On Thursday, the citizens of the United Kingdom (UK) voted to leave the European Union (EU). The markets had anticipated that the UK would vote to stay in the EU, so the surprise voting results immediately drove strong movements in markets.
Key Points
▪ The majority of UK residents voted to leave the EU. The results showed that the split between leave and remain was 51.9 percent and 48.1 percent, respectively.
▪ The UK has voted to leave the EU, but the process will take time. Article 50 of the Treaty on EU provides for a 2-year exit negotiation process, which will start when the Prime Minister provides official notice of withdrawal.
▪ David Cameron has stepped down as Prime Minister, but will remain as a caretaker of the government until October. He said he would like the new Prime Minister to trigger Article 50 and start the formal and legal process of leaving the EU.
▪ The Leave campaign did not present a unified way forward, so the approach and configuration of the government will likely take some time to articulate.
▪ German, French and EU leaders have pledged to move forward without the UK as a unified group of 27 countries. There will be an EU meeting on Tuesday, but these leaders face significant domestic challenges of their own.
▪ The Bank of England has pledged an initial liquidity injection of £250 billion and additional measures as necessary.
▪ The European Central Bank, Bank of Japan and other central banks have made statements of readiness to provide additional liquidity, foreign exchange swaps and other crisis management support. The Swiss National Bank has intervened to slow the appreciation of the Swiss Franc.
Initial Impacts
▪ Uncertainty in the market about the exit process and its impact on economic growth is expected to keep volatility elevated.
▪ Political uncertainty will be high, particularly in Europe, with Spanish elections on Sunday and additional elections across Europe into next year.
▪ Predictably, there has been a flight to quality. Equity markets are down around the globe, reflecting uncertainty. Similarly, yields on U.S., German and UK sovereign debt declined aggressively.
▪ As expected, currencies have been the most volatile asset class.
Market Implications: Our View
▪ Uncertainty and volatility are likely to remain high, but we believe the global financial system is in a position to withstand near-term pressures.
▪ Monetary policy should remain accommodative and central banks will provide liquidity to support economics. The Federal Reserve is likely to take an even slower approach to policy normalization.
▪ The decision to leave the EU is fundamentally negative for the UK as it is likely to slow its growth, put pressure on domestic assets and elevate UK risk premiums. How Europe handles this will help determine the degree to which the political fallout can be contained as well as the broader economic impact beyond the UK.
▪ The broader global impact will be dependent upon developments in confidence and political contagion. However, the global economy is not heavily dependent upon UK economic performance. Stability of global trade and broader economic confidence are of greater importance.
▪ Currently, UK and global banks remain well capitalized, have strong credit profiles and are highly regulated. U.S. and European banks have endured annual stress tests at the hands of regulators. These stress tests generally assume conditions more severe and long-lasting than the recent financial crisis itself. The most recent stress test results for U.S. banks were released on June 23, 2016, and all 33 banks that were tested passed. The results of European bank stress tests will likely be released early in the 3rd quarter of 2016.
▪ This event is unlikely to cause an end to the credit cycle. Investment grade corporates and high yield bonds are likely to remain attractive sectors for investors.
▪ Municipal bonds may benefit from the flight to quality and relative insulation from global market impacts. Additionally, attractive yields relative to other fixed income asset classes, tight supply and ongoing strong demand should be supportive of municipal bonds.
▪ We see the severe downside movement in equity markets as an opportunity to buy. Markets often overcorrect, and we see the accommodative push from central banks as supportive to equities in the near term.
▪ Active management with strong fundamental research may become more critical in global fixed income and equity markets given our expectation for ongoing volatility and political risk.
Nuveen Asset Management is based in Chicago, Illinois.
With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.
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