after brexit, is it time for regrexit now?

By Vaibhav Dhabaria

1 July, 2016

After BREXIT, is it time for REGREXIT now ??

Background

• The European Union (EU) is made up of 28 member states committed, through a series of treaties, to ever closer economic and political union.

• On June 24th , United Kingdom voted in a referendum to LEAVE the European Union, often termed as “BREXIT”.

• The LEAVE camp won by a narrow margin was 52% to 48%.

• While majorly England and Wales voted to LEAVE the EU, Scotland and Northern Island voted to REMAIN in the EU.

As expected, these equity and currency markets were hit around the world and have created many opportunities.

After BREXIT, is it time for REGREXIT now ?? ** BREXIT= Britain’s exit from the EU, REGREXIT= Britain regretting to leave the EU 2

The Equity markets were hit by this news ! !

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DJI FTSE 250 FTSE 100 DAX Index CAC Index MXEF IndexIndexJune 1,2016 =100

Source: Bloomberg, Author’s calculation; Data as of : 6/30/2016

3After BREXIT, is it time for REGREXIT now ??

** BREXIT= Britain’s exit from the EU, REGREXIT= Britain regretting to leave the EU

.. And while other currencies managed to stay flat - Pound took a beating and Yen appreciated !

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GBP DXY EUR YEN JPM EM Currency indexIndexJune 1,2016 =100




But, was BREXIT so BAD for the GLOBAL MARKETS ??

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Standardized S&P 500 VIX index

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A. 9/11 attack: 2.37 Standard Deviation points of shock B. Iraq invasion : 2.74 Standard Deviation points shockC. Global Financial Crisis: 6.73 Standard Deviation points shock

D. Greek Financial Crisis: 2.79 Standard Deviation points shockE. Chinese devaluation : 2.26 Standard Deviation points shockF. BREXIT : 0.38 Standard Deviation points shock


Higher the value, Bigger the shock.



A closer look at the markets, suggest that it might turn out to be a DOMESTIC issue with some spillovers ! !

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Spread between FTSE 100 vs. FTSE 250 FTSE 250 FTSE 100IndexJune 1,2016 =100


*FTSE 100 is more dominated by international companies whereas, FTSE 250 has more domestic exposure.



Expected impact of BREXIT on UK’s economy

Foreign Direct Investment is expected to get adversely affected ..

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BEL DEU GRC DNK AUT LUX IRL PRT SWE ITA FRA FIN ESP NLD UnitedKingdom

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UK’s share in FDI inflows to EU15*

1993-2006 2007-13 2014

Over the years, UK has been one of the largest recipient of FDI in the EU. However, after the BREXIT if access to Single Market is lost, firms might become skeptical to make long term investments. Also, EU countries are the biggest source of FDI in UK (accounting more 30% of total inward FDI of UK in 2014).

*EU15 refers to Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden and United Kingdom.Source: United Nations Conference on Trade and Development, April and ONS (2015), Author’s calculation



.. making the financing of its already high Current Account deficit more difficult !

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Trade in goods Trade in services Primary and secondary income Current account balance

Source: ONS (2016) and OECD

Current account deficit was at 5.5% of GDP during the second half of 2015 and it might worsen as half of UK’s

export goes to EU. Moreover, this high Current account deficit is significantly financed by the Foreign direct

investment and a sudden stop to this channel might will make things worse for UK.



Chances are that the “productive” migrants might find it difficult to work in UK in future!

Economically, the UK economy has been a net beneficiary from migration of skilled labor. However, immigration was one of mainreasons for BREXIT and politically, UK would want to limit immigration and the welfare benefits given to the immigrants.

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2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015%

Real GDP Growth by contribution

Productivity Employment of UK born Employment of EU born Employment of non-EU born GDP growth

Source: ONS (2016) and OECD



Overall, the Growth of UK’s economy is expected to fall ! !

Forecasted values Near term (2020) Long Term (2030)

OECD -3.1% -5.1%

CBI/PwC - FTA -3.1% -1.2%

CBI/PwC - WTO -5.5% -3.5%

LSE/CEP – FTA -1.3% -6.3% to -9.5%

LSE/CEP – WTO -2.6% -6.3% to -9.5%

Treasury – EEA -3.8%

Treasury – FTA -6.2%

Treasury – WTO -7.5%

To a large extent the amount of damage would be determined by the kind of deal that UK and EU agree upon. Also, apart

from economic consequences, there will be political damage which both the parties will have to suffer.



Outlook

I. The road to this deal …

• Once the UK starts the formal process to leave the EU by invoking Article 50, the negotiation process is at the minimum going to take 2 years, which can further be extended by unanimous consent.

• UK can negotiate a deal in between the two extremes of Norwegian Model and WTO model or strike a new deal altogether.

Norway model

•Become a member of European Economic Area (EEA), thereby retaining access to single market.

•Contributions to be made to the EU budget

•Free movement of goods, services, capital and people.

Swiss Model

•Become a member of European Free Trade Agreement (EFTA) only, with some limited access to single market.

•Trade agreements required with individual EU countries

•Contribution to be made to the EU budget.

