Breaking up Is Hard to Do

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What to expect as the dust settles

As the financial markets adjust to the aftershocks of the historic U.K. referendum vote, spectators aren’t the only ones left scratching their heads. After the referendum, financial markets have begun to adjust, moving beyond the initial emotional response. So, as the dust begins to settle, many are left asking, “Now what?”

Here’s what you can expect in a post-Brexit world.

1. A long goodbye
Under what's known as Article 50 of the Lisbon Treaty, the U.K. will have two years to negotiate leaving after it gives formal notification to the European Union (EU). The two-year countdown begins once the notification is made and even then, an extension can be requested if all parties agree.

2. The art of negotiation
The U.K. and EU have a lot of work ahead renegotiating trade agreements for the exchange of goods and services and immigration policies. Since many of the U.K.’s trade agreements are through the EU, new negotiations will be required with all of its trading partners — a colossal undertaking in just two years, especially when a single political deal takes time when the parties are on good terms let alone during a messy divorce. Some estimate as many as 150 different types of agreements need to be negotiated, and even Brexit supporters have suggested an exit date closer to 2020 is more appropriate.

3. What the markets can (and can’t) tell you
Unlike the expected “drip, drip, drip” flow of negotiations, markets tend to react quickly. These spikes result when the market attempts to predict the final outcome with limited information. Unfortunately, these reactive predictions are often wrong.

A far better indicator of how the U.K. referendum will affect the global markets will be to observe the first few trade agreements. If the market sees them negotiated quickly and on reasonable terms, you’ll see the markets trend accordingly. On the flip side, if the first few trade agreements show signs of conflict, you could see the reverse.

Consequently, the recovery in major equity market indices needs to be seen against a background of uncertainty. Investors should not confuse the ebbing of initial shock with clarity about the eventual outcome.

4. Prepare for debates
While the world argues over the pros and cons of the vote, the same debate is taking place within the U.K. Northern Ireland, Scotland and London voted in favor of remaining in the EU, while Wales and the rest of England generally voted in favor of leaving.

Scotland’s recent decision to stay in the U.K was likely motivated by fear of leaving the European Union. In light of the U.K. referendum vote, I think we can expect to see the Scottish National Party explore a further referendum to leave the U.K. and rejoin the EU.

It gets even more complicated in the North of Ireland. Sinn Fein, one of the larger political parties there, has hinted at requesting a referendum to unite with the Republic of Ireland on the premise they could remain in the EU. This has enormous political complications given the centuries of sectarian division.

With votes on the horizon for Spain and Italy, and referendum rumblings gaining attention in Denmark, the Netherlands and even France, a wave like this could be very hard to stop. Though the EU and its respective members’ governments will likely say "No," general elections could sway politicians to offer a referendum in the hopes of maintaining party control, as we saw with outgoing U.K. Prime Minister David Cameron.

5. The British pound will be a policy tool
Compared with the central banks of other European countries, the Bank of England is in a relatively good position. There's a big difference between the U.K. leaving the EU rather than France or Spain. That’s because the U.K. has its own currency, the British pound, unlike many of the EU’s members, who share a common currency, the euro. Britain’s pound is critical as an adjustment tool to absorb a shock like Brexit. It has already fallen significantly, and recent statements from the Bank of England imply they are comfortable with this lower level.

6. The banking system will be tested
Threat to the financial system is one of the ways a geopolitical event can have ripple effects throughout markets. The question is, can the European banking system stand up to this disruption? In the end I think it will be fine, but initially it is the area that will take the most impact. However, unlike in 2008 the U.K. and U.S. banking systems are significantly well-capitalized and have passed strenuous stress tests. In fact, the Federal Reserve recently announced that all 33 strategically important U.S. banks passed their stress tests. Therefore, global banking contagion is highly unlikely.

One of the challenges we face is that the European banking system may not be quite as well-capitalized as it needs to be. Central banks can take care of liquidity, but some EU banks will need to find ways to recapitalize through the markets. So, while the U.S. and U.K. banking systems are strong, central European banks are where my concern is focused.

7. Rest easier knowing institutions were prepared
When it comes to events like the U.K. referendum, the accuracy of predictions isn’t nearly as important as being prepared for both outcomes. While the vote to leave was a surprise to most, the fact that institutions like the Bank of England and the European Central Bank (ECB) were prepared for either outcome has helped calm the financial markets.

This is one of the great lessons of the global financial crisis. I am very impressed by the speed and magnitude of central bank action in repose to the U.K. referendum. The ECB has already made a statement of what it's going to do, as have the Bank of England, the Bank of Japan, the Bank of China and the Fed.

Bottom line: This is not a time to panic. Four key factors will aid in our ability to weather the UK referendum vote: adequate time to reflect and respond to the upcoming changes; the speed at which the central banks have moved; the U.K.’s independent currency as an adjustment factor; and the lessons from the global crisis.

© Columbia Threadneedle Investments

© Columbia Threadneedle Investments

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