Yesterday, the British people made the decision to exit, or “Brexit” (a British exit), the European Union (EU), likely their most important decision in a generation. The vote was close, with 52% voting to leave and 48% to remain. Prime Minister David Cameron has since announced he will resign by October; he campaigned strongly for the Remain Side, arguing that an exit would reduce economic growth, trigger a recession, and result in a long period of instability for the economy, trade, and jobs.
While the intellectual argument of the Leave Side focused on British sovereignty and burdensome EU regulation, the emotional argument focused on what it deemed uncontrolled immigration and the resulting risks of crime and terrorism. The emotional case seemed to gain significant momentum as the vote approached.
Britain’s exit is a big hit to the EU, which is already dealing with slow population growth, low productivity growth, large debt levels, high unemployment, a migrant crisis, the Ukranian conflict, and lots of cross-border squabbling. Most of all, Brexit creates more risk that other EU countries may hold similar referendums.
Yesterday’s financial markets did not expect or like the vote: U.K. stocks were down 3.8%, European stocks were down 6.9%, and U.S. stocks were down 3.6%. The British Pound fell 8.1% against the dollar and sits at its lowest level in 30 years. The euro fell 2.4% against the dollar.
Despite yesterday’s market reaction, we believe the long-term impact to your portfolio will be minimal. Any reduction in our European stock-market expectations will be small, and those changes will be muted by your portfolio’s non-European-stock-market emphasis and bond exposure. With a little luck, the current volatility might even present us with an opportunity to add a new, attractively priced security to your portfolio.
EU and the U.K.
Since World War II and the devastation of much of Europe, a series of treaties led to a more integrated, less war-prone Europe. In 1951, The Treaty of Paris created The European Coal and Steel Community (ECSC), which launched the movement and brought sharing of the production of coal and steel, two primary resources during the war, between France and Germany, two primary enemies during the war.
At least 10 subsequent treaties and acts have wound from the ECSC toward the European Union (EU). The EU was a union of 29 member countries covering over 500 million people, providing a single market ensuring the free movement of people, goods, services, and capital.
Today’s EU is the same, less the U.K. It is the first country to leave the EU, and the repercussions are uncertain.
According to the World Bank, the total Gross Domestic Product (GDP, or the total value of goods and services produced within a region) of the EU was $18 trillion in 2014, compared with $17 trillion for the U.S. The U.K. was the second-largest economy in the EU (behind Germany) and fifth-largest in the world, at approximately 17% of EU GDP. (For comparison, California was roughly 15% of U.S. GDP). And as can be seen in Figure 1 below, exports to the EU are quite important to the U.K., and vice-versa.
“Leave Side”, Immigration
Despite the obvious financial interdependence of the U.K. and the EU, the risk of reduced long-term economic growth, and the near-term uncertainties caused by the exit, 52% of Brits voted to leave the EU. They point to Norway and Switzerland as successful examples outside the EU. However, among many other economic and cultural differences, the population of the U.K. is 64 million, many times the eight million for Switzerland and five million for Norway. And leaving the EU is altogether different than simply operating outside of it.
The Leave Side’s campaign clearly identified immigration as a key source of frustration and worry (see Figure 2 below) among Brits. Many were convinced that leaving was the only way for the U.K. to control immigration, since the free movement of the bloc's citizens is a basic tenet of EU law.
In 2004, the EU added eight Eastern European countries, triggering a surge of immigration from those countries, due to higher unemployment and strained public services. Since then, the percentage of foreign-born residents in the U.K. has doubled, to 13% of the population. Britain’s relatively attractive economic growth rate, which has been twice the level of the euro zone (i.e., a 19-country subset of the EU that adopted the euro as its currency), has drawn many looking for work.
Net migration to Britain in 2015 was 330,000 people, the largest level since 2005, the year after Poland and other Eastern states joined the EU. According to EU rules, there was no way to limit most of the influx. And despite a belief by some that immigration provided a net economic benefit, others felt that British identity and jobs were at risk.
Additionally, in the “Vote Leave” campaign’s official leaflet, a map showed how the prospect of Turkish membership would create an EU border with Syria, Iraq, and Iran. This seemed to imply both a concern over the inclusion of Turkey, a country of 75 million with a 97%-Muslim population, as well as concern over a border-driven vulnerability to radical terrorism, heavily impacted by the Syrian-refugee debate.
