What do we know as investors and what are the unknowns? || Part 1

Most informed commentators thought that the status quo would prevail. Well, as we now know the UK public has voted by a narrow, but decisive, margin to leave the EU. Financial markets do not react well to unexpected news and the Brexit result was undoubtedly the “wrong” decision as far as they were concerned.

Indeed, from the innumerable reports I received in the days following the outcome of the referendum, I have selected some of the relevant points from a Standard Life analysis on this historical event.

Standard Life is a global institution and insurance company that we have worked with for many years in respect of much of our clients’ savings and investments. The global resources they have, therefore, make an assessment of the situation appear more orderly upon which to evaluate an opinion for what the future may hold for all of us, both as investors and as people searching for answers.

Below are details of the key areas surrounding politics, economics, financial markets and timeframes, where I will start with what is known/certain and what is not.

There is confidence that:
▪ Political uncertainty will continue for some time
▪ Economic growth will be affected
▪ Monetary and fiscal policy will be easier globally
▪ Sterling should weaken
▪ Market volatility will rise and safe haven assets will benefit
▪ Global bond yields will stay lower for longer
▪ The financial system is more stable than in 2008
▪ There is a further headwind to the globalisation agenda.

The unknown aspects include:
▪ The composition of the UK government
▪ The UK’s negotiating stance
▪ The EU’s response to the Brexit vote
▪ The impact of the referendum on politics in other countries
▪ The strength, speed and effectiveness of the policy responses
▪ The shifts in global capital flows
▪ The private sector reaction function to the Brexit vote.

Political implications

Brexit is a process, not an event, and it is an issue for the whole of Europe, rather than just the UK. The political fallout will take many years to become clear.

In the EU, there is a decision in terms of which fork in the road to take: does Europe move further and faster towards closer integration, or does it move into a new desynchronised pattern allowing more national flexibility?

The complexity of the interaction between politics, economics and markets makes the situation so difficult to predict. There is a global dimension too; Brexit is part of a populist reaction being experienced in many countries to globalisation.

It is understandable that commentators have been searching for historical parallels for the enormity of the decision taken in the UK’s referendum. Comparisons have been made with other events such as the fall of the Berlin Wall or 9/11, in terms of marking the closure of one era and the start of a new. Put more simply, a major earthquake has aftershocks for some time.

In the UK, the referendum has shown a bewildered and fractured society, and one which needs to redefine its relationship with the rest of Europe. Overall, the quality of UK policy-making could suffer in a political vacuum.

Europe faces a stark choice, a fork in the road, as German Chancellor Angela Merkel has been quick to realise. One possibility is that politicians in France, Germany and Brussels endeavour to push ahead with policies to integrate Europe more quickly; more practically, the Five Presidents report is brought forward to be completed by, say, 2020 rather than 2025.

Another approach is decentralisation, the recognition by politicians, such as President of the European Council Donald Tusk, that the important lesson to learn from the referendum is only integrating where necessary while devolving more, allowing more subsidiarity at the national level.

Either course may have adverse effects; contagion between financial markets, economics and politics could pick up even further. A key point to remember is that European Monetary Union cannot continue forever in its current format; substantial reforms to create a firmer foundation were required even before the Brexit vote.

Economic analysis

The UK economy will suffer a further slowdown in economic growth and potentially a recession. The uncertainty shock from the Brexit vote will affect hiring and investment decisions among companies as well as consumer confidence and spending on high value goods.

The reaction function is an unknown from overseas investors and companies that had been looking to the UK as a business-friendly gateway to Europe or simply a safe haven. As and when this source of capital inflow slows, it will require a lower level of the pound and weaker import growth to restore balance.

The EU economy is also expected to suffer, via the links with one of its largest trading partners as well as adverse confidence and wealth effects on businesses and households. Countries with the closest economic links to the UK – such as Ireland and Holland – will suffer more than others.

The length and depth of the economic slowdown will partly depend on financial market stress but also on the policy responses, not just in the UK. Initially, the Bank of England (BoE) has announced a £250 billion programme to provide liquidity to banks.

If the financial fallout is particularly severe, the BoE will be forced to return to Quantitative Easing (QE) more quickly, as it pre-empts the economic downturn rather than waiting for it to become evident in the data.

A related issue is whether UK banks find it difficult to attract funding, which may require extra BoE support to tide them over. If European assets come under undue pressure, we assume the European Central Bank (ECB) will enhance its existing QE programme purchasing €80 billion of bonds a month.

This is part one of a two-part series. The second part will be published in the July 21 edition.

This article is intended to provide a general review of certain topics and its purpose is to inform but NOT to recommend or support any specific investments or course of action.

By Raoul Ruiz Martinez
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Raoul Ruiz Martinez is a resident and independent consultant for Finesco Financial Services Ltd., Glasgow and advises clients on private financial matters in both the UK and throughout Europe under the MiFID regulation. Finesco Financial Services Ltd is authorised and regulated by the Financial Conduct Authority (FCA). Some of the services provided are not regulated by the FCA because they are not included within the Financial Services and Markets Act 2000. | 289 561 333