What Is Brexit & How Will It Affect the Economy?

Charlie Smith in Market Outlook 20 June, 2016

Over the past several weeks, headlines about ‘Brexit’ have been circulating in anticipation of the British referendum on June 23. The British people will vote on Thursday of this week on whether to leave the European Union (EU). If they do vote to leave, the UK people are effectively saying they don’t want to play by the EU’s economic rules any more.

Issues surrounding Brexit

From the voter’s (rather than the pundit’s) perspective, motivation for exiting the EU stems largely from refugee issues, which have given many British people the feeling that they’ve lost control of their nation. To those who want to leave, whatever economic benefits that might come from being part of the EU are outweighed by the problems that come from taking in hundreds of thousands of refugees from the Middle East, Africa and southern Europe. In other words, the bargain is no longer a good one. Remaining in the EU forces the Brits to give up too much control to Brussels on border issues and harboring refugees.

Pundits worry that a Brexit vote will prompt other dissatisfied members of the EU to leave as well. Great Britain doesn’t carry the same economic baggage as other EU nations, primarily because their debt isn’t as great a percentage of Gross Domestic Product (GDP). But if the Brits do vote to exit, it could create a template for other nations that are more poorly positioned. This is the last thing EU leadership wants to see.

This potential “domino effect” is also what most concerns financial markets worldwide. In the months leading up to the referendum, the value of the British pound has traded inversely with Brexit odds, rising when polls say stay, and falling when polls say leave. In addition, we’ve seen a material decline in the value of European bank stocks. Over time, the greatest concerns regarding Brexit stem from the potential reversal of various forms of economic integration and trade that have resulted from political union.

US impact

For US investors, the immediate impact of Brexit is the extra volatility it brings to international currency and debt markets. Longer term, the effects on the US economy are not likely to be material. Larger US banks operating in London (the financial center of Europe) may be forced to move elsewhere to remain in the EU. Also, certain permissions to trade and operate within the Eurozone could be revoked, or at least come into question. If the Brits do vote to leave, the EU may mandate that any bank operating in London no longer has the capability of dealing freely and openly in the Eurozone, and this could create minor problems for some US financial institutions, as well as other firms that do a lot of business in Britain and the Eurozone.

The odds of Brexit

According to British bookies, the odds on Brexit have been rising in recent few weeks. From our perspective, a vote in Switzerland earlier this month to reject a “universal basic income” could provide an interesting parallel. The Swiss government put up a referendum to decide if the people wanted to pay out a set amount of money each month to every Swiss household, no questions asked. There was a lot of talk in the press that there was a very good chance it would pass. The vote was ultimately 77 percent against to 23 percent for the UBI. The handicappers had it wrong. When it comes to Brexit, keep in mind that there could be a large (but much less vocal) majority in favor of staying in the EU.

We will see how the vote plays out on June 23rd!

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