Recently, citizens of the United Kingdom (UK) collectively voted in favor of leaving the European Union (EU). Now begins the process of negotiating a withdrawal accord and the terms of the UK’s relationship with the political-economic bloc, including 80,000 pages of EU trade agreements. This will likely take a minimum of two years, but the exact timing ultimately depends on how the negotiations play out. During this time, Britain will continue to abide by EU treaties and laws, but will not take part in any decision-making on behalf of the union.
From an investment perspective, there are various implications to consider. Looking at the longer-term, big picture, we do not believe that it is a foregone conclusion that the UK is any worse off by leaving the EU. The country could actually benefit from less regulation and the ability to negotiate its own, potentially more favorable, trade deals.
In the short-term, we expect UK equity markets and the British pound to experience notable bouts of volatility, as the decision to leave the EU opens up significant uncertainty regarding the UK’s future political environment and trade policies. This means that the currency could see a sell-off that may last more than a few days.
Conditions in UK bond markets have thus far been indicative of a rush for safety, with sovereign yields falling. However, with the just announced resignation of Prime Minister David Cameron and a new election on the horizon, UK sovereign and corporate borrowing costs may also increase in the weeks and months ahead. While a cheaper pound would be beneficial for UK’s international companies, the situation could lead to a de-facto tightening of the UK economy if UK borrowing costs do in fact climb. To counter any impact of financial conditions tightening, the Bank of England has already made 250 billion pounds of liquidity available to the financial system, and we would expect more monetary easing to be put into place if conditions warrant. This is reassuring, but it should be expected that in the near-term, business confidence, foreign and domestic investment, and ultimately economic growth in the UK could become adversely affected.
In the event that a wide-spread and sustained sell-off in UK assets materializes and valuations pull back to more attractive levels, we will look to opportunistically buy UK-based exporters and/or multinational companies with very strong competitive positions and healthy balance sheets. These types of globally diversified companies are less exposed to any near-term negative consequences facing the UK economy and would also benefit from a weaker currency over the medium-term. Though domestically-focused UK companies would suffer the most during a panic selloff—as they would be most exposed to slowing UK growth—some very good domestically-oriented businesses may become cheap enough where it would make sense to own them as well.
Britain exiting the EU could also lead to spillover effects into the euro currency and euro-denominated assets, as investors may begin to price in more uncertainty to European political unity. Quite simply, the Brexit may increase the attention euro-skeptic political parties receive from their populations and from market participants. Similar to the UK, European exporters and multinationals that have very strong competitive positions and attractive fundamentals at reasonable valuations may also provide attractive investment opportunities.
While uncertainty can lead to bouts of short-term volatility, it also creates opportunities to capitalize on what we expect to play out over the long-term. We believe that buying good companies with good fundamentals at reduced prices should lead to attractive long-term returns for investors.
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