The referendum result was prologue and a new chapter awaits.
The United Kingdom has held two referendums on its membership of the European Union or, in its previous incarnation, the European Economic Community. In 1975, voters overwhelmingly chose to remain on the inside. Yesterday, however, the country chose to bring its 43-year membership to an end. What began under one Europhile Conservative prime minister has been handed its notice under another. Before Ted Heath led the country into the EEC in 1973, there were just six members. When the UK leaves, there will be 27 members that remain.
It is undoubtedly a significant decision, with ramifications for the UK, the EU and the wider world. The UK prime minister has already given notice that he will step down by October to allow new leadership to negotiate the UK’s future, but for now the implications remain almost entirely unknown. For the UK to leave the EU, it must first trigger Article 50 of the Lisbon Treaty, and then start exit negotiations in order to determine the UK’s new trade arrangements with the trading bloc. David Cameron said in his resignation statement that he would leave the job of triggering the exit clause to his successor, meaning those important negotiations cannot begin before his departure from Number 10.
There may be immediate political implications in continental Europe too. Given that recent polls show high levels of Euroscepticism in a number of major European countries, there have already been calls for copycat referendums elsewhere, albeit by those who remain outside the political centre. There are certainly broader questions about how the EU will respond. Donald Tusk, president of the European Council, made a statement this morning.
“Today, on behalf of the 27 leaders I can say that we are determined to keep our unity as 27,” he said. “I want to reassure everyone that we are prepared also for this negative scenario. I have offered the leaders an informal meeting of the 27 in the margins of the European Council summit [on Tuesday] and I will also propose to the leaders that we start a wider reflection on the future of our Union.”
In short, while the referendum has supplied the answer to that first question of whether the UK remains in the EU, it has raised a whole new series of questions in its stead. Some of these will take months – perhaps even years – to answer. This morning Mark Carney, governor of the Bank of England, said that “some market and economic volatility can be expected as the [negotiation] process unfolds”. He went on to explain that the Bank of England has prepared for such a scenario.
“As a result of these actions, UK banks have raised over £130 billion of capital, and now have more than £600 billion of high quality liquid assets,” he said. “Moreover, as a backstop, and to support the functioning of the markets, the Bank of England stands ready to provide more than £250 billion of additional funds through its normal facilities.”
Some initial adverse market reaction was to be expected, and the immediate response to the vote is likely to be the most extreme, until details emerge about what the next steps will be. In fact, once the initial shock has been absorbed by markets, there are reasons to believe markets may become more settled, not least because the main uncertainty has now been removed.
“Caught by the unexpected, the initial reaction of the UK market was to suffer a fall and since then the market has been thinking on its feet and grasping for some thread of likely, longer term outcomes – naturally this is nigh on impossible,” said Adrian Frost of Artemis. “International investors have been more worried about Brexit than domestic investors. They are holding plenty of cash and are underweight the UK. This is worth recognising if there are more positive developments. Finally, this is not a ‘Lehman moment’ in that there is no imminent financial crisis or lack of credit; and very unlike the credit crisis, this time central banks are ready and waiting with fire extinguishers in hand.”
In an environment of uncertainty, it is crucial that investors keep short-term volatility in context and avoid the temptation to allow such fluctuations to influence long-term plans.
“We now face a period of uncertainty as the exact terms of Britain’s exit from Europe are negotiated,” said Neil Woodford of Woodford Investment Management. “Financial markets loathe uncertainty as amply demonstrated by this morning’s reaction across all asset classes.”
Moreover, that sense of uncertainty has been heightened by the fact that markets had not expected a vote to leave.
“Financial markets had been under-pricing the risk of a Brexit for some time, even more so in the last week, which has served to make todays moves in the broader market indices even more severe,” said Gary Kirk of TwentyFour Asset Management. “ Brexit will harm [UK economic] growth and result in a policy response from the Bank of England, with a rate cut to 0.25% at the next MPC meeting on July 14th. We had contemplated very seriously the not unlikely prospect of a vote to exit and consequently we placed a number of hedges in the portfolios that we manage for St. James’s Place.”
Investors are already turning to consider the impact on different sectors – financial companies are expected to draw plenty of attention, at least in the short term.
