Brexit Q&A

Q: Why exactly did the UK vote to leave the European Union?

To answer that, let’s have a brief discussion about what exactly the European Union is.

The EU is both an economic and political union of 28 different European nations. Most of the member states share a common currency, and they work in concert to enact laws and regulations that ensure the free movement of people, goods, and services. The United Kingdom joined in 1973, but from the start, it was a shaky marriage. Only two years after joining, the UK held a vote to decide whether staying in the EU was a good idea. The majority of voters decided to remain on that particular occasion, but it signaled the start of a decades-long debate.

Fast forward to 2015. During the UK’s general election, British Prime Minister David Cameron gave voters a promise: if reelected, he would see to it that another vote would be held to settle the issue.

Cameron was reelected, and, true to his word, scheduled the referendum for June 23, 2016.

So why did voters want a referendum? While the “Leavers,” as they are known, had many reasons for wanting to withdraw from the EU, a few in particular stand out:

• A desire for more national sovereignty
• A desire to rid themselves of what they claim to be excessive regulation imposed by the EU
• A desire to have greater control of their own borders to stop what they see as an unwanted influx of immigrants

On the other side, there were many people who wanted to stay in the European Union. Choosing otherwise, they claimed, would result in millions of jobs being lost. The “Remainers” also see immigration as good for the economy, and believe the UK enjoys more influence inside the EU than out.

Ultimately, though, the “Leave” campaign won by a 51.9% to 48.1% margin.¹

Q: So why should investors care about this?

Close your eyes for a moment and imagine ripples on a pond. When you get down to it, ripples are just a series of concentric circles that grow larger as they extend outward. But if you’ve ever thrown a pebble into a lake, you know that it doesn’t take much to create some seriously large ripples—and that they usually don’t stop until they reach the opposite shore.

For investors, the global markets are a kind of pond, too … a pond extremely prone to ripples. What starts as a local issue soon becomes a national issue, then extends to a continental issue, until it finally becomes a truly global issue.  Such is the case here—with Brexit being far bigger than a mere pebble.

Let’s start with the smallest ripple and move outwards. In this case, the smallest ripple is the British economy itself. For months, many economists have warned that any of the following things could happen if the UK voted to leave:

• The UK would lose access to the EU’s single market, or may have to pay more for access. The single market refers to the association of European countries that trade with each other without restrictions or tariffs. Losing access to this would make it more difficult for UK to trade with the EU, which could lead to a marked decrease in economic growth.
• London could lose its status as a European financial center. Already, many of Europe’s largest banks and financial institutions have said they will decrease their presence in London in favor of cities like Frankfurt.  That means a potential exodus of jobs, funds, and influence.

The referendum occurred only a few days ago, and already the UK is feeling the effects. On June 24, Britain’s currency, the pound sterling, fell to its lowest level (compared to the US dollar) since 1985.²

Many analysts expect the slide to continue. And the FTSE 100, the UK’s equivalent to our Dow^®, promptly fell 8% before recovering somewhat by the end of the day.² One pre-Brexit study even suggested that British stocks “could [eventually] lose up to a quarter of their value.”³

Now let’s move outward to the next largest ripple: Europe. With the UK gone, the EU will have to face the departure of over $100 billion in securities from European banks.⁴

  And should certain members of the European Union continue to experience economic hardship, they will have to deal with it without the UK’s help.

Even more pressing from the EU’s viewpoint is the destabilizing effect Brexit could have. In fact, the UK’s decision has already prompted several other countries to examine whether they should leave the EU as well.  The concern is that Brexit will trigger a chain reaction that leads to the complete unraveling of the European Union as we know it.

These are all troubling possibilities, but perhaps the most worrying thing for Europeans to contemplate is the many unknown consequences. You see, the nations of the EU are linked together in many different ways.  They don’t just trade together—they live together.  As a result, just about every economic area you can think of will be affected: banking, business (large and small), scientific research, you name it.

Finally, let’s move out to an even larger ripple and look at how Brexit could affect the US, and of course us Canadians as well.

First off, a weaker pound means a stronger dollar, which would make it more expensive for US companies to export to the UK. For a manufacturing industry that is still recovering from the Great Recession, this is hardly good news. And of course, there are many companies in the US that have made investments in the United Kingdom. In 2014 alone, U.S. companies invested a total of $588 billion into Britain.⁴ These companies could be financially impacted if the British stock market suffers.

But it’s the EU’s future that has US economists most concerned. For years now, we’ve felt the shock waves whenever a European country—like Greece or Spain—experiences an economic earthquake. Should the European Union truly fall apart, the United States will feel the impact both in trade and foreign investment. For this reason, it’s quite possible the Federal Reserve will decide against raising interest rates in the near future, which goes against their stated policy of raising rates four times in 2016. But now, with economic turmoil, slower growth, and market volatility all on the horizon, it’s very possible the Fed will actually cut rates instead of raise them.

Already, Brexit has impacted the US markets. The Dow fell over 600 points on Friday, then fell another 250 points by early Monday morning.⁵ Over the long term, it remains to be seen what the markets will do, but one thing is certain: uncertainty creates volatility, and in this situation, there is a lot of uncertainty.

Which brings us to our third question:

Q: So what happens now?

Here’s the thing: nobody really knows. And it’s that uncertainty that has the markets so worried. With Brexit, there are so many unknowns, so many variables, so many maybes and mights. The fact of the matter is that nobody knows what the UK will do next.  And that uncertainty has many investors nervous.

We’re in uncharted waters. While European law makes it permissible for a member state to leave the EU, something like this has never really happened before.  But here’s what we know for now:

• In order to officially leave the EU, the United Kingdom must invoke what’s known as Article 50 of the Treaty of Lisbon. This essentially launches a two-year period for the UK and the EU to negotiate a formal withdrawal. Many issues will have to be settled during this period, including whether the UK will still have access to the single market, and if so, under what terms.

