Market analysis: Brexit fallout is no simple story

The British pound fell pound against currencies including the US dollar after Britain voted to exit the European Union. SeongJoon Cho / Bloomberg

I think it’s important to break the UK Brexit referendum vote into two components: the first being the permanent effects it is likely to have on the United Kingdom, Europe and the global economy; and the second being the temporary factors.

In terms of the permanent effects, clearly the vote result was a negative for the UK economy, as trade with Europe is more than 50 per cent of the country’s total. It is going to be very difficult for the UK to negotiate free-trade agreements to replicate the types of arrangements that it has as part of the European Union (EU). Labour mobility is going to be affected. The London-based financial sector also is going to be affected.

Probably the bigger effect is what will happen to Europe if this is an indication of a rise in populist, nationalist sentiment throughout the continent against the EU and the euro-zone project.

In 2011, we were convinced the euro zone would stick together despite the massive economic imbalances and the lack of political union, the lack of fiscal union, the lack of banking union and the inability of Italy to reform structurally. We saw those issues could be worked through, provided there was an unconditional and convincing political will to stay together as a union.

Unfortunately, what Brexit and the surprise outcome has indicated is that this broad political will is quickly deteriorating. There are likely now to be more referendums and more nationalist parties advocating exits, which will create a tremendous amount of volatility and a difficult period in the euro zone.

We don’t expect any of this to be an immediate outcome but certainly it is something, as investors, that we need to take into account.

In regard to the temporary effects, typically when you see a shock like this, you have massive risk aversion and we saw that in the post-vote rally in US Treasuries and in the Japanese yen and in the sell-off of emerging-market assets. We think these are more temporary effects, and over the course of the next month or so, the market trends may begin to reverse course as people realise this is a long-term challenge for the euro zone.

The investment outlook is not materially changed for emerging markets such as Mexico or Indonesia.

We have been continuously monitoring the market activity and have been looking to potentially take advantage of some of the post-vote dislocations. At specific points during the post-vote volatility, we found what we estimated to be a bit of a bottom in specific emerging markets: a number of emerging market currencies had initially fallen by 5 per cent to 7 per cent but began to regain some lost ground as things began to normalise later during the June 24 trading period.

Over the weekend and next couple of weeks, once people begin to distil what really matters surrounding the outcome of this event for Europe and the rest of the world, I think that some of those risk assets in emerging markets that sold off will begin to recover.

But the shock to Europe is probably one that could be a little more permanent and people will probably begin to question investments in the euro zone over the longer term. As a result, we remain convinced the euro is likely to weaken.

Michael Hasenstab is the chief investment officer at Templeton Global Macro.

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