There is no comparable precedent for Brexit. As HSBC Chairman Douglas Flint said, “We are today entering a new era for Britain and British business. The work to establish fresh terms of trade with our European and global partners will be complex and time consuming.”
Upon its exit, the U.K. will forfeit the favorable trade terms that EU membership offers. While we have seen a wide range of numbers from various sources, the International Monetary Fund (IMF) projects that U.K. GDP could drop between one percent and four percent by 2021, depending on the policies adopted. While this would be a lousy five-year outcome with lots of employment and other consequences, a flattish economy is quite far from a depression.
Prior to the vote, Goldman Sachs, JPMorgan Chase, and HSBC all warned that a Brexit could cause them to move thousands of jobs out of the U.K. In the case of JPMorgan Chase, the company specifically referenced the prospect of moving 25% of its 16,000-member U.K. workforce. It appears banks in the U.K. may lose their “passporting” rights, which will force firms that wish to access EU markets to move their operations within those markets. As a result, the status of London as one of the world’s top financial centers is at some risk.
There are many similar examples. British airlines currently have the freedom to fly within and between EU countries, thanks to an existing agreement with the EU. Last night’s outcome may mean the U.K. will lose these freedoms if new contracts are not put into place. In the long term, airlines may consider replacing London with another European city as an entry point into Europe and could also make flying into and out of the U.K. more expensive. Even the U.K. film and television industry has been the beneficiary of EU funding, affecting the future production of shows such as HBO’s Game of Thrones, which is filmed mostly in Northern Ireland.
While these types of economic and trade risks are very real in the short term, we expect that they will be largely resolved in the longer term – somehow. The consensus seems to be that Europe will reorganize in a way that will keep Britain in the single market, but the details will likely emerge slowly and painfully.
From our view, the largest remaining concern is that other EU members will be encouraged to hold their own referendums, with potentially similar results. We have been concerned for years about a departure from the EU, though we have worried much more about a move by one of the countries in the eurozone (i.e., the 19-country subset of the EU using the euro). A departure from both the EU and euro would be, in our opinion, far messier and riskier than a U.K./non-euro departure. And if it were a prospective exit by one of the larger eurozone countries – Germany, France, Italy, or Spain – we would be very nervous and would consider significant changes to your portfolio. World leaders have voiced public concern over such dislocation risk having been precipitated by Brexit, boldly emphasizing the need to rethink the union immediately. French Prime Minister Manuel said of the U.K. exit, “It's an explosive shock. At stake is the break up pure and simple of the union. Now is the time to invent another Europe.” We hope and believe that a significant eurozone departure will be avoided, if for no other reason than the risk of the consequences is so large. Some of the potential country-specific consequences are outlined in Figure 3 below.
Impact on Your Portfolio
From an investment perspective, Brexit means that our long-term expected returns for U.K. and European stocks will decrease. At this point, it’s difficult to think through the implications for the U.K. itself, let alone the EU. Even in the U.S., it might be that expected returns are reduced slightly; Europe is nearly 25% of global GDP, so a slowdown in the EU would affect most companies around the world to some small degree.
But while we aren’t yet able to quantify the reduction to our expected returns, we do not believe the decrease will be significant. As a result, we do not anticipate substantial changes to your portfolio holdings.
Our economic-growth-rate assumptions, just one part of our expected returns for stocks, were already quite low in all developed markets (including the U.S., Europe, and Japan). And most of our long-term expected return for European stocks is derived from four factors not (directly) dependent on economic growth: dividend yields (and net share repurchases), an increase in corporate profit margins, an increase in valuation levels, and an increase in currency value. As a result, the expected return for your European stocks will decrease only moderately, despite the still-slower economic growth now expected.
In summary, we believe the long-term impact to your portfolio from the U.K. exit will be minimal. Any reduction in our European stock-market expectations will be small, and those changes will be muted by your portfolio’s non-European-stock-market emphasis (nearly 80% of your stocks) and bond exposure (with no expected change in its expected return). With a little luck, the current volatility might even present us with an opportunity to add a new, attractively priced security to your portfolio. Stay tuned.