Brexit – where to from here?
The UK has voted to leave the European Union. This has global implications, the extent of which will be determined over time. It is important to understand why this event occurred and what the ramifications are for global economies and markets including South Africa.
What happens now?
As a first step, the British Government has to invoke Article 50 of the Treaty of Lisbon, which is the relevant piece of law to enact an exit from the European Union. At the time of writing, this had not yet been done. The stipulated time period for the withdrawal agreement to be negotiated once Article 50 is triggered is two years. Comments from the leave camp have suggested that the UK would be better off getting close to a negotiated “deal” between it and the EU before setting the clock running. Prime Minister David Cameron, who tendered his resignation following the result of the referendum, has also stated that Article 50 will not be invoked until a new British leader has been appointed, which has been signalled to happen in October this year. Practically, the timeline to the UK withdrawal looks uncertain, but could conceivably take well in excess of two years.
How could this affect asset markets?
The Brexit vote is part of an international phenomenon: a populist backlash of western politics against globalisation and mainstream economics, particularly where there has been an increasing demand to impose restrictions on immigration and where the people are increasingly suspicious of free trade.
It is likely that the Brexit decision will have a significant effect on asset markets. We have seen signs of this already in terms of the fall in the pound, the decline in equity prices and the almost immediate flight to safe haven assets such as gold.
For the UK, Brexit could mean sharply lower growth and further easing from the Bank of England. The ECB will likely stand ready to inject extra liquidity into the markets when deemed necessary and the increased market volatility could also mean that the Fed is unlikely to raise rates at the September meeting. Meanwhile, the future of trading relations with the EU is expected to remain unclear for some time and will depend on whether negotiations will be amicable or confrontational.
The diagram below shows the current relationships of the European nations.
As illustrated, Iceland, Lichtenstein and Norway are in the European Economic Area. This affords them access to the single market. Switzerland has two bilateral agreements that achieve the same result.
These four countries are richer and have lower unemployment than the EU. Britain may hope for a bespoke deal – i.e. access to the single market without the EU rules, free movement of people, or budget considerations. However, this is highly unlikely. The EU, in an attempt to dissuade other nations from following the path of the UK, could impose harsh exit conditions. There is also a risk that without the UK, the EU could move towards protectionism. Certainly, global players including the US, China and Japan will be watching events unfold with some degree of trepidation.
In terms of investment strategy, from a global perspective, the near-term uncertainty will result in investors de-risking their positions. As a result, investment flows will likely favour safe-havens such as the US Dollar, Treasuries (government bonds), the Yen and gold.
The response by the Central Banks is likely to see:
- Direct intervention in the currency markets by the Bank of Japan to push down the rate of the Yen
- Further monetary easing by the Bank of England, Japan, Swiss Central Bank and the ECB
- The Fed is unlikely to hike rates until after the US election and then only if there is enough confidence that the US has not suffered much contagion.
So what does this mean for South Africa?
While our direct trade exposure to the UK is only around 4%, the EU is South Africa’s largest trading partner, accounting for almost a quarter of our exports. Approximately 20% of foreign tourists visiting South Africa are from the UK; however, this figure could decrease if the pound continues to depreciate. Importantly, net portfolio investments (bond and equity flows) from the UK - which have helped to fund a third of the current account - could decline.
The implications of Brexit on South Africa’s GDP growth will be negative. However, exactly how negative is difficult to quantify at this stage. The extent of the potential negative foreign earnings from South African corporates and the negative wealth effect for local consumers will become more apparent in time.
Local currency as well as bonds firmed ahead of the Brexit vote, with investors banking on the “Remain” camp being successful. While this has now reversed somewhat, the yield on the R186 government bond has gone back to just over 9% and has been supported by foreign buying. In a world where interest rates are declining, the search for yield will continue.
With respect to the Nedgroup Investments Stable Fund, we have increased the fund’s weighting to bonds over the past 6 months but have retained a lower allocation to bonds relative to cash, and have opted to invest in shorter maturity issuances, given the uncertain outlook for sovereign debt. We have a low conviction call to domestic shares in the portfolio with a preference for non-resource rand-hedge shares, where the offshore earnings base is diversified.
Around 70% of the revenues which the JSE listed companies generate, are from geographies outside SA. This has been the main reason why equity prices have held up well despite the deteriorating local economy. A downward shift in global growth is likely to have a negative effect on corporate earnings and ultimately on share prices.
It therefore becomes paramount to invest in companies with strong balance sheets and good growth potential. During times like these it is inevitable that good opportunities will present themselves i.e. where companies are oversold relative to the outlook for earnings. Cash has been accumulated and therefore the fund will be well placed to take advantage of these opportunities. The fund also has limited direct exposure to companies that are likely to be impacted by Brexit and has held gold (via an ETF) as a hedge for some time.
The uncertainty of how things will evolve following Brexit will endure for a considerable period of time. However, what is certain is that capital preservation is foremost in our minds during this very unsettling time.