Brexit: What now?

1. June 27, 2016
Market update
Brexit: What now?
The political earthquake that has rocked Britain is being felt in markets around the world, but little is
certain other than we are entering a period of heightened uncertainty. This is not a “Lehman” moment.
Rather, it is a moment of “What now?”
The markets jerk their knees…
Friday’s action in the world’s markets looked ugly. The pound plunged to a 30 year low. Equities,
especially those in peripheral Europe sold off sharply, as did major stock markets in North America but to
a lesser degree. In fixed income markets, Canadian and U.S. bond yields dropped approaching all-time
lows, UK gilt yields hit a record low, and German bund yields once again dipped into negative yield
territory. But despite the apparent carnage, Canadian and U.S. equity markets, not to mention the Loonie,
ended the week barely changed from their previous week’s close. Even London’s FTSE stock index
ended the week up 2% (although given the plunge in sterling, foreign investors in European and British
stocks took a more considerable beating.)
That being said, investors are uneasily looking for an appropriate analogy to provide some guidance as to
what to expect from markets in the coming days and weeks. Comparisons to 1987’s Black Monday and
2001’s 9/11 only added to anxiety levels as market participants tried to take in a veritable fire hose of
opinion, commentary, and developing news over the weekend. It is important to understand none of these
previous crises come close to reflecting a realistic analogy of current events. In particular, Brexit is first
and foremost an unanticipated political shock, not an economic one. There are undoubtedly severe
potential economic ramifications, but such economic fallout will take some time to manifest and be
accurately assessed.
“As might have been expected, Monday saw markets pick up where they left off Friday with the British
pound tumbling, further declines in oil and other commodity prices, and continued weakness in stocks,
particularly European bank shares which have seen their worst two-day sell off ever. The safe haven
assets like gold and the U.S. dollar continued to strengthen, and G7 bond yields pushed to new record
lows. But all these moves fell short of the intensity of Friday sell off that some feared would be repeated
today. Spain’s IBEX index in particular faired surprisingly well, after relatively calming results in
Sunday’s national election. Even more surprising was a rebound in Asian equities, with rallies in Japan
and China helping the region overcome Brexit fears,” said Chief Investment Officer Jeff Singer.
Expect elevated volatility.
Uncertainty is the root of volatility, so markets can be expected to be unsettled for a while, as the details
of the process are worked out, and then the terms of a new relationship between Britain and the E.U. are
worked out. However markets have already begun the adjustment. The pound and equities have declined
and gold and other safe haven assets have jumped.
Global capital markets are unlikely to make any more dramatic moves until further clarity emerges, but
most observers expect to see a continued move toward safe haven markets and assets. The most obvious

2. beneficiaries of this will be gold and the U.S. dollar. And while G7 bond yields are down, those in
peripheral Europe (e.g. Spain, Italy, Portugal) have risen, reflecting the greater uncertainty regarding
growth in regions already anemic and with weak government finances.
In the meantime, global central banks have made it clear they will move to cushion any significant fall in
asset prices if necessary and the G7 has indicated preparation for co-ordinated action if currency markets
become dysfunctional.
Slow down and take a deep breath.
Withdrawal from the E.U. is not going to happen overnight. The timing of the process is the first big
source of uncertainty. The referendum supposedly commits the British government to initiating a process
that will take two years once formal notice is given. But the timing of that notice itself is up in the air.
Already European politicians are calling for the divorce to be made effective as quickly as possible, so as
to allow the EU to get on with life without Britain (and also to send as quickly as possible a harsh
warning to other members thinking of exit.) But the treaty allows the U.K. to set the pace and the British
government is unlikely to want to start the clock until they have settled the question of who will do the
negotiating. That means the start of negotiations will likely have to wait until after a new Prime Minister
has been selected in the fall. Brexit campaign leaders such as Boris Johnson suggested after Friday’s
results that notice could be delayed even further. For that matter, there is no truly legal obligation to
proceed at all, just a political one. And already petitions and campaigns aimed at a “re-do” are underway:
there is a small (very small) chance Brexit may not happen at all.
Global economic risks are limited.
Most market observers expect the U.K. to quickly enter a brief recession in response to the shock, but
growth elsewhere, and in North America in particular, is likely to be only slightly dampened. The
consensus among economists and strategists is perhaps a -0.5% hit to global Gross Domestic Product
(GDP). As the U.K. represents only about 2% of global GDP and its share of trade with both Canada and
the U.S. is relatively small, the impact here is probably less than that.
The biggest risk is that increased uncertainty undermines confidence and causes business investment,
already weak, to pull back further. Beyond the direct uncertainty surrounding British and European
growth and the future status of trading relationships, there is the added scare that populist sentiment is
being underestimated elsewhere, including in the United States. This can only add to uncertainty
surrounding future policy directions, and thus prolong weak growth by discouraging investment.
The Federal Reserve is well aware of, and well prepared for, the risks to the fledgling economic recovery
in the U.S. if European growth slows or uncertainty weighs on the markets (already unlikely, a July rate
hike is probably ruled out now.)
Stay the course.
There are not yet any signs of panic in North American markets. Friday’s -1.7% decline in the S&P/TSX
leaves the index still up +6.8% year-to-date and less than 7% off its 12-month high. In the U.S., the S&P
500’s fall of -3.6% Friday leaves it virtually flat year-to-date and less than 4% from its 12-month high.
It is worth noting the expansion and market advance since the 2008 financial crisis is replete with
obstacles that seemed formidable challenges at the time, yet failed to undermine the fundamental trends
underlying the progress (see Figure 1.)

3. Figure 1. Source I.G.I.M., Bloomberg
Since 1926, the S&P 500 has experienced a 10% pullback on average once every year. The index has seen
a 5% pullback on average three times per year. So far 2016 has seen only one. What’s more, despite the
frequency of intra-year drops, the market almost always recovers promptly. S&P 500 annual returns have
ended in positive territory in 27 of the last 36 years. Selling in response to a sudden or dramatic downturn
only crystallizes what until then had been just temporary paper losses. This is a time for investors to heed
the famous British maxim “Keep Calm and Carry On.”
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