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Trading the Brexit: Will U.S. Markets Feel An Impact?

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May 23, 2016
Brexit: Will Great Britain leave the eurozone, and what will be the impact on U.S. markets?

British voters face a big decision on June 23: Whether to remain in the European Union.

Investors also face a big decision: Whether to factor Britain’s vote into their trading strategy during the weeks ahead and after the referendum, should Britain exit.

Is this something U.S. investors should fret about? Not necessarily. Despite the drama that surrounds Britain’s possible secession, some argue that the markets have already priced in most of the risk. European markets are most likely to be affected, and the macroeconomic impact of a British exit would be felt more over the long term, potentially with no immediate repercussions beyond the psychological ones.

That said, there could be volatility leading up to the referendum and right afterward, especially in European stocks and currencies. These markets don’t trade in a vacuum, so possible impact on the dollar and U.S. equity markets can’t be completely discounted.

Here’s a little background: Proponents of a British exit, or “Brexit,” from the E.U. say membership imposes too many fees and regulations on Britain. But a Brexit raises questions about Britain’s $3 trillion economy. Mark Carney, head of the Bank of England, told lawmakers earlier this year that a Brexit is the “biggest domestic risk” to financial stability. Already, uncertainty has dramatically eroded the value of the British pound.

British pound versus U.S. dollar

FIGURE 1: TAKING A “POUNDING?”

The British pound is declining against the U.S. dollar as the June 23 referendum approaches. Image source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

And it’s not just Britain that faces uncertainty. About half of Britain’s imports come from E.U. member states, so the European economy is under scrutiny as well. E.U. membership gives Britain free trade in goods and services with other member countries, but that won’t necessarily remain true if Britain exits. If Brexit happens, it would take at least a couple of years for the full impact on trade to be determined.

Uncertainty began affecting markets as long as six months ago, when the pound started to crumble, said David Settle, curriculum development manager at Investools. “The British pound is one of the weakest currencies out there,” Settle said. “It’s setting multi-decade lows against the dollar.” British bond yields are also down sharply based on Brexit talk.

Which Markets Could Get Hurt? Helped?

Which if any sectors could get hurt by weakness in the British economy and possible erosion in trade between the rest of the E.U. and Britain? British stocks, and the British banking sector in particular, come to mind.

“Brexit could have a negative effect on the British economy as uncertainties could cause investment spending and perhaps consumer spending in the United Kingdom to slump, at least in the short run,” Wells Fargo wrote in a recent note to investors. “Any weakening in U.K. economic growth that was triggered by Brexit could lead to some losses among banks with exposure to British households and businesses.”

The European economy, along with stocks of companies with large exposure to Europe, could also take a hit from Brexit, analysts said. Investors who track currencies may already have noticed the approaching referendum’s effect on the pound, and it’s important to watch the euro as well in the days ahead.

“The risks of a Brexit might be far larger for the EU and, in particular, for the eurozone,” wrote Erik Norland, executive director and senior economist of CME Group, in a recent note. “A victory for those who want to ‘leave’ might ultimately create as much or more volatility in the euro than it does in the pound.” If Britain leaves, Norland said, other members might also get ideas about cutting their ties with the E.U., another potential blow to the economic union. All that could put pressure on the euro.

Settle said if Brexit does happen, U.S. financial sector stocks could benefit because they compete directly with banks in London, and anything negative for London’s banks would conceivably be positive for their U.S. counterparts. Swiss stocks could also benefit from Brexit, he added, because Switzerland has its own currency and a big banking industry that competes with Britain’s.

Volatility to Ease After Vote?

“Eventually, once the vote comes out, uncertainty of the result of the vote will be gone, and that will take out a lot of volatility,” Settle said. There’d be a general “knee-jerk” reaction to the news of a Brexit, he added, with some flight to safety, but he believes that scenario would be short-lived.

Settle thinks the pound could bounce back after the referendum, however it’s decided, since uncertainty would be out of the way. That could put pressure on the dollar, and commodities typically benefit from a weak dollar. In general, volatility would relax, since uncertainty drives volatility.

What is the most likely scenario for the Brexit referendum? Other countries, including Scotland, have threatened to leave the E.U. but never did. Polls, however, predict a close vote.

What to Watch

Investors interested in tracking the referendum’s effect on markets should consider following daily price movements of the pound (GBP); the Swiss franc (CHF); and British stocks (the FTSE 100 is a good index of key British companies). Also, a website closely followed by those interested in the Brexit issue has been forecasting odds for the referendum.

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