In May 2015 the Conservative government was returned to power in the UK, winning a majority victory for the second election running, which surprised the country. During the campaign Britain’s membership of the EU became a key issue, and towards its end David Cameron capitulated to popular demand, promising the country a referendum on EU membership in order to sway Eurosceptic voters to vote for him.
In the run-up to the referendum the UK equity market saw volatility pick up, with many UK shares falling and rising in price in synchronisation with the opinion polls. The fact that the market had been trading in step with the poll results suggested the referendum would have a large impact on risk premiums, the return required by investors to hold risky assets. With confirmation of a win for the ‘leave’ campaign, many asset classes have traded as predicted.
The British pound bore the brunt of the referendum, falling sharply against all currencies, especially the Japanese yen, which is universally viewed as a safe-haven currency and as such is generally a strong performer during periods of volatility. In equity markets, shares related to the housing market – including UK banks, house builders, and real estate investment trusts (REITS) – have weakened dramatically. Companies that import goods to sell into the UK have also seen their shares fall dramatically overnight as terms of trade deteriorate. Our European partners have also suffered financial contagion as the implications of the vote weaken the Euro area. Popular opinion has soured towards the European project, not just in the UK, but across many European countries, which are now facing petitions for a similar referendum. In the coming months, the market will test the political harmony needed for the single currency to hold together despite vastly different country-specific economic conditions.
David Cameron has now stepped down as Prime Minister, and in the UK the political landscape is more uncertain than ever. Scotland, having decided to remain in the UK, voted strongly to remain in the EU and a second referendum there would seem reasonable. In the short run this uncertainty will continue to make markets volatile at a time when global economic growth is still more sluggish than central bankers would like.
The people of Britain have taken a brave decision to vote for significant political change, and while in the short run we’ve seen a negative effect on financial markets, we need to remember that change can also improve things. Politicians often neglect longer-term reforms out of fear for the short-term impact on economies. With the pain committed to and taken, the opportunity now exists to craft longer-term solutions. Investors with a global outlook, investing in a diversified basket of quality global equities, would have mitigated some of the losses from the currency fall. Government bonds, together with an allocation to some commodities, further reinforce the benefits of diversification. Politics has far less of an impact on company profits than perceived. While it can affect taxes, tariffs, regulation, access to markets, and can even revoke permission to compete, we must always remember that companies change and adapt. Factories can be moved, plans and strategy can be adjusted, and manufacturing processes can be altered. In the short term, any macro-economic change may dent one or two years of profits, but equities represent a claim on an infinite future of profitability, which can be restored.
Economist Adam Smith in 1776 described England as ‘a nation of shopkeepers’, referring to their desire to work and trade with each other for mutual prosperity. The UK may have voted to leave the EU political system, but the nation remains as eager as ever to produce and trade with the world. English law is respected globally and the UK remains one of the most secure places to do business, with centuries of tradition respecting property rights. The politicians will now abandon ‘project fear’, and pull together to launch ‘project confidence’. They will be supported by central banks eager to help, as well as a Europe eager to continue to access UK markets.
While the road may be rocky and the path uncertain, the destination may well turn out to be a very good place at which to end up. For global investors looking in at the UK, there are some good assets that have just been put on sale. The first buyers might be overseas corporations eager to buy some growth in what remains a slowly growing economy.