Brexit is (not quite yet) a reality
This is bad, but not the end of the world. UK will remain a member of the EU for at least another two years while negotiations are ongoing. The British PM Cameron has made what is possibly his single best contribution of his career to UK and EU - instead of invoking article 50 and start the UK exit procedure immediately, to step down and give UK another 6 months to regroup for a new reality.
Headline risk will persist, and whipsaw volatility patterns will be the short-term daily norm in financial markets. This should be addressed by an active tactical approach.
In sum, for investors not much changed since our last update on 14 June 2016.
As it happened
What started as an ill-conceived strategy to protect the right wing of the Tories against incursions from the UK Independence Party (UKIP) has now proven every bit as disastrous as predicted. UK PM David Cameron made a promise in 2013 he expected never to have to deliver on. However, he was re-elected in 2015, and saw no way around the referendum, presumably believing that it would be a formality. As it were, his calculations were wrong all the way.
With 51.9% of the vote, UK decided to leave the European Union. An issue only partially related to the EU, immigration, appears to have tipped the scale in favour of an exit. Of the 350,000 immigrants arriving in the UK last year, half came from the EU, the other half largely from commonwealth countries. Britain has managed to receive almost no Syrian refugees.
A Brexit will precipitate what has been necessary for quite a while: a readjustment of the European political landscape to finally dealing with the post-Soviet world. Europe has profited from 25 years of “peace dividend” and has yet to re-orient itself to a new and much less stable world.
Consequences for the UK
Short term and in the financial markets, the most important factor is the increased uncertainty. It will hold back investment. Growth will slow a bit, and the Tory government is likely to respond in the wrong way by tightening up public expenditure, making the downturn worse.
UK stocks will fall and the Sterling may lose further ground. But it will be a transitory period. Some positive effects will come from the weaker currency, but since UKs main exports are services and not manufacturing, this effect will be limited.
The UK will have to decide which kind of relationship the country wants to have with the EU. The first issue is whether UK will activate the (by now) famous paragraph 50 leading to an exit from the EU within two years. It will automatically put the UK in a bad negotiating position and it is likely that other ways will be tried, possibly leading to a real treaty change.
If UK will go for an association agreement in the style of Norway and Switzerland, it will be clear that the UK will have to accept large swathes of the EU legislation, including migration of labour, without being able to influence that very same legislation. The UK will also have to contribute to the EU financially. Maybe a bit less than today, but still a significant amount.
If the UK decides to go for its own model, negotiations can take a good deal longer. UK is unlikely to be able to extract concessions from the EU and it means that we are entering uncharted territory.
Scotland voted nearly 2 to 1 for remaining and Scottish politicians have already called for a new referendum in order to stay inside the EU. Politicians from Northern Ireland call for a unification with the Irish republic. The outcome is evidently uncertain, but the risk is that the UK may simply cease to exist and that England (and Wales) will leave, while Northern Ireland and Scotland stay in the EU.
Consequences for the other EU members
The immediate fears of a growth slowdown has predictably hit bank shares, even if the macroeconomic effect will be smaller than in the UK. EU will lose some 16% of its economic output and budget but may not necessarily enter into a period of slower growth. The UK is a significant export market for some countries, but the single market, the free movement of labour and capital remains, at least in the next two years or so.
The main risk is political and it can lead to increased uncertainty, which may in turn influence investments.
The most obvious danger is that the entire EU begins to unravel as other countries may now cast their own referendums. Denmark, the Netherlands, Italy, even France may go that way. That creates a unique dilemma for Bruxelles. If the UK activates the exit paragraph, EU will meet English demands for a special arrangement with stiff resistance. Leaving the EU should not be made too easy, too comfortable or too profitable.
On the other hand, EU will have a huge interest in avoiding a UK exit and it is very possible that EU will now be ready to enter real negotiations in order to avoid broader consequences. The only problem is that such negotiations will be very long – probably up to a decade.
The rest of the world
Russia sees that its most formidable political opponent on the Eurasian land mass has begun to unravel and Russia will continue to fan the fire by offering further support to the anti-EU parties. This situation threatens to change the balance of power west of the Ural mountains.
If UK really ends up leaving, the USA will have lost its strongest ally inside the EU and President Obama has already made it clear that US geopolitical interests are having UK inside the EU. Attention will be directed towards the de facto leader of the EU, Germany. But the political instincts of Germans are not the same as those of the brits, and the cooperation will be more testy.
We have seen stock markets fall between 4 and 12 per cent. UK stocks fell 7 per cent from the morning. We expect that the European stock markets gradually will recover as it becomes clearer that the immediate impact of the vote is limited. ECB may even step in with further initiatives to stabilise the situation.
GBP fell between 5 and 10 per cent, and it could well find new equilibrium levels here.
Long bond yields have continued to fall and we expect that they accurately will track the sentiment regarding the European economy.