By David Nelson, CFA
The biggest concern surrounding Brexit and the threat of Britain leaving the EU is that it's an unknown forcing investors to prepare for the worst. Some put on hedges and others raise cash or delay purchases waiting for the skies to clear.
Since the end of the financial crisis investors have been on high alert looking far and wide for the next Black Swan. Is the Brexit it? No one can be certain just what life after Brexit would look like but IMHO forecasted events often don't have the dire effects headlines suggest. Black Swan events bydefinition are unknown and difficult if not impossible to predict.
If Britain does leave, I'm sure there will be a knee jerk reaction in the markets but in the end trade will go on. How they negotiate the exit is far more important.
The vote to leave the European Union has morphed into a populist movement not unlike the political backdrop here in the United States. Prime Minister David Cameron and business leaders want to maintain the status quo and have warned of dire circumstances if in fact Britain exits. A parade of world leaders, economists and celebrates have taken to the media to get out the message giving the impression that Brexit is the end of life as we know it. It's the man on the street dealing with the day to day frustrations of policy being dictated by Brussels who is looking to get out.
Last week on Fox Business Making Money, host Charles Payne and I discussedthe possibility the debate was taking on a Y2K like atmosphere. Interestingly, in this week's Barron's "Up and Down Wall Street" columnist Randall Forsyth made some excellent points to that end in his article "Brexit, Another Y2K."
Even after divorce life goes on. First of all it will take some time perhaps even years for a Britain exit to unwind. Second, the UK's parliament could try to re-negotiate another deal and offer another referendum.
While this is a possibility I find it unlikely especially if the vote to leave is convincing. It's important to understand that despite any short term disruption it's in everyone's interest to get trade and business done.
While the Prime Minister continues to talk about the dire implications of aLeave Vote, he will do an about face if and when it happens. He will look to reassure business leaders that his government is doing everything to smooth the way for an easy transition. Whether or not he survives a leave vote is the subject of heated debate. Many suggest the time frame to his resignation could be measured in hours.
The Murder of Jo Cox
The tragic murder of Labor MP Jo Cox has shaken both sides to the core. Early speculation was that the vote might be delayed and sympathy had swung to the remain camp. The first poll conducted post this senseless crime has shocked the street showing just the opposite. USA reports; Qriously, a London-based technology start-up that gathers data and intelligence about consumers through mobile phone apps, found that backing among likely voters for Britain's EU membership has dropped to 32% from 40% before her death. It's just one poll but certainly flew in the face of conventional wisdom.
Since then there have been two new polls swinging back in favor of remain. Research firm Survation for the Mail and YouGov for the Sunday times this weekend puts the vote much closer. Obviously, the situation is fluid making the vote itself the only true barometer.
What does it mean for the EU if Britain leaves? - The EU has survived other crises before and will put on its best face but its flaws and challenges become more visible. The migration crises, repeated debt crises in Greece, zombie banks, unemployment and a weak economy have left many supporters disillusioned. This is true of the Euro as well. How do you manage a common currency without a common government? Some like yours truly have suggested a United States of Europe structure as a solution. With such diverse cultures and member states all insisting on sovereignty, it seems unlikely.
What to look for next week
The currency markets will probably be the first to react post the vote. If the remain vote succeeds expect Sterling to Rally and the EUR/USD should rally as well. The relative fall in USD might have the added benefit of helping US large cap exporters.
Goldman is on record saying if a Leave vote succeeds Sterling could weaken as much as 11% and the Euro by 4%. The scenario assumes uncertainty similar to the Lehman collapse. Anything is possible but I believe the odds of a hit that large as remote.
The financial sector will probably see the largest disruption given that capital is the center of everything and they are the gatekeepers. Goldman (NYSE:GS) & JPMorgan (NYSE:JPM) as well as Morgan Stanley (NYSE:MS) could all see pressure at least initially if a leave vote succeeds. Keefe, Bruyette & Woods points out that Goldman and JPMorgan * together generate $14 Billion in operating income from the U.K.
Be ready to Buy
If I'm wrong and markets (NYSEARCA:SPY) haven't priced in the event and we get a big selloff pounce on the opportunity. Size your trades accordingly. You don't have to pour it on all at once. Scale in over the next 3 days. If the vote is to remain in the EU a rally is likely but certainly not a lock. A lot of players have bought protection or remain under invested. Those hedges will have to be unwound putting upward pressure on the market.
Remember, even after divorce, life goes on.
*At the time of this article funds managed by David Nelson were long SPY & JPM
Disclosure: I am/we are long SPY, JPM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.