Turkish Model

•Join neither the EEA and EFTA and no access to single market, instead join EU Customs Union

•Tariff free access to most of the EU Single Market, however, financial services not included.

WTO Model• Access the EU market under EU’s common external tariff.



.. is expected to be LONG and BUMPY !

Major Concerns:

• UK’s Public debt is at 90% (Maastricht definition), out of which almost a quarter of it is held by foreigners. In case of a major panic, the foreign owner could shun the UK government debt which could further aggravate the problems.

• London’s status as a global financial center is under threat as firms that established themselves in London to have easy access to European markets could be relocating to other places thereby, affecting the growth.

• Uncertain Political scenario: Prime Minister David Cameron has resigned and will be leaving the office, Scotland might file another referendum to leave UK, and with elections in France and Germany the political uncertainty might make things more difficult.

• Further depreciation of the Pound.

Upside Risks:

A quick and smooth negotiation between UK and EU.

Outlook:

At this point, a lot would depend on what kind of deal is struck between the EU and UK as that would decide the effect it would have on the businesses operating in UK. Unfortunately, it is a lengthy and an uncertain process.



II. Impact of BREXIT on Rest of the World:

• European Union:

Both EU and UK are expected to be affected by this separation. A lot would depend on the terms of the deal. Though, chances are that UK would be suffering a bigger negative economic impact than the EU. But politically, both EU and UK would lose a powerful partner.

• United States:

In economic terms, US exports just 3.8% of it exports to the U.K and 14.3% of its to EU(ex UK) so, BREXIT might not have a huge impact on the US economy. However, because of the rising uncertainty and volatility in the financial markets, we might see the Fed rate hikes being postponed.

• Emerging Markets:

The UK is not a big trading partner of the Emerging economies. The biggest exposure it has is in the Central and eastern Europe (CEE), where 5.4% of exports go to the UK. However, there might be few occasional bouts of volatility in the financial markets. Overall, though Emerging markets (apart from CEE) do not seem at risk from BREXIT, until and unless BREXIT becomes a bigger problems and starts affecting other European economies.



Investment Implications

Owing to UNCERTAINTY, safe-haven assets have rallied this year; reaching new highs after BREXIT

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Gold price

Due to the uncertainty this year rising from various sources, SAFE HAVEN assets like :

i. Gold : has appreciated 28%

ii. US Treasuries, both 10 years and 30 years, have fallen to new lows trading at 1.38% and 2.12%

iii. Yen has appreciated is trading around the ¥100 per dollar.




.. And the long negotiation process is expected to add to that !

Negotiations of BREXIT are expected to take at least 2 years, which will result in significant Economic uncertainty. The

corporates could even POSTPONE their investment decisions in such a scenario. Also, there is a fair chance, that these

shocks might get transmitted to other European countries.

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Economic Policy Uncertainty Index - UK

Source: Datastream, Author’s calculation; Data as of : 6/30/2016



Opportunities ahead ??

One of the major implications of the BREXIT event is that as a result of this uncertainty, the FED is EXPECTED to be more DOVISH in the short term. However, rate hikes might just be postponed by few months at best.

Developed Markets:

I. After the BREXIT shock, US markets recovered very well because of its domestic exposure. Consumer and health sector performed are considered relatively stable in such volatile times.

II. Though valuations are attractive in Japan, but with rising currency and a recovering economy, it asks for a greater scrutiny before investing a large share of the portfolio in Japanese Equities.

Emerging Markets:

With the negative interest rates around the world and the recent BREXIT event, investors are again showing interest in the Emerging Markets (EM), who were not performing well in the recent years. Though, the risk of a rate hike looms, the FED is certainly more Dovish now, which is good news for the Emerging markets.

I. EM equities offer better value at this moment, especially the Asian Emerging markets.

II. EM debt might be good place to park some money with a selective approach. Investing in Sovereign bonds would be a nice idea, too. Some of the countries which might be a good option are : India, Brazil and Mexico.

Commodities:

As most of commodities are struggling and Oil has rebounded since the start of the year, Gold might be investment to diversify the portfolio, given the heightened level of uncertainty that is expected in the upcoming months.

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** Author’s views for next 6 to 12 months

After BREXIT, is it time for REGREXIT now ?? ** BREXIT= Britain’s exit from the EU, REGREXIT= Britain regretting to leave the EU

About the Author:

Vaibhav Dhabaria is an experienced Buy-side Macro Analyst with 2+ years of Investment Research experience. Currently, he is doing his MS in Financial Statistics and Risk Management at Rutgers University. During his previous work experiences, he has worked closely with Senior Portfolio managers and Senior Economists on projects ranging from Macroeconomic research on various economies to building quantitative tools to assess the health of the economy. With his education in Economics, Statistics and

programming he plans to start his career in the Financial industry soon.

Prior work experiences: Investment Analyst I at Bank of New York Mellon (2012 to 2014).Emerging Markets Summer Intern at The Hartford (2015)

Please feel free to send your feedback or queries about the presentation.

Email ID: [email protected]

LinkedIn: https://www.linkedin.com/in/vaibhav-dhabaria-2b588b47

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after brexit, is it time for regrexit now?

Economy & Finance