“It is too early to say what the ultimate outcome of the referendum result will be, but even prior to this we were concerned about a weakening UK economy combined with high valuations of domestic cyclicals,” said Nick Purves of RWC Partners. “We have therefore had very low exposure to UK financials and cyclicals and were carrying a high cash balance which we should be able to put to use if share prices fall significantly. Finally, the weakness in the British pound will lead to earnings upgrades for many of our companies with significant overseas earnings and thus if their share prices are weak, that may represent a buying opportunity.”
Investors need to remember that negotiations to leave the EU have not yet begun and are expected to last for years. Even the leaders of the Leave camp forecast that, in the event of a vote to leave, the UK would not end up quitting the EU until 2019 or 2020. This means that the UK’s departure from the EU, and precise details of its new trade arrangements, will emerge only gradually. The initial turmoil experienced on markets will not persist ad infinitum. Trade negotiations are a good deal less exciting for markets than referendum votes. The UK will remain a member of the EU for several years, and the rhetoric of policymakers is now likely to shift towards reassuring markets, rather than scaremongering.
“We [commissioned] an independent report…on the economic implications of Brexit,” said Neil Woodford of Woodford Investment Management. “It concluded that Britain’s long-term economic future would be largely unaffected by a decision to leave the European Union. We stand by these conclusions. In the near term it is likely UK GDP will be lower over the next 18 months or so than if we had voted to remain but…in the longer term the trajectory of the UK economy, and more importantly the world economy, will not be influenced significantly by today’s outcome. Consequently, the portfolio strategy will not change. I remain confident the portfolio will deliver the returns we have targeted.”
Of course, the economic and financial ramifications of Britain’s decision extend across the Channel too, albeit on a smaller scale.
“It’s very difficult to know the implications at this point, but in the short-term, assets will be under a lot of pressure,” said Stuart Mitchell of S. W. Mitchell Capital. “The UK accounts for only around 6% of European exports and so, while there is likely to be some contagion, the impact on European growth is not obvious. The impact of the fall in sterling will be cushioned for investors with European holdings – as a European fund, you will lose less money. We are much more focused on core Europe than on the UK.”
Looking through the short-term noise in markets isn’t always easy, but it remains the right course for investors who know that they need to remember the long-term record of real assets in providing capital growth and income.
Investors should remind themselves of the following:
- Indiscriminate market falls ignore the qualities of individual companies and provide opportunities for long-term investors to benefit by taking advantage of cheaper prices.
- Inevitably, some companies will struggle in the difficult economic environment that may result, or will be unable to adapt to the new world. In contrast, strong management teams will take the necessary and potentially difficult steps to make the changes that will benefit their company – and its shareholders – over the longer term. It is the job of expert and active fund managers to identify those companies and buying opportunities.
- Sharp market falls are always unsettling, but it is important to remember how stockmarkets have behaved in the past after such shocks. In October 2008, on the worst day of the financial crisis, the FTSE All-Share index lost 8.3%, yet one year later it had returned 26%. Looking longer term, after a one-day fall of 5% in February 2009, the FTSE All-Share returned 126% over the following five years. (Source: Schroders/Financial Express, June 2016. Please be aware that past performance is not indicative of future performance.)
- Although there may be a temptation to seek the perceived safety of cash, the dilemma for investors is then the difficulty of timing a move back into the markets. Furthermore, it has already been suggested by the Bank of England that a vote to leave may even prompt a further cut in interest rates. Whether or not that happens, it does seem likely that returns on cash will remain at very low levels for some years to come.
- These events underline once again the value and importance of creating and maintaining a balanced and well-diversified portfolio, which should help cushion investors against the worst effect of short term market fluctuations. The value of investing in global assets has already been demonstrated, as the drop in sterling will help cushion the impact of falls in the value of international holdings.
The referendum result may yet alter a great deal about the United Kingdom, but it does not alter the principles of investing or the need for individuals to take action to ensure their long-term financial security.
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Please note that the opinions expressed by the fund managers are subject to change at any time, due to changes in market or economic conditions. This material is not intended to be relied upon as a forecast, research or investment advice and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any strategy. The views are not necessarily shared by other investment managers or St. James's Place Wealth Management.