Financial markets have been reeling as a result of the British decision by referendum to leave the European Union. This event, coined the "Brexit," is now impacting portfolios and planning around the world, so I’d like to peel the onion a bit and look into all the fuss.
First, it’s important to realize while Great Britain is our closest geo-political ally, as a trading partner they are far less significant. With only 4 percent of U.S. exports being sold into Great Britain the nation can hardly be considered a critical trading partner. So from a purely economic activity perspective, the Brexit is highly unlikely to derail the U.S. economy.
Where Great Britain has become much more mission critical to the United States and the world economy however, is in the financial realm. If New York City and Wall Street are considered the financial capital of the world, London has to be considered a close second.
Great Britain is one of only a handful of truly global banking centers and British banks are giants, present worldwide and heavily intertwined everywhere. There is no doubt that the process of the Brexit will impact the operations and competitiveness of British banks, possibly putting the weaker players at risk. And so I believe the initial highly negative reaction to the Brexit is largely due to investors attempting to discern the increased potential risks to the global financial system as a whole.
When Lehman failed in 2008 the event impacted the balance sheets of financial institutions everywhere as the world was reminded just how interconnected the global financial system really is. The failure of a large British bank would impact the global financial system in a similar or even more dramatic fashion.
Recent analysis completed in February of the largest British banks did not indicate any imminent risk, but the Brexit is destined to change the economic and financial environment in Britain, creating uncertainty needing to be evaluated. While the decline in stock markets around the world since the Brexit vote has been broad in nature, bank stocks have been hit by far the hardest.
When Great Britain leaves the regulatory environment of the European Union many of the nation’s financial regulations will need to be redefined. I know from recent experience with the investment advice industry here in the United States that when huge regulatory changes are on the horizon, firms tend to stop investing in new products, technology and people.
This regulatory uncertainty, combined with interest rates that seem to trend ever lower will create strong headwinds for British banks, and financial market are bound to stay on edge for a while.
The good news is Britain never adopted the Euro currency and so the Brexit process should be less disruptive than if they had. In three to five years I believe the world will have comfortably adjusted to this event, but over the shorter term uncertainty and volatility now seem sure to rule the day.
For experienced long-term investors, the increased volatility could create some opportunities, but anyone looking to deploy capital should be willing to accept some heightened risk and volatility for the time being.