Britain’s vote to exit the European Union (EU) may end an era of expanding European integration, creating ripple effects felt throughout the world.  After the vote, Prime Minister David Cameron announced that he will resign by October, pending election of a new Conservative Party leader. The stage is set for a summer leadership election, with former London Mayor and Brexit supporter Boris Johnson the early favorite. The Brexit vote creates new uncertainty in Scotland, as Scottish First Minister Nicola Sturgeon opened the door for a possible second referendum on Scottish independence.

Vladimir Putin may be the most satisfied world leader after the Brexit vote, as the refugee crisis created in part by Russian military activity in Syria weakened an already-fragile European unity. Immigration was a major issue in the Brexit vote – as concerns about EU rules that require free movement of people between member states may have been more important to voters than worries about the impact of leaving the common market in trade.  The debate about immigration in the U.K. foreshadows continuing controversy that will play out in the U.S. and other countries in the coming months. 

The vote will trigger the first exit in history from the European Union, but isn’t legally binding until ratified by the British Parliament. The 2007 Treaty of Lisbon provides the constitutional basis for the EU, and provides for a two-year period for renegotiating trade and other agreements should a member depart. 

The “clock” starts once the U.K. formally notifies the EU of its departure plans.  

The negotiation process is likely to be contentious, as the EU will have an incentive to “talk tough” in order to discourage other countries from following the U.K. Interestingly, however, European politicians including Germany’s Angela Merkel are pushing for early talks while U.K. leaders are signaling that they want to take more time before starting negotiations. 

Given the fluid political situation and tensions within the Eurozone, the speed and tone of discussions may change direction in the coming days.

Investment Reaction and Implications

I watched the voting results from my bedroom as my wife and cat tried to sleep through the noise from the television and my simultaneous typing on laptop and ipad! When it became apparent that “Leave” proponents were winning the vote, European markets and currencies plunged. 

The U.K.’s FTSE stock market index declined in its worst day since January, the British pound fell sharply, and global equity markets dropped in sympathy. The market move reversed a rally in the days preceding the vote, as polls and betting odds had pointed to a narrow vote in favor of “Remain.” 

In context, however, the FTSE index is higher than it was at the February lows, and the pound is not far below the February lows. Market volatility is becoming an unfortunate fact of life in our muted growth environment. (See Brexit: 3 Points to Allay Client Fears.)

Uncertainty is likely to continue for an extended period of time, as negotiations will take time and broader implications become more apparent. Brexit is a negative for the U.K. economy, but likely to have less impact for the eurozone or the broader global economy. In addition, the U.K. departure from what is primarily a trade-oriented group may present less of an impact than a departure from a common currency such as the Euro.  

More than 40% of the U.K.’s exports are to EU countries, while only 15% of the EU’s exports go to the U.K.. Trade volumes may not be disrupted in the near term, but lack of clarity about longer-term trade pacts will present a major concern for investors. The U.K. “divorce” from the EU is likely to be messy, and creates risk of a protracted standoff that could delay needed structural reforms throughout Europe. 

Analysts expect U.K. exporters to benefit from currency weakness, while U.K. importers are likely to face higher costs. Domestically oriented businesses may suffer from depressed economic activity, and financial services companies that have used London as a gateway into the U.K. may decide to relocate or downsize their U.K. operations. Banks have been hit particularly hard in trading throughout Europe, perhaps an overreaction to the vote (See Brexit Sends Banks, BDs Reeling). The Bank of England may have to remain “lower for longer” in interest rate policy, potentially fueling an uptick in inflation.

The impact of Brexit will be felt beyond the U.K. and the EU’s headquarters in Brussels. The vote against European integration is likely to embolden critics of the European “experiment.” Spain and Italy were among the stock markets that fell the most after the Brexit vote, falling in fear that they will be more likely to leave the euro. 

Portfolio Implications

The outcome of the Brexit vote was thought to be a binary one — in that a vote in favor of remaining in the EU would reinforce a positive outlook for U.K. and Eurozone equities while a vote to leave would compromise that point of view. Given data leading up to the election that indicated a better-than-50% assessment that Britain would vote to stay in the EU, markets rallied in hopes that the negative scenario would be avoided. Given the surprise of the Brexit vote, investors may find their point of view about Europe compromised and look for more attractive opportunities elsewhere in the world. 

Emotional reactions are common after an event like this, and markets often overreact before rebounding. It is likely that policymakers such as the Federal Reserve, Bank of England and the European Central Bank will take actions to provide liquidity to markets. (See U.S. Regulators ‘Carefully’ Watch Brexit Fallout, Promise Coordination.)

Given the fluid nature of the environment, advisors would be well-served to monitor events as they unfold while searching for underpriced assets that were sold in haste. 

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(Check out all of ThinkAdvisor’s news and analysis on Brexit.)