Brexit has brought into sharper focus the rise of anti-establishment sentiment across the developed world. The EU itself could come under pressure as EU sceptics in other countries are emboldened, ultimately threatening the existence of the Euro Zone. This vote is likely to change perception in the global political economy and moderate complacency in the belief that the global economic arrangements will continue and are stable. It is important to note that the mechanics of the UK leaving the EU are complicated and the process will take at least two years, however in the interim global financial markets will most likely tither with uncertainty.
While we, and most market participants, had expected that voters would opt for the UK to remain part of the trading block, the odds were uncertain, and we had taken into account the possibility that the “leave” camp would prevail in our asset allocation. We now expect that the prevailing risk-off sentiment could persist as markets assess what the costs of Brexit will ultimately be. There is broad consensus that:
- The UK economy will suffer short and medium term negative consequences from the decision to leave the EU. This decision will be a drag on Euro Zone confidence and negatively affect growth in the region, and will lead to lower growth globally as the financial and trade implications reverberate.
- The level of uncertainty in markets has risen and could remain elevated for some time. Consequently risky assets could remain under pressure until there is better visibility with respect to what the implications of this vote will be over the medium and longer term.
- Central banks could move to try and support growth increasing the intensity of the monetary policy easing (ECB), starting to ease policy (BOE) and/or leaving rates unchanged (Fed). Policy maker’s response will not be clear until the impact of this decision on economies and financial conditions is more apparent, but will be a key determinant of what the long term implications of this decision will be.
The decision to leave the EU affects South Africa via financial linkages and trade linkages with the UK and the EU and its impact on global financial market conditions. Weaker growth in the EU will negatively affect domestic exports and GDP at a time when growth is already weak. Domestic firms invested in the UK could also see profits eroded, leading to earnings compression. At this stage we estimate that close to 20% of domestic listed equity earnings come from the UK and broader Euro zone area.
Most immediately tightening financial conditions could see the rand weaker and the inflation outlook deteriorating. On balance, the decision today could further entrench the stagflationary forces that we have seen in the South African economy, intensifying the policy dilemma that the SARB has been at pains to highlight.
The situation remains fluid, with many moving parts. Our long-term investment horizon allows us to be more circumspect with respect to our response. We will continue to closely monitor events and assess the long-term impact on the investments we hold.
