British citizens voted June 24 to leave the European Union — a surprise that reverberated through the financial markets. To understand where the markets might head now, we need to look at the underlying economic impact of the decision to leave the EU, and how it will affect the U.K. and global financial markets.
Economic impact of Brexit:
The increase in uncertainty about economic growth in the United Kingdom is the major driver behind the immediate reaction in the financial markets. Brexit will inevitably increase the friction between the UK and its international trading partners. Many large businesses, unsure of future access to the common European market for goods and services, will most likely postpone or even freeze their major investments in the U.K. And because global business is so interconnected, the prospect of a worldwide economic slowdown becomes more plausible.
The impact on UK markets:
Because of this unexpected slowdown in economic activity, the first obvious casualty of the Brexit vote was the British pound, which significantly depreciated against other major currencies. (Two days after the vote, the pound dropped to its lowest value in more than 30 years.) Lower value of British currency has an uneven impact on the value of businesses inside the country. On the one hand, major British exporters such as BP, BAT and Rio Tinto, will benefit from the declining pound because their domestic costs will now be lower; at the same time, the value of their exports will proportionally increase. Domestic producers that use a lot of imported components will see their costs increase and their profits evaporate. These contrasting scenarios explain the mixed reaction in the UK stock market, which was still negative for the average company in the FTSE index. In addition to a sharp drop in value of the pound, the volatility of the exchange rates between the pound and other major currencies has reached unprecedented levels. This alone makes it very hard for investors to project a companies’ earnings and thus might cause further selloff in the medium-to-long term.
What happens to markets outside the U.K.?
The effect of Brexit is not limited to the UK economy: Britain is one of the largest economies in the world, importing billions of pounds worth of goods and services from other countries. If British consumers and businesses decrease their imports from abroad due to their declining purchasing power, they will cause other economies to slow down. The Economist Group estimates that for every point decline in the U.K. economy’s growth, the other European countries will experience one-half to one-third-of-one-point decline, resulting in lower profits for European companies. That's why stock markets all across Europe declined in the immediate aftermath of the vote. And since the U.K. is one of the largest importers from Asian countries including China and Japan, Brexit also caused a sharp negative reaction in Asian stock markets.
A spike in "safe haven" assets:
Because of the unprecedented nature of Brexit, it's unclear how economic events will unfold in the coming months. As usual, investors started to consider protecting themselves against the worst possible outcomes and began moving their capital into what are perceived as “safe haven” assets, such as Japanese yen, U.S. Treasury bonds, and gold. This flight to safety caused sharp increases in value of all those assets. In fact, the demand for U.S. Treasury bonds was so high that the price set an all-time record within a few days of the Brexit vote. In general, the safe haven assets have proved the only constant to which large institutional investors turn in case of any economic upheaval.
Brexit and the US stock market:
The economic impact of Brexit on the U.S. stock market is complex. Right after the vote, all major U.S. indices declined by about five percent as many U.S. investors swapped their holdings of equity for much safer Treasuries. Within a week, though, the fall in equities reversed completely: Within two weeks of the vote, the S&P 500 index reached an all-time high. A Wall Street Journal survey of leading economists “found forecasters making no major changes to their projections for economic growth this year and next, and no significant change to their outlook for the U.S. unemployment rate, due to the decision by U.K. citizens to exit the EU.”
There seem to be two key reasons Brexit is having a less substantial impact on the United States market. First is the relative isolation of the U.S. economy: Only about 15 percent of GDP is related to international trade. Second, in the last 18 months, U.S. investors were anticipating a possible interest rate increase by the Fed — and its potential negative impact on companies’ profits. Following Brexit, and the higher global economic uncertainty caused by it, the Fed put that increase on hold, thus leaving the U.S. markets plenty of liquidity to go even higher.
Dr. Andrei Nikiforov is a professor of finance at Rutgers University, and an expert of stock prices and bonds.