What is Brexit All About?
After Fridays’ historic vote for the United Kingdom to leave the European Union, there are more questions in the minds of investors than before. So, let’s begin with the history and background on the European Union before we discuss the potential implications of their vote for the future.
The European Union is described foremost as a political and economic partnership-type institution with 28 member states, all of them European countries. Also referred to as the ‘EU’. The EU was founded after the end of the Second World War. The EU aimed to establish economic cooperation and partnerships between European countries. Interdependence in trading was seen as a guarantee for peaceful relationships between nations. While EU beginnings may have had a basis in economic goals, activities in the EU also encompass environmental policy, cultural development, integration policy and international exchange as well as the promotion of human rights. As with all governing entities over time, they seem to morph into power wielding entities which fail at listening to the needs of their population. This is one of many reasons the EU has become so unpopular with the general population throughout Europe.
The unification of European countries began in the 1950s through the European Coal and Steel Community. Belgium, France, Germany, Italy, Luxembourg and the Netherlands were the six founding members of the EU. 1957 saw the creation of the Treaty of Rome, which gave birth to the European Economic Community (EEC), or the so-called ‘Common Market’. The European Union has basically become an enormous market of its own with a common currency used by a number of its member states.
We must understand the Brexit vote to leave the EU was a non-binding referendum, which means the government is not legally bound to act upon it. Yes, that is correct, they are not required to act on it. It is highly unlikely that would happen. With fifty-two percent of the country voting in favor of leaving, the government will act in some manner. According to the original agreement, the UK must invoke Article 50 which begins negotiations to exit the EU. Once invoked there is a two-year period for the UK to negotiate their departure. It may or may not take the full two years. What needs to be negotiated is vast, complex and encompasses financial, regulatory, tax and trade policies to mention a few.
Why was the vote so significant? If you follow European news services or have traveled Europe, you can see and hear the discontent of the general population with all the regulation, taxes and requirements the EU has placed upon them. In essence the people are funding two governing bodies, The EU and their own country. Leading polls show the discontent in France, Italy, Spain and many other nations are even higher than in the UK. France tops the list with 70% wanting to leave the EU. With the UK vote to leave, the EU is now scrambling to hold the EU together. The potential fallout from the Brexit vote is it may trigger other countries to follow the UK and leave the EU as well. Ten years from now, we may look back and realize this was a historic event and the start to the unraveling of the European Union.
The UK has attempted to renegotiate their relationship with the EU. Their attempt was met with significant resistance from the EU. The UK’s efforts became futile and that is what triggered the referendum. Article 50 will likely be invoked and negotiations will start, but that doesn’t mean the UK will ultimately leave. It is possible they may negotiate the changes they wish and decide to stay in the EU. It is one possibility which doesn’t carry a high probability. Why bring that up? The point here is this is a fluid situation, which over time, can change significantly. Two years is a long time and it is almost impossible to determine with any certainty what will ultimately happen. It all depends on what comes out of the negotiations.
The volatility we witnessed in the global market on Friday says one thing with certainty. -No one knows what will happen- What the future holds or the consequences, intended or otherwise, from the UK departure are as numerous as the number of people talking about it. It is all speculation at this point since we do not know the outcome from the upcoming negotiations. As early as Saturday morning several other EU members are calling for similar votes in their own country. This makes the EU officials in Brussels very nervous. They now fear a stampede for the EU exit door. Hence the reason for an emergency EU officials meeting yesterday.
The 600-point decline in the Dow Jones Industrials was extra-ordinary in that it was several standard deviations outside the recent trading realm. Although 600 points sounds large, it was only a 3% move in the index. European markets experienced losses of 12-15% on Friday. I am sure most investors have experienced three percent moves in a day on their individual stock holdings. Let’s keep that in mind and not start thinking this is 2008 all over again. It isn’t. The uncertainty which surrounds this event is great, so expect market volatility to remain high for some time across most asset classes. The last event we saw have a similar effect on the markets was when China devalued their currency. It took several months for the markets to recover. I’d expect the same here as a general rule.
Despite all the distraction around Brexit, we should not lose sight of the upcoming earnings season. Actually, ten companies from the S&P 500 have already reported. They look promising, but ten are hardly a valid sample to make any determination for the quarter. Q2 earning estimates for the S&P 500 are expected to be down -6.1% on -0.70% lower revenue YOY. If these estimates hold in the weeks ahead it will be 0.40% better than Q1 final numbers. The turnaround in oil prices from the February lows and the fading impact of the dollar strength will be big contributors for Q2.
The Q3 estimates currently stand at 0.00% YOY. This was the same for Q2 estimates at the beginning of April and then drifted lower throughout the quarter and ending down -6.5% when all was said and done. If the magnitude of negative revisions for this quarter continue to improve, as we saw last quarter, we may be coming to the end of declining earnings and a possible turn upwards going forward. Time will tell.
On the sector front, the three more promising sectors are Utilities, Conglomerates and Autos. On the other side Oil/Energy, Basic Materials and Transportation will remain under pressure. As we move forward from here, there will be a buying opportunity. Unfortunately, it is hard to say when at this time. As the markets heal in the weeks ahead the buying opportunity will become clear to everyone. For now, the focus is on earnings for Q2 and the revisions of estimates for Q3.
Lastly, we can say this. The markets will open on Monday as usual and there is life after Brexit.