U.K. Vote to Leave European Union Roils Financial Markets

British voters surprised the world on Thursday by narrowly approving a proposal to abandon the European Union and strike out on their own. The decision sent global equity and futures markets sharply lower on Friday while the pound sterling plummeted against the euro and the U.S. dollar. However, the outcome of the referendum does not mean the U.K. will immediately leave the 28-nation bloc. That process, if it is followed to completion, is expected to take at least two years.

“The key point to remember is, this referendum is the beginning of a process, it’s not the end,” says Capital Group portfolio manager Rob Lovelace. “The market has interpreted this as a bimodal event and it isn’t. Now that the referendum has passed, we start a two-year process of negotiations.”

U.K. voters were asked a simple, straight forward question: “Should the United Kingdom remain a member of the European Union or leave the European Union?” Those who wanted Britain to leave the EU – the so-called “Brexit” scenario – had argued that the U.K. would benefit by ridding itself of costly EU regulations and by restricting the ability of immigrants to enter the country. Brexit opponents warned that abandoning the EU would damage the U.K. economy by voiding long-held trade deals and other agreements that provide for the free flow of people and capital in the 28-nation bloc that stretches from Finland and Sweden in the north to Italy and Greece in the south.

“The market is interpreting this event as perhaps the beginning of the end for the European Union. If that happens, it won’t happen overnight. A process like that takes many years,” said portfolio manager David Riley.

Great Britain joined the European Economic Community in 1973 — before the “European Union” name was adopted and its regulatory powers expanded. Even at the time, it was a controversial decision. Some loyalists complained that Britain was giving up a measure of its sovereignty to continental Europe. Years later, when the euro was adopted, the U.K. refused to join the common currency, opting to stay with the pound instead.

The idea of Britain leaving the EU has been batted around for many years, but it gained renewed momentum in the midst of a tough reelection campaign in 2013. Facing a surge of anti-EU sentiment in his own party, Prime Minister David Cameron pledged to call a referendum on EU membership if the Conservatives won the election in 2015. After they won in a landslide, the Brexit referendum was scheduled for June 23, 2016.

The Brexit movement essentially split the Conservative party down the middle — with many prominent members on both sides of the debate. The Labour party, by contrast, was solidly in favor of remaining in the European Union.

“The bitter campaigning around the referendum has exposed issues related to immigration and demographics that the political system will need to address. While no one ever likes to know that there are more problems than you realize, you can’t start solving the problems if you don’t know what they are. We know what the problems are now and those problems will continue to be a challenge for the U.K., both internally and externally,” Rob said.

David Riley said the sectors that will likely get through Brexit relatively unscathed include consumer staples — particularly tobacco companies — and utilities with strong balance sheets and attractive dividend payments. “Defensive sectors are the place to be,” he added. “Tobacco, utilities and even pharmaceuticals. Their products will continue to be in demand, no matter what happens between Britain and the EU.”

A Domino Effect in Europe?

The bigger question in front of markets is the implications this will have on the future of the European Union. Portfolio manager Mark Brett says “this isn’t just about the U.K. leaving. Ultimately, the U.K. should be able to devalue its currency enough into a competitive position. The bigger question is how the other 27 countries deal with their problems now.”

An exit by the U.K. could possibly encourage certain political parties in several European countries, for example Front National in France, to promote similar actions in their respective nations. A Greek exit could be put back on the table, while polls in other countries, including the Netherlands and the Czech Republic, have suggested that their populations might want to follow with similar votes.

Portfolio manager Thomas Hogh notes, however, that “Brexit could do the reverse and propel the EU towards a greater political and fiscal union, including common deposit insurance. History suggests that a crisis may be what is needed to propel the EU into making structural progress.”

Even when markets are falling, it is not unusual for equity, bond and exchange rate markets to overreact and these kinds of market pullbacks can create opportunities for active managers. Thomas notes that “most of the adjustment necessary to rebalance growth and finance the current account deficit in the U.K. is likely to come through a depreciation of the British pound and we could see the pound overshooting amid capital flight.”

“Once the situation becomes clearer, we can focus on our in-depth company and security research in an effort to identify valuation opportunities that may have been overly impacted by short-term market fears,” Thomas noted.

One factor that is often overlooked by the markets in these volatile periods is how international many companies are these days, especially with increasing integration of global markets and economies over the past decade. In fact, almost 50% of revenues from companies in the MSCI Europe Index come from outside of Europe. This figure is even higher for the UK FTSE 100, where there are many companies that are listed in the U.K., but operate elsewhere. The British economy and markets are among the most globally integrated.

Source:  https://www.thecapitalgroup.com/capitalideas/article/uk-votes-to-leave-eu-financial-markets.html