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An unexpected precedent: the Brexit

The UK took the world by surprise last week when its citizens voted to leave the European Union (EU). While markets were volatile in the lead-up to the referendum, the news saw sharemarkets fall and the British Pound significantly depreciate. The unprecedented move opens a lot of questions about what’s next – not just for the UK and EU economies, but for global markets.

The next steps for the UK and EU

First the UK Government is expected to ratify the referendum decision before invoking article 50 of the Lisbon Treaty, to inform the EU it would like to leave. From there, the UK Government will have two years to negotiate its terms for exit with the other EU countries on matters such as immigration. It will also need to negotiate its own trade agreements with countries like the US and China which currently have trade agreements with the EU (but not the UK).

UK Prime Minister David Cameron was a vocal supporter of the ‘Remain’ vote. He has now announced he will resign in October which opens questions over who will be negotiating terms with the EU.

Brexit has created a number of challenges for the EU, with the fear of contagion being one of the key concerns. With the UK setting a precedent for leaving the EU, there are concerns a large member like Spain or France will also consider a similar exit. While leaving would be much more difficult for countries like Spain or France, which are tied into the EU through the currency bloc, some commentators wonder whether the EU will try to “punish” the UK in negotiations to send a clear message to other prospective leavers.

As the Eurozone continues its recovery – and a Brexit creates volatility – it is also possible the European Central Bank (ECB) will consider more monetary stimulus to bolster the region during the Brexit transition. The Bank of England (BOE) may consider similar measures within the UK during this period.

A negative for the UK

Latest figures showed significant depreciation in the UK pound, and while sharemarkets globally were volatile in initial trading, UK and European sharemarkets have suffered heavily in the immediate aftermath.

There is little doubt the decision will have, at least in the short-term, a negative impact on political and financial stability in the UK. The UK Treasury and OECD have gone further to estimate the UK economy will be about 5% smaller in 15 years time compared to how it would have been otherwise.

Some anticipated financial consequences of the Brexit are outlined as follows:
► Trade

There may be some disruption to trade volumes to and from the UK while future terms are negotiated over the next two years. In some cases, disruption could be longer given trade deals between the US and EU took three years to negotiate and may take a similar time for the UK to negotiate.

► International and UK investment

The UK has traditionally been seen by international investors as a gateway to Europe, so many investors may move their investments to other countries. UK domestic investment may also decline while there is uncertainty over the outcomes of Brexit and political instability. This same instability may also see a decrease in consumer and business confidence.

► Financial sector

The UK financial sector has traditionally held a dominant position in Europe and is likely to lose this with Brexit. Its status as an international financial hub is also likely to be negatively impacted with some international finance companies already threatening to remove staff.

The decision of Prime Minister David Cameron to resign has signalled the start of political instability in the UK but uncertainty over leadership is not the sole concern. Northern Ireland and Scotland overwhelming voted in favour of remaining in the EU, and this may see a second Scottish referendum to leave the UK.

The bigger picture for investments

The full impact on investment markets will depend on what happens next in terms of how the UK and EU manage the situation and negotiate terms.

In the short-term though, the uncertainty will likely continue to drive volatility in sharemarkets – and potentially a “flight to safety” to defensive assets like fixed interest.

Inflation has been low and this is likely to continue, with the US indicating it may postpone planned increases to the Federal Funds Rate in light of the Brexit result. Countries like Australia will continue monitoring to see if further cuts to the cash rate may be required.

The impact on Australia

As part of the global community, Australia can expect to see some direct negative impact from Brexit, though at this stage, they are anticipated to be relatively small. Australian exports to the UK are minimal, representing 1.5% of total exports, whereas the UK represents 8% of Australian services exports. This suggests tourism may see a larger impact compared to other Australian sectors. That said, the Australian banking sector is heavily exposed to the UK and Eurozone and is likely to face challenges over the Brexit transition.

There is a possibility for lower growth in commodities demand in the UK and elsewhere that will translate to lower commodity prices – this will have a negative impact on Australia which is still resources-driven.

The Reserve Bank of Australia (RBA) has indicated in previous meetings that it may cut the official cash rate further this year. In light of increased global volatility from Brexit, it looks likely the RBA will continue with this. A cut to the Australian cash rate should encourage business investment (through lower costs to borrowing and investing), in turn supporting the local economy.



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