The average investor may not understand why markets are reacting so unfavorably to Brexit.
For those readers unfamiliar with the background of the European Union (EU), I’m posting a video below. The video doesn’t discuss Brexit, but it’s probably the best use of 12 minutes for someone trying to get up to speed on why the EU exists. It does an especially good job of explaining monetary, fiscal policy, and the friction between creditor and debtor countries.
Once you understand why the EU exists, then you’ll understand why Brexit has markets worried. In short, the goal of the EU is to benefit its members economically by lowering trade and immigration barriers. With Brexit, one of the EU’s main members has voted to leave therefore creating tremendous uncertainty. Nobody knows what the post-Brexit regulatory framework will look like. Businesses and consumers are liable to hold off spending as they wait for the uncertainty to clear up. From an investor's perspective, less spending means less GDP growth and lower corporate profits.
Over the weekend famous hedge fund manager, George Soros, chimed in with this thoughts on Brexit. Here are his main points:
- The leave campaign won by stoking fears of uncontrolled immigration due to  Europe’s refugee situation. Many citizens of Britain are feeling insecure about their financial situations and the leave campaign exploited fears of immigrants stealing jobs and unduly benefiting from government social programs.
- Soros believes that the EU’s disintegration is inevitable. Several other European countries have citizens who want to leave the EU for reasons similar to the U.K. They are also dissatisfied with the EU leadership for various reasons such as perceived bureaucracy, arrogance, unjust policies, etc. Brexit will potentially embolden more countries to exit causing more uncertainty and discord.
- The U.K. itself may be further damaged if Scotland and Northern Ireland decide to leave.
- Soros believes that there could be a painful exit negotiation ahead because of conflicting incentives. On one side, you have British politicians eager to deliver on the promises they made. On the other side, the EU is incentivized to negotiate punitive terms that deter other countries from leaving. The primary points of contention are Britain’s access to the EU’s single-market economy and immigration policies.
- “Britain eventually may or may not be relatively better off than other countries by leaving the EU, but its economy and people stand to suffer significantly in the short to medium term. The pound plunged to its lowest level in more than three decades immediately after the vote, and financial markets worldwide are likely to remain in turmoil as the long, complicated process of political and economic divorce from the EU is negotiated. The consequences for the real economy will be comparable only to the financial crisis of 2007-2008.”
Final thoughts
Brexit is an once-in-a-lifetime unexpected event. What’s disconcerting about the situation is that nobody has a clue what happens next. There are a lot of possible outcomes. Britain needs to negotiate the terms of its exit, but its prime minister, David Cameron, has announced his resignation so it’s not even determined who will negotiate on Britain’s behalf.
It’s also possible Britain doesn’t leave the EU. In order to leave it need to invoke Article 50 of the Lisbon Treaty, which it has not done. Cameron has said he’ll leave it to his successor to invoke Article 50 but maybe British voters voice a change of heart before then. There are already reports of voters with Brexit remorse. From an investor perspective, it’s prudent to closely monitor events as they unfold and tread cautiously. If we take Soros’ views, we can expect a painful adjustment period ahead.
