It is safe to say, looking at today’s market movements, that the result of the U.K.’s E.U. referendum – a 51.9% victory for the LEAVE camp – has taken many investors by surprise. In this Insight, we share some preliminary thoughts on the implications of Brexit, particularly as it relates to the European banks.

First, the short-term impact on the fundamental performance of the European banks would seem to be largely indirect, if at all. However, in absence of an abrupt slowdown in economic activity in the U.K. which weighs on other European countries, it is difficult to see how overall European bank profitability would be directly – and materially – impacted. In our view, it is also difficult to see how this causes a global recession, as the U.K. accounts for only ~4% of the global economy. Investors will be watching the economic indicators in the coming quarters for evidence.

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Second, the market is very focused on whether Brexit will be a catalyst for member countries to leave the eurozone. There is a special emphasis/concern for Italy, given its size and importance (~10% of total European GDP). While recognizing the potential negative impact to the U.K. (in the form of economic uncertainty), it is our view that leaving the European Union (i.e., open borders, common market) is significantly less complicated than leaving the eurozone (i.e., common currency, shared central bank/monetary policy, and significant economic integration). Nonetheless, how Brexit ultimately impacts the unity of the eurozone is too uncertain to predict, and is not likely to be known for many years.

On Brexit and the future of the U.K., what does history tell us?

The long-term impact on the U.K. will be determined by whether this change in association results in the country adopting more pro-growth policies outside the E.U. – i.e., related to tax, labour, regulation, free movement of capital, among other things. If it does, history strongly suggests that the U.K. would benefit in the form of higher longer-term GDP, notwithstanding the current short-term dislocation/uncertainty. History also strongly suggests that the U.K., as one of the world’s oldest democracies and most capitalistic economies, is more likely than “Europe” to adopt pro-growth policies in the medium-term.

As one of the world’s largest economies, the U.K. would be in a good position to pursue its own trade agreements outside of Europe. In addition, its importance to Europe would suggest that some trade arrangements will ultimately be agreed upon within the next several years. It is worth noting that there are other European countries that are not part of the E.U. but have separate arrangements, so there is precedent.

In the end, the REMAIN camp simply could not reconcile a fundamental contradiction in its argument/message. How is it that the U.K. could be significantly better off by not joining the eurozone, but leaving the European Union would have dramatic negative consequences? Further weakening the credibility of the REMAIN camp was that essentially the same arguments and gloomy predictions were made by economists/politicians in the 1990’s with respect to the U.K. not joining the eurozone. It is obvious, with hindsight, that not only were those predictions spectacularly wrong, but that, in fact, NOT joining the eurozone was hugely beneficial. It is reasonable to conclude that this likely weakened the credibility of the REMAIN predictions of dire consequences (especially to older voters).

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It is worth noting that despite being beside the largest and most powerful economy in the world, Canada thrived without free trade with the United States from 1867 until 1988 (and indeed, there is currently not even free trade between the Canadian provinces). Having said that, in an effort to discourage member countries from contemplating leaving the eurozone, it is possible the E.U. opts to “punish” the U.K. by making cross border trade more difficult, which weighs on GDP in the short-term (possibly even causing a recession). The substantial decline in the pound could, of course, serve as a shock absorber.

Less likely, but also possible in the short-term, is that a reasonable accommodation is made that is in the economic interests of all affected countries. We will await the declaration of Article 50, which will start the two year countdown.

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