• As of this writing, Article 50 has not yet been invoked, and it may not be any time soon. David Cameron, the UK Prime Minister, announced his resignation, stating his intention to leave the matter to his successor. But many of the Leave campaign’s leading figures have expressed no hurry to actually start the process of leaving.  There are two likely reasons for this:

1. They hope that by stalling the process, they can pressure the EU into granting more favourable terms, such as access to the single market without having to pay tariffs.
2. They are suddenly faced with the fact that they may not be able to deliver all the things they promised British voters. For example, one prominent Leave advocate pledged to spend money that would have gone to the EU on national health services. Within hours of the referendum, he had already backtracked on that promise.6
   

• On the other hand, most European officials are pressing the UK to start the process as quickly as possible. From their perspective, it’s better to have a quick break than a long, drawn-out divorce, which could prompt other nations to either leave themselves or try to wrangle concessions from EU leadership.
• To make matters more confusing, it’s not entirely certain the UK will leave at all. Technically, the referendum is not legally binding. That means Parliament is under no obligation to actually do anything. While it seems unthinkable that the UK’s government would so blatantly deny the will of its own people, this does make an already-murky situation less clear-cut.

Here’s what we don’t know:

• Even if the UK does leave, what will their relationship be with the EU going forward? There’s a strong possibility they will have to continue abiding by EU rules and regulations—especially on immigration—if they want to retain access to the single market. Which of course begs the question: what was the point of all this?
• What Scotland and Northern Ireland will do. These two nations, which are part of the UK but retain considerable autonomy, both voted overwhelmingly to stay in the EU. Scotland’s first minister has already declared it likely that Scotland will conduct a referendum of their own on whether to leave the United Kingdom.  If this happens, expect a messy situation to get messier.

With all that said, here’s what I expect to happen: several months at least of gridlock and stalemate. Because so many political questions remain up in the air, I think it’s likely that both the UK and the EU will need some time just to understand exactly what’s going on. And even once the actual process of withdrawal begins, it will be some time before any real change happens. Hopefully, this will give the markets time to adapt once the initial panic subsides.

Q: So what should we do?

«Salutation», it should be clear by now that this is an extremely complex situation. It touches on geopolitics, macroeconomics, and many other terms typically reserved for college textbooks.

I wish I could tell you exactly what the markets will do or what the world will look like a year from now. Unfortunately, I can’t.  No one can.  And you should never believe anyone who tells you otherwise.

So what should we do?  The answer is actually fairly simple:

Focus on what we can control instead of what we can’t.

No single person can control the destiny of nations. No single person can move markets. No single person can end uncertainty. But what we can do is control how we react to it. We can control how we invest and how we save.  We can control our emotions and our decisions.

So to help focus on what we can control, I present to you:

Five Steps to “de-Brexit-ing” Your Summer

1. First, remember that my team and I are keeping a close eye on the situation. In particular, we will continue monitoring your portfolio for any exposure to the United Kingdom or the European Union. If we feel any changes are warranted, we’ll let you know immediately.
2. Second, don’t overreact. While the media makes a living off overreacting, savvy investors like you know that overreacting is one of the worst things we could do. Instead, we will be careful, watchful, and analytical.  We will make decisions based on strategy instead of impulse.
3. Speaking of strategy, we will continue to stick to ours. After all, it’s designed to see us through good times and bad.  We will continue choosing investments based on whether they are in line with our long term goals and other preferences.  Not because the media is telling us it’s time to panic.
4. Fourth, never forget that you can ask me questions whenever you want! So in the coming weeks, if you see a scary headline or read a troubling article, shoot me an email or give me a call. As Marie Curie said, “nothing in life is to be feared, only understood.” Let’s continue making every effort to understand what’s going on, and why. I think you will find that the more you do, the less frightening things look.
5. Fifth, remember that there’s more to life than the temporary ups-and-downs of the markets. It’s true that Brexit is a big deal—but at some point in the future, it will be just another item for the history books. Just because something looms large doesn’t mean it looms eternal. So go out and enjoy the summer sun. Sometimes it’s easy for analysts and pundits to be caught in a news bubble, where nothing seems to matter—or even exist—beyond the stock ticker. But we know better. There’s a whole beautiful world outside that bubble, so go explore it!

«Salutation», there’s a lot of uncertainty surrounding Brexit right now, but it’ll clear up as time passes. I’ll keep watching the situation, and will send you updates as necessary. In the meantime, we’ll stick to our strategy, stay the course, and soak in the summer sun.

As always, thank you for the trust you place in me and my team. Please let us know if there is ever anything else we can do for you.

Sources

1. “EU Referendum Results,” BBC News, http://www.bbc.com/news/politics/eu_referendum/results.
2. “Pound plunges after Leave vote,” BBC News, http://www.bbc.com/news/business-36611512 3 Ivana Kottasova, “Brexit could trigger European stock market crash,” CNN Money,” http://money.cnn.com/2016/06/10/investing/brexit-stocks-eu-referendum/
3. Tim Smith, “How the Brexit Could Affect U.S. Investors,” Investopedia, http://www.investopedia.com/articles/markets/061616/how-brexit-could-affect-us-investors.asp
4. Jethro Mullen, “Dow plunges over 600 points as UK earthquake crushes global markets,” CNN Money, http://money.cnn.com/2016/06/23/investing/eu-referendum-markets/index.html?iid=EL
5. Jon Stone, “Nigel Farage backtracks on pledge,” The Independent, http://www.independent.co.uk/news/uk/politics/eu- referendum-result-nigel-farage-nhs-pledge-disowns-350-million-pounds-a7099906.html