Today's Headlines: From The Grexit To The Brexit

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Today's Headlines: From The Grexit To The Brexit
March 1, 2016

Another Challenge for the EU

Any organization that attempts to get multiple governments to agree on any topic is always facing challenges. Over the past several years, this has been especially true for the European Union (EU).

As worldwide economic growth continues to falter, EU and Eurozone nations have been dealing with the intersection of their own economic crises and those of their fellow members. Their problems have been myriad and complex. Just last year, Greece narrowly dodged an exit from the Eurozone (the much feared "Grexit". To make matters worse, the massive influx of immigrants from war-torn areas of the Middle East are further straining EU ties as member countries debate the most equitable way to deal with the humanitarian crisis. Finally, the EU faces the possibility of a member leaving the union as Great Britain holds an upcoming referendum on leaving (commonly known as the "Brexit").

Prime Minister David Cameron has called for a referendum on June 23 to address Britain's membership in the EU. Should voters decide to leave, the EU will be plunged into uncharted territory — there are no procedures or outlines for how such an exit would take place.

Keep in mind that the Eurozone is not the EU; it's a 19-member subset of the 28 EU nations that share a common currency. Britain has chosen to remain outside the Eurozone, making a Brexit potentially more straightforward than a Grexit, which involved potential extraction from both the Eurozone and the EU.

What is driving Britain to consider such a change? The issues are similar to the Greek situation in a broad sense, although the details are very different.

Why a Brexit is Different from a Grexit

Two of the three fundamental issues driving a potential Brexit are similar to the issues in Greece: economics and sovereignty. The third issue, immigration, also involves Greece in a fundamental way since Greece is the gateway for many immigrants entering Europe from the east. All three topics are intertwined.

Greece represents a basic issue of economic hardship and survival, while Britain's case is a calculated gamble of economic improvement. Would the British economy be better off forgoing the free trade arrangement within the EU in exchange for freedom from excessive EU regulation?

Sovereignty was an issue in both cases, as elected governments in each country chafe under mandates from "unelected bureaucrats in Brussels." Greece has a much smaller GDP than Britain — and a commensurately smaller economic impact on the broader EU — but in both cases, the home governments may overestimate their leverage.

According to The Economist, Britain takes in around 10% of EU exports while the EU accounts for nearly half of Britain's exports. Most of that trade would likely continue — but on what terms? Exit from the EU will have to be negotiated, and the EU is likely to play hardball to give other nations disincentive to consider leaving the EU.

The immigration angle threatens to swamp the economic argument. Greece is receiving growing pressure from EU nations to control the flow of incoming immigrants, while Britain is debating EU efforts to relocate immigrants throughout the EU nations. Not surprisingly, nationalism and security concerns are taking center stage.

Cameron returned from a recent meeting in Brussels having renegotiated terms for Britain to remain in the EU, but the concessions have not been enough to sway public opinion. To make matters worse, popular London Mayor Boris Johnson came out in favor of a Brexit, as have other key members of Cameron's Tory party.

Market Effects of a Brexit

The mere mention of the referendum has sent the British pound down sharply, currently trading at around $1.39. Many UK economists express concern about a potential exit from the EU, citing investor uncertainty and capital flight — but why should we in the US be concerned about a Brexit?

Consider that Britain is the fifth-largest economy in the world with a GDP of approximately $3 trillion, and the total trade between the US and the UK was over $104 billion in 2015 (split almost evenly between exports and imports). A trade agreement will need to be re-negotiated with a newly unencumbered Britain and the outcomes of that agreement is uncertain – especially since the terms of exit from the EU will have to be negotiated simultaneously. The collective uncertainty is likely to slow growth worldwide in the short-term as businesses assess the likely outcome for both Britain and the EU.

The effect on American businesses would be significant, according to Joseph Quinlan of Bank of America Global Wealth and Investment Management. Quinlan points out that many US multinationals have great presence in the UK — so much so that in 2013 the economic output of the UK affiliates of US companies was $153 billion, greater than the GDP of many countries.

From an investment and capital flow standpoint, the effect is even larger. In 2014, US capital investment in Britain added up to $588 billion. In comparison, US corporate investment in China was a mere 11% of that total. Britain has been a far easier place to do business than China or India and has served as a gateway for US trade with the rest of the EU. Consequently, as Britain debates its course of action, many institutional and private Investors are rethinking their British investment philosophy.

If Brexit supporters are correct, the short-term pain will be overcome by long-term gain as a new Britain, freed from oppressive EU rules, soars to new economic heights with new trade arrangements. However, they will have to do so without the collective economic power of the EU. In either case, all parties agree that the short-term effect of a Brexit is likely to be market chaos.

The Takeaway

At this point, the referendum in Great Britain is too close to call. If the polling remains close until the referendum approaches in June, volatility in UK stocks is likely to increase as polls shift and pronouncements and predictions are made — similar to the US stock market gyrations based on predictions of Federal Reserve actions (or inactions).

Do your investments have strong ties to the UK and the EU? Effects go beyond international funds. For example, if you are invested in an American company that gets a great deal of income from the UK, you should keep tabs on the referendum and the follow-up. New trade deals could have serious ramifications for your investments, good, bad, or mixed. Moreover, currency fluctuations on both the pound and Euro are likely to continue — so consider if any of your investments are denominated in either currency.

While you shouldn’t overreact to the short-term volatility here, it would be wise to monitor the situation for its possible long-term impact on your portfolio and its performance. The more ties you have to EU and UK investments, the more important it is that you monitor the referendum on the Brexit and make some alternative investment plans in advance should the Brexit actually come to pass.

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