, when volatility spikes and investors are highly pessimistic (such as today), it is often a good time to be buying into the market. Things are often not as bad as they initially appear, and while the market certainly can have significant drops like today, we continue to believe that the best long-term strategy for making money is to stick to your investment plan and stay continuously invested in high-quality companies. 

Background information on the European Union:

The EU is a collection of 28, soon to be 27, member countries that operate collectively in the governing of their economies, environmental policies, immigration policies and trade agreements, amongst other things. The purpose for which this geopolitical initiative began was to essentially create a “United States of Europe.” Since the 1960s, the member nations have pledged to slowly move toward a more united Europe in order to make all the countries larger and stronger economically, socially, etc. To simplify the structure, there is a European Commission, which can be compared to the executive branch of the US Government; a European Parliament and European Council, which is akin to the US Congress; and the European Court of Justice, which works similarly to the US Supreme Court. Through these entities, legislation for the EU member countries is proposed, written, ratified, interpreted and enforced. Of the 28 member EU, 19 of them participate in the Euro currency, which further ties those 19 nations together in monetary affairs. These 19 countries use the Euro as their national currency, and the ECB as their central bank. The UK was never part of the Euro currency but was a member of the EU governing structure and did have to adhere to trade policies, environmental policies, legislation on foreign affairs, etc. The lack of excisable sovereignty in those areas is what the people of the UK voted to end.

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