European flag jigsaw piece with British flag missing piece
by: Sanj Ediris

BREXIT: THE ‘SHOCKS’, WHAT IT MEANS FOR US & WHAT HAPPENS NEXT

Britain has voted to ‘Leave’ the European Union (EU) 52 – 48 per cent. But the debate about the implications for economies and financial markets is just beginning.

The magnitude of the impact on markets and economies is open to debate. The likely rolling series of “shocks” are expected to be financial, political and economic. The UK will be most affected. But Europe (and the rest of the world) will not emerge unscathed.

 

This information has been prepared by Colonial First State Investments Limited ABN 98 002 348 352, AFS Licence 232468 (Colonial First State) based on its understanding of current regulatory requirements and laws as at 24 June 2016 and BT Financial Group which is the wealth management arm of Westpac Banking Corporation ABN 33 007 457 141 AFSL and Australian Credit Licence 233714 (Westpac), and is current as at 26 June 2016.

 

UK Ref Result

A FINANCIAL SHOCK

Volatility has risen in the wake of the Brexit decision. Currency volatility can be seen in the Pound, US dollar and Australian dollar. We anticipate it will take up to another week before currency volatility settles down.

Standard & Poor’s indicated that a Brexit vote will see the UK lose its AAA rating. We expect the UK Gilt curve to steepen as investors leave the AAA (now AA). We don’t see the banking system as being as exposed to risk as it was during the GFC or various crises since then. Regulators and central banks are now well practised in providing liquidity during market disruptions.

The financial impacts will flow beyond the pure market reaction. Brexit will mean, for example, that the UK will lose its seat at the table when it comes to negotiations on European regulation and supervision (even as they still have to comply with many of those rules to do business in the EU). The risk of less market-friendly outcomes lifts as a result.

A POLITICAL SHOCK

With a Brexit, political casualties were inevitable. Britain’s Prime Minister David Cameron has resigned after the ‘Leave’ vote. Former Mayor of London, Boris Johnson responded by thanking Mr Cameron and saying, “There is no need for haste, nothing will change in the short term”.

The rest of Europe won’t escape unscathed. An Ipsos MORI poll published in early May surveyed voters across Belgium, France, Germany, Hungary, Italy, Poland, Spain and Sweden. Some 45% thought their own countries should hold a referendum on EU membership. And 33% indicated that they would vote to leave.

A CONFIDENCE SHOCK

UK household and business confidence was under some downward pressure as uncertainty increased and polling day neared. Further declines are likely as the complexity and difficulties associated with Brexit become clearer. European sentiment would be affected as well. The long timeframe for an exit means that confidence headwinds could persist for an extended period.

AN ECONOMIC SHOCK

The main argument against Brexit was the potential economic costs. These costs are difficult to estimate. But all the serious modelling work suggests the impact will be large and long lasting.

In the short term, there is a significant risk that the UK economy slides into recession later in 2016 and 2017. The negative impact on activity from the confidence shock would be accentuated by a tightening in UK financial conditions. A UK recession would dent the already fragile growth prospects in Europe as well.

The longer-term cost to the UK economy comes from higher trade costs and less favourable trade access. A smaller-than-otherwise capital stock and labour force, and an erosion of skills, means the UK’s potential growth rate will step down.

BREXIT & AUSTRALIA

The general consensus is that the direct impact of Brexit on Australia will be fairly limited. Research shows Australia is less exposed than other countries to UK/European problems, partly because of our Asian orientation. While the real economy may escape relatively unscathed, the main danger may be to the income side of the growth equation.

Brexit will add to general market volatility and would see the AUD and interest rates move lower. These moves, especially the lower Aussie dollar, would provide some protection to the Australian economy.

Australian banks direct exposure to UK and Europe is significant. According to the RBA, the exposure of Australian-owned banks to the UK and Europe amounts to 25% of international exposures and 7% of global consolidated assets (as at the end of 2015).

RBA commentary on Brexit has been very limited. It is not mentioned in the March Financial Stability Review and gets only one mention in the May Statement on Monetary Policy and one mention in the Minutes of the July Board meeting. Nevertheless, the potential Brexit economic fallout would add to the RBA’s easing bias.

THE UK, EUROPE & OPPORTUNITIES FOR AUSTRALIA

There are some more medium-term opportunities for Australia from the Brexit vote. These opportunities lie with any re-orientation in UK trade and investment flows.

A shift in UK trade focus towards Asia, for example, could see a reversal of business platform flows. Instead of Australian companies using the UK as a springboard into Europe, UK companies may view Australia as a platform for launching into Asia.

