BREXIT – investors, don’t be spooked

Given that markets had been rallying ahead in anticipation of a Stay vote, the surprise pro-Brexit announcement last week was clearly not what the markets had expected.  What exactly does it mean for investors?

When this kind of panic last hit markets in 2008, banks were littered with toxic assets which threatened their existence and with it the functioning of the global financial system. However, we remind you that this is not the global financial crisis. Brexit will have some ramifications, but in all likelihood, less than what the markets reflected today. Investors should not get spooked by the volatility that the Brexit outcome caused and make hasty trades based on an emotional response, but rather take time to reflect on the severity of the likely longer term impact.

What does Brexit actually mean?
The UK has two years to negotiate the terms of their departure from the EU. It is not an abrupt change or a case of all trade and movement of goods and people terminating overnight. Furthermore, where the UK in future have goods to trade, there is no reason why trade won’t happen – this is not an embargo or sanctions, just a withdrawal from a current set of trade agreements, which are likely to be replaced by a series of alternative agreements such as, eg: a series of new bilateral trade agreements with individual countries. From a big picture perspective, it is not the biggest of issues. It might add some additional cost in the process and there might be new tariffs here or there, but the currency will adjust (as it has already done) to compensate for this.

What is the likely impact going to be on the real economy?
The uncertainty surrounding the impact of Brexit might cause a conservative reaction of increased savings and reduced or delayed spending, as well as a reduction in capital investment. If this happens, UK growth will slow and it may even go into recession for a while. To some extent, a similar (but less pronounced) effect might be observed in Europe. So there may be a likely (but small) knock-on effect on global growth. Indeed, the expected decline in UK growth could lower global GDP by 0,1% directly in 2016, with some additional spill-over impacts.

At a company level, certain UK companies could face slightly higher costs and more red tape to do international trade, which could add slightly to inflation and reduce efficiency. But at the same time, this could be beneficial to direct non-UK competitors, which could then help lift growth elsewhere.

What is the most likely policy response?
If there does turn out to be a detrimental impact on UK and European growth, the probability will rise that the current accommodative policy regime will be prolonged or further augmented.

What to make of today’s movements: what are the most likely impacts on financial markets?
Once the dust of the initial knee-jerk reaction settles, the markets are likely to reflect the fact that not much will change overnight and that the longer-term impacts will take time to reveal themselves and are likely to not be catastrophic. Unless there is additional negative news flow in the world such as negative earnings-related news flow in equity markets, the sharp moves seen today are likely to reflect a reversal of the very sharp rallies seen in markets in the last couple of days, rather than the start of a protracted decline. The most likely conclusion is that the Brexit event will be another reason to keep rates lower for longer, which should continue to put downward pressure on bond yields. Lower for longer interest rates would continue to keep returns on fixed-interest assets low, which would continue to support equity valuations that are high relative to very long term average levels. On a stand-alone basis, Brexit should not lead to a sharp contraction in either equity or bond markets.

Are there other longer-term associated risks?
The UK’s action might prompt other countries to consider leaving the EU. While considered unlikely, it remains a possibility given a global rise in nationalism in developed economies. Such a development would be more worrying and would be likely to add to global inflation in the long-term, due to waning efficiency (which won’t necessarily trouble global central banks, given their stated desire to raise inflation amidst generally high government debt levels).

Ultimately though we may see slowing momentum in globalisation. Specifically for the UK, limiting immigration against the backdrop of an ageing population (the share of the population of working age is already in significant decline), is bad news for long-term growth prospects. More generally, a protectionist stance (less competition) implies a loss in efficiency. In turn, to the extent this may catch on around the globe, it risks a worsening trade-off between world real economic growth and inflation in the longer term.

What about South Africa?
South Africa imported 2.9% of its goods from the UK in the opening four months of 2016, while exporting 3.4% of their goods to the UK. We still have two years to negotiate trade agreements with the UK. The overall direct impact is, therefore, not large. But, there is likely to be an additional impact given South Africa’s exposure to Europe more generally.

Markets obviously loathe the uncertainty and we are seeing an inevitable reaction and a sell-off in ‘risk assets’ generally. However, we remain calm, and continue to look for opportunities to pick up assets, which may have been oversold amidst the carnage in the markets.

Disclaimer:
Sanlam Investment Management (Pty) Ltd (“SIM”) is an authorised Financial Services Provider. This publication is intended for information purposes only and the information in it does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act. Although all reasonable steps have been taken to ensure the information in this document is accurate, SIM does not accept any responsibility for any claim, damages, loss or expense, however it arises, out of or in connection with the information in this document. Please note that past performances are not necessarily an accurate determination of future performances and a performance of the fund depends on the underlying assets and variable market factors. International investments or investments in foreign securities could be accompanied by additional risks, such as potential constraints on liquidity and the repatriation of funds, macroeconomic risk, political risk, foreign exchange risk, tax risk and settlement risk, as well as potential limitations on the availability of market information. Independent professional financial advice should always be sought before making an investment decision.