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Question of the Week - June 20, 2016

Question of the Week - June 20, 2016

Guest Post - Monday, June 20, 2016

What are the primary concerns with a 'Brexit'?

The U.K. is a member of the European Union, which is an organization consisting of 28 nations on that continent dedicated to economic efficiencies, which includes free movement of labor, capital, goods and services, and includes a removal of trade barriers, such as tariffs, as well as other quasi-political functions, such as judiciary and environmental. The EU was formed in the 1950's as a reorganization and enlargement of several smaller unions that had been in place beginning in the years following World War II in an attempt to 'keep the peace' and soften support for some of the war's major causes, such as intense nationalism. After a few decades of existence, it was enhanced under the Treaty of Maastricht in 1993 with additional features, and that's how the monetary union component was formulated and implemented a few years later (although not all nations in the EU chose to participate in a shared currency, and several, such as the U.K., still don't). Encompassing nearly 30 countries, mainstream economists often generally agree that the union is beneficial to its members, through the classic free trade argument that each member is allowed to export the goods/services it is best at providing, while importing what it needs from others doing the same thing.

Since the U.K. isn't part of the Eurozone currency union, it retained the pound as its sovereign currency, so central bank functions also remain effectively independent from the European Central Bank. The U.K. didn't the EU at the very beginning, and it took 20 years for this to happen in the early 1970's (which is itself a longer story, which included blocks from other countries to keep them out). And the issue of an exit isn't new—in 1975 a similar referendum was put out for vote, with 2/3 calling for staying (the U.K. had only been a member for 2 years at that point).

The question 40 years ago is similar to the one today—benefits vs. costs, as well as who's calling the shots. While many smaller nations (like Greece) really have no choice but to acquiesce to the larger, more powerful nations in Europe, U.K. is much larger and does not always feel its interests are necessarily best served by what's best for Germany, France or Italy. With historical cultural and military rivalries between various members, that's not entirely surprising. Those arguing to leave the EU feel that the U.K. is paying more than its fair share, while not receiving enough benefits from the arrangement, while pro-EU folks are driven by the ideological free market and other benefits, or 'let's not rock the boat' at the very least.

It's important to recognize why the EU was formed in the first place. In the aftermath of a battle-torn, weary and distrustful post-war Europe, the pact allowed for a re-linking to keep the peace, first and foremost, by integrating the fortunes of each nation with the broader continent, as well as well as creating economic advantages for doing so. Considering Europe's volatile history, these were not small considerations. This is a key difference in how such a treaty between more similarly-sized partners differs from something like NAFTA, where members U.S., Canada and Mexico are generally amenable to one another, but the U.S. holds overwhelming clout.

If Britain decides to leave the EU, it won't be the end of the world. But it will necessitate the renegotiation of trade linkages and reduce some benefits for all parties involved, most likely. It will likely create more red tape, just different red tape than what is inherent in a larger EU bureaucracy anyway. On the positive side, an exit frees Britain from the necessity to agree with broader EU mandates, in regard to immigration and some other controversial political matters where British opinion differs from the rest of Europe (this has been a larger issue in recent years). There are also costs, as the EU will lose a major anchor country (U.K. being one of the largest economies in the world), and the revenue from the anchor, which will put more of the burden on Germany, France, Italy, and others. It also raises the possibility of other members considering a similar move, which has already been discussed in several countries.

If 'Brexit' does pass, there could be some other short-term pain. The pound might take a hit, which could pressure upward on the U.S. dollar a bit (even though the pound is only 12% of the U.S. dollar index), especially if through a 'flight to quality' effect. A weaker pound would be a benefit to British exporters, though, which could offset the impact in a positive way. From a trade standpoint, other non-EU members, particularly Switzerland and Norway, already export significantly to EU nations, so EU membership is not required for foreign trade to continue or decrease. There is also some degree of exposure to the U.K. that could affect U.S. company earnings, but this exposure is not huge. Energy has the most, at just over 5%, with technology and materials at just under 4%, and others below that; most of the exposures appear fairly concentrated within a few firms.

Current polls continue to put the odds of a Brexit at 50/50, although the 'stay' camp appears to have gained some ground over the weekend. Interestingly, the Scottish independence referendum in late 2014 polled similarly, although it ended up failing, and Scotland stayed in the U.K. Often, voters think such an idea is a good one in theory, but after considering the uncertain aftermath, opt to stick with the known status quo.

Uncertainty is the key issue and investment markets like certain outcomes. The recent uncertainty about this matter and others, like Fed policy, has already pushed down U.S. treasury yields and this effect could persist until markets see resolution or focus turns to something else. Naturally, British and global equities could be affected, but the impact and duration is always uncertain as is usually the case with geopolitical events like this, but markets have had a few weeks to already digest the possibility.

Read our Weekly Review for June 20, 2016.

Read the previous Question of the Week for May 31, 2016.

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