The UK has always been a significant investor in the Australian economy. They remain the second largest foreign investor. Again, Australia could benefit from any redirection of UK foreign investment flows away from Europe.

A BANKING SHOCK?

The Brexit win has negative consequences for UK banks and to some degree EU and US banks that base themselves out of London. But we regard the situation as quite manageable.

The lengthy exit process means lending volumes are likely to suffer as uncertainty around trade relationships and growth limit confidence. The lower interest rate environment will see margins pressured.

Lower GDP growth and rising unemployment typically points to higher credit costs. However, this is unlikely to be dramatic as UK banks are coming from a position of relative strength.

Operational challenges will present themselves in relation to London’s standing as a financial hub, which may see firms relocate to the Continent, presenting sizeable one off costs.

The rating agencies have indicated a double notch downgrade is coming to the UK sovereign rating (from AAA to AA). But we do not see an imminent threat to UK bank ratings, ie the sovereign downgrade is not a trigger for immediate downgrades to UK banks. None of the UK bank’s ratings include any uplift on account of implied government support.

 

SO WHAT HAPPENS NEXT….?

 

The UK government is expected to ratify the referendum decision and invoke article 50 of the Lisbon Treaty to inform the EU it would like to leave. Then it has a two year timeframe to negotiate its terms for exit including, importantly, trade arrangements and immigration. It will also need to negotiate with countries like the US and China which currently have trade agreements with the EU (but not the UK).

There will also be political uncertainty in the UK, as the Prime Minister, David Cameron, has announced his resignation.

THE BOTTOM-LINE FOR THE UK

Brexit will cause financial and political disruption for the UK and some of this is outlined below.

  • Trade with the UK is likely to be negatively affected while the UK renegotiates terms.
  • Northern Ireland and Scotland voted to remain with the EU – will they now vote to leave the UK?
  • International and domestic investment will be impacted by uncertainty and many international investors may move elsewhere to access a gateway to Europe.

WHAT ABOUT THE REST OF THE EU?

There are fears other countries, like Spain or France, might also try to leave the EU. There’s also uncertainty over how the EU will react – will they try to punish the UK in the negotiation? And will they implement more stimulus into Europe to help support it through the transition?

There’s a lot we don’t know yet – so it’s hard to work out the whole picture in terms of consequences.

MARKETS DON’T LIKE UNCERTAINTY

Sharemarkets tend to be volatile when there’s uncertainty – and this time is no exception. Even though UK and European shares have suffered an immediate impact, there has been volatility globally. This is likely to continue until there is more clarity on Brexit and the next steps. Countries like the US are considering how this might impact their economies.

This may feel worlds away from Australia but we are still affected by this. Banking, tourism and resources in Australia may all see a negative impact and there is likely to be market volatility.

It doesn’t all have to be negative though. There is likely to be increased interest in asset classes like bonds due to the volatility in sharemarkets because they are typically seen as safer.

MANAGING YOUR INVESTMENTS DURING BREXIT VOLATILITY

The key is to remain calm and stick to your investment strategy when sharemarkets are volatile.

There are a few things to keep in mind when markets are volatile.

Hold the course

If you react to short-term conditions like Brexit volatility by selling your investments, any losses become permanent and you may miss the potential for recovery down the track.

Diversification

That is, spreading your investment across a range of assets like shares, bonds, property and cash can help protect your money when there is volatility in one asset class.

Know your risk appetite and your financial plan

You need to understand what your objectives for your investments are and what your appetite for risk is (your willingness and ability to accept losses or gains). This can change over time so you need to regularly review this.

THE NOT-SO-DISTANT FUTURE

The impact regarding the Brexit referendum is still in its early days – and the UK government has not ratified it yet. So we can expect market volatility to continue – at least in the short term. The key is to make sure your investments are right for you and be prepared for some movement in the meantime.

 

Have Questions? Speak to a Qualified Financial Advisor

 

DISCLAIMER

This information has been prepared by Colonial First State Investments Limited ABN 98 002 348 352, AFS Licence 232468 (Colonial First State) based on its understanding of current regulatory requirements and laws as at 24 June 2016 and BT Financial Group which is the wealth management arm of Westpac Banking Corporation ABN 33 007 457 141 AFSL and Australian Credit Licence 233714 (Westpac), and is current as at 26 June 2016.

Material contained in this publication is an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such.

This information does not take into account your personal objectives, financial situation or needs and so you should consider its appropriateness having regard to these factors before acting on it.

Please contact your Honan financial adviser if you wish to make an appointment to discuss your personal circumstances.

Any projections are predictive. Whilst we have used every effort to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The actual results may differ materially from these projections. Past performance is not a reliable indicator of future performance.

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