What will Brexit do to US investors?

From Virginia Ko at Morgan Stanley:

US equities sold off on the Friday following the Brexit voter, with the S&P 500 falling 76 points, or 3.6%, to close at 2,037. Global risk assets corrected sharply on the back of yesterday’s European Union referendum results in the United Kingdom, in which British voters were asked to opine on whether they believe the United Kingdom should remain in the European Union. While markets rallied into the event this week on speculation that the ‘remain’ camp would prevail, last night’s ‘leave’ victory injected significant uncertainty into the future of both the United Kingdom and the European Union, driving a risk-off move that saw global equity indices largely post mid-single-digit percentage declines, while global bonds rallied. In what was a volatile session, European stocks (Euro Stoxx 50) finished the day down nearly 9%, while US stocks (S&P 500) finished down nearly 4%. US Treasuries rallied, with the 10-year Treasury yield finishing the day at 1.57%, though rates were well off their low levels for the session. The US Dollar Index rallied 2.1% on the day, and crude oil settled 4.8% lower.

While today’s moves were abrupt, it should be noted that the action across many markets today simply reversed gains that were seen in recent sessions; in fact the Euro Stoxx 50 closed less than 1% below its low last Tuesday, while the S&P 500 closed just 0.6% below its low last week. The euro essentially traded at the same levels against the dollar as it had at last week’s lows, and the US 10-year Treasury yield actually settled 5 bps above its lows from last week. What does all this mean? In the Global Investment Committee’s (GIC) view, markets have been pricing the potential for BREXIT risk in the weeks leading up to the event, as the referendum has been front of mind for traders. While markets rallied in recent days on hopes of a ‘remain’ victory, yesterday’s results led markets to reverse those gains today, sending asset prices back to levels seen last week when markets sold off on fears that ‘leave’ would win. While there still may be more downside in global risk assets, the GIC believes any further sell-off is likely to be swift, as markets have had much time to prepare for the BREXIT risk; the ECB stands ready to act should policy support be necessary; and European equities trade at attractive valuations that may draw interest near current levels.

What happened with yesterday’s EU referendum in the UK? Financial & betting markets were wrong―despite rising expectations that the ‘remain’ camp would prevail, the ‘leave’ side proved victorious, by a 52% to 48% margin on high voter turnout. Though the referendum was non-binding, it is expected that the UK government will follow through with the will of the people, and the stage has been set for the UK to leave the EU. Importantly, leaving the EU is a process, not a point in time―a UK exit from the EU is likely to be at least a two-year process, with political and economic uncertainty around the exit negotiations likely to persist for months, if not years. Further, in the history of the EU, no member state has ever left the Union, so yesterday’s decision from UK voters is also likely to trigger fears that other nations may follow, particularly in the context of the rise in populist movements Europe, and to an extent the globe, has seen in recent years.

What will the BREXIT process look like? Last night’s ‘leave’ victory does not mean the UK is out of the EU today. Logistically, BREXIT is unlikely to be a quick process. First, UK leaders must agree on a policy for exit, which may take many months to begin with, and then they must officially invoke ‘Article 50’ of the Treaty on European Union, which notifies the EU of the UK’s official intent to leave. This kicks off a two-year negotiation process, which also has the ability to be extended by unanimous approval, to determine the exact terms of UK’s exit from the EU. Put together, when accounting for the process and negotiation considerations, MS & Co.’s European economics team believes a UK exit from the EU is unlikely to occur before 2019.

What effects will an ultimate BREXIT have on markets and economies?  In the near term, the direct effects of BREXIT are likely to be limited, though the uncertainty they pose will clearly be an overhang to markets both in Europe and globally. As a result of this uncertainty, MS & Co. economists forecast BREXIT to negatively contribute 0.3%, 0.5% and 1.0% to Global, Euro Area, and United Kingdom GDP growth in 2017, respectively. Further, with UK voters now having elected to leave the EU, markets are likely to consider the risk of further referendums down the road as other EU members potentially consider independence. Importantly, this is a political crisis, not an economic or financial one―global central banks are likely to do what is necessary to attempt to limit the near-term financial market ramifications that BREXIT poses, but the ultimate impacts of BREXIT will hinge on politicians (particularly in the UK and EU) working together and sounding a constructive tone on what a post-BREXIT world will look like.

While BREXIT is without doubt a negative for global growth, the GIC remains constructive on global equities as the energy/industrial/manufacturing recession that began almost a year ago appears to be nearing an end.  Evidence has been building that global growth has bottomed and is even accelerating at this point led by durable goods orders, manufacturing purchasing manager surveys, consumer confidence and credit growth.  Earnings growth also appears to have bottomed, too, in the first quarter of 2016 and could register close to double-digit growth by the first quarter of 2017 against easy comparisons. Should the data continue to improve despite the uncertainty now posed by BREXIT, the GIC believes risk assets can perform well over the next 12 months.