Lessons from Brexit: economic, political impact on investors

There's one thing we know from the Brexit vote: Nothing is certain except uncertainty.

Whether the sterling or all European equities will rebound or plunge further will depend on central banks' monetary policies, as well as a host of political developments in Britain, the rest of Europe and other countries. By definition, these political events will be as unpredictable as the referendum itself.

In the U.S., stocks will probably act as a safe haven for equity investors around the world because of the safety of the dollar, a lower likelihood of U.S. rate hikes and the prospect that earnings will fall less than in other economies.

For institutional investors with international portfolios, key drivers for risk appetite in the coming weeks will pertain to U.K. and broader European political dynamics, how the Bank of Japan copes with further unwanted yen strength, and whether the recent stability in both oil and Chinese economic data hold.

The initial shock to the markets might amount to an asset price adjustment to the new realities of higher inflation and lower growth, and possible recession, in the U.K. Rising euroscepticism and political uncertainty also will hike the premiums demanded by investors for both U.K. and European risk assets.

Over the next six months, investors should gauge three main political events and global phenomena: the U.K. and Europe's next steps, central banks' effectiveness in deploying liquidity facilities and the extreme polarization on national issues represented by Brexit or even the U.S. presidential election.

It is unclear whether there will be a decision to redo the EU referendum, exit the European Union quickly, or partake in a two-year negotiation period.

Until a new prime minister is in place, the U.K. government will not start a two-year countdown to withdrawal unless the remaining 27 EU states agree unanimously to extend the process, prolonging business uncertainty. Depending on who wins the party contest, the new prime minister could technically choose to announce a snap election to win a new mandate for exit, since the current House of Commons is dominated by members of Parliament who support continued EU membership.

In terms of the exit agreement, the trickiest part will be the U.K.'s access to the common market. Brexit would involve various other negotiations like initiatives to integrate EU laws into British