Investment Commentary
June 24, 2016

The United Kingdom
to depart the European Union

June 24, 2016
Clement K. Miller
Clement K. Miller, CFA
Portfolio Manager Wilmington Multi-Manager International Fund

What we know:
  • The United Kingdom (U.K.) is exiting the European Union (EU)
  • Expect two years of contentious separation agreement negotiations
What we don't know:
  • Whether London will stay Europe's financial center
  • The future of euro-denominated instruments
  • If other nations will line up to make their exit

Yesterday, the people of the United Kingdom (Great Britain and Northern Ireland), unexpectedly voted to exit the European Union, a move referred to as "Brexit." The close decision elicited a magnified market reaction, constituting a re-rating of global financial risks.

The vote to split up doesn't mean there will be a clean, quick break. In fact, the Lisbon Treaty provides for a two-year period from the date that the U.K. government formally notifies the EU of its intention to withdraw, which is expected in the fall of 2016. Future arrangements would likely constitute bilateral agreements to replace European Commission directives that regulate affairs in the U.K. and Europe. Over the next 24 months, we expect:

Contentious negotiations. Since immigration was the hot-button issue in the Brexit debate, we think the U.K. government and its new prime minister will unilaterally enact laws restricting emigration from other EU countries, thereby flouting a core EU principle and infuriating its members. Further, we expect the U.K. government to cherry-pick those directives that suit it best. EU governments will likely be averse to offer such concessions, lest they encourage anti-EU movements in other member-countries.

Brinksmanship over whether London will remain Europe's principal financial center, resulting in sporadic outbreaks of global financial market instability. The London financial markets serve broader Europe like New York's serve the broader United States. London is home to the London Stock Exchange, the London International Financial Futures and Options Exchange, the London Metals Exchange, and Lloyd's of London. It is also home to many commercial and investment banks, insurers, and asset managers, as well as the law and accounting firms that serve them. Some of these are U.K. subsidiaries or affiliates of U.S. companies.

EU membership has thus far afforded London-based financial institutions the opportunity to provide services to companies throughout the bloc. At the end of 2015, U.K. banks held over $1.3 trillion of euro-denominated claims on foreign counterparties (including both banks and non-banks), while non-U.K. banks hold nearly $1.2 trillion of euro-denominated claims on U.K. counterparties (Figure 1). The U.K.'s unfettered access to the EU's single market was assured because the nation had implemented a number of European Commission financial services directives, which are akin to SEC regulations in the United States.

Absent successor bilateral agreements, in two years the U.K. will no longer be in compliance with such directives, thus jeopardizing U.K. financial services firms' continued access to the EU market. Given the prominent role played by London in global finance, instability in London's financial markets could readily spread to New York and Asian financial centers, with potential global financial ramifications.

The future of euro-denominated instruments
In continental Europe, there are powerful forces "for" and "against" the continued prominent role of London. The European Central Bank (ECB) has long been troubled by the fact that most trading in euro-denominated instruments occurs in London, beyond its writ as central bank for the eurozone.

Figure 1
Cross-border claims by currency, in USD billions

Source: Bank for International Settlements
As of December 31, 2015

The ECB will seek to bring much of that trading to Frankfurt and other European centers. Further, the ECB will have allies in continental European securities exchanges and other financial institutions that want to capture London's market share. However, the London financial markets provide many beneficial services to companies across Europe. These firms and associated businesses are sure to lobby for negotiation of continued access. Given these various interests, one can count on difficult negotiations regarding the future status of London.

An additional issue is that of the U.K. trading goods with the EU. At the end of the two-year period, absent a new bilateral agreement, U.K. goods will no longer have duty-free access to the EU, and vice versa. Instead, U.K.-EU bilateral trade will be subject to World Trade Organization rules, like U.S. trade with the EU. If duties are reimposed on U.K. trade with the EU, they will likely harm Europe and U.K. manufactures (including subsidiaries of U.S. firms). "Exit" supporters have argued they can negotiate a free trade agreement with the EU that does not involve onerous European Commission red tape, but we feel that is overly optimistic.

The "exit" victory also raises the risk of other adverse political events, as it will likely increase popular support for withdrawal from the EU—particularly among those who wish to restrict immigration. Anti-EU anti-immigrant parties may enter governing coalitions and force the holding of further referendums on whether to exit the EU. The vote may also increase the chance of another Scottish independence referendum, since many Scots would prefer to remain in the EU.

The U.S. presidential election has involved nationalist, anti-immigrant rhetoric similar to that invoked by the British exit campaign and by European nationalists. We are closely tracking political developments both in Europe and in the U.S. in order to assess their potential investment consequences. It is possible that the unexpected Brexit outcome could signal greater popular support for Donald Trump than might be appreciated in Washington or New York.

From a client portfolio perspective, we strive to position holdings in a way that best manages and mitigates risk. This will most certainly continue to be the case as circumstances unfold in the wake of this critical Brexit decision.

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