It’s the question that’s on seemingly every investor’s mind: Will the United Kingdom exit the European Union?
And for good reason. The EU as a whole is the world’s second-biggest economy. A breakup could have a number of unfavorable long-term effects.
Fears over the “Brexit” sent world markets into a tizzy last week. Stocks fell while bond prices soared.
In fact, the yield on the 10-year German bund briefly fell to a negative yield. It still yields a paltry 0.01%. In Switzerland, even the 30-year bond was yielding a negative rate.
This week promises to bring even more volatility with the Brexit vote scheduled for Thursday.
Brexit or Bremain: A Coin Flip
Will the British actually leave the European Union? Both pollsters and bookies have the odds at about 50/50.
Economically, it makes more sense if the U.K. to stay in – especially if one looks at trade.
Studies show that Britain’s trade with the EU is 55% higher than it would have been outside the EU. On the other end, Britain is the third-biggest export market for Germany. And 32% of Irish exports go to neighboring Britain.
But this is a time of global discontent with the political and economic elites.
Here in the U.S., we have the populist campaigns of Donald Trump and Bernie Sanders. In Brazil, the people seem to want to throw out the entire system.
And in Europe, populist parties are growing like weeds. Take the Netherlands, for example. It has nationalist politician Geert Wilders, who not only sounds a bit like Trump, but has the funny hair too. Wilders is currently ahead in the polls to become the country’s next leader in next year’s election.
Getting back to Britain, most U.K. citizens don’t have a problem with Europe. They dislike the unelected EU bureaucrats in Brussels that are imposing taxes and regulations upon them. It’s sort of a modern-day spin on “taxation without representation.”
It is these same bureaucrats that the British will have to worry about if they vote to leave.
The official breakup wouldn’t really be finalized until 2019. But Brussels could turn it into a messy divorce and try to make Britain pay a heavy price for leaving.
Why? Because there is widespread discontent across Europe with these unelected bureaucrats.
Polls even in places like France show the citizenry are against the EU. These bureaucrats are afraid the Brexit would start a mass exodus out of the Union.
The countries in the north of Europe seem particularly anxious to leave. The populist Danish People’s Party came in second in last year’s election thanks to its anti-EU policy. It is talking about working a new deal for its people with the EU.
Denmark has strong traditional ties to Britain. In fact, it waited to enter the EU until Britain did. It may be the first to follow if the Brexit happens.
Financial Market Effects
Let’s now look at the Brexit effects on financial markets.
In the currency markets, I actually think the euro may end up moving more than the British pound. The pound has already fallen 10% versus the U.S. dollar in the past year. If the pound falls further, it will only make Britain more competitive trade-wise.
The euro common currency will be under stress if Brexit happens, as people question whether the Union will stay together. I suspect, though, that the eurozone will survive, as will the euro.
Whether Brexit happens or not, bond yields will likely continue lower due to central banks’ crazy policies.
What about stocks?
If the British vote to remain in the EU, I suspect we’ll see a rally in stocks – particularly in Europe and Britain.
But what if they leave?
U.K. small caps will remain largely unaffected in the event of a Brexit. These companies are mainly domestically focused. That makes the iShares MSCI United Kingdom Small-Cap ETF (BATS: EWUS) an interesting way to play either a Brexit or Bremain outcome.
A eurozone equivalent of EWUS is the WisdomTree Europe SmallCap Dividend Fund (NYSEArca: DFE). It is down only 3.5% this year, outperforming its large-cap counterparts. It also has some U.K. small caps in its portfolio.
No one knows if Brexit will happen and/or what it will bring if it does happen. I’m reminded of the famous Yogi Berra quote, “It’s tough to make predictions, especially about the future.” But if I had to hazard a guess, I say Bremain wins … barely.
Whatever happens, don’t panic. Just stay the course. And that includes having some portfolio exposure to Europe.
How to Sleep Easy at Night
Is the economy keeping you up at night? Do you worry there’s another crash just around the corner? If so, you can stop worrying right now. All it takes is a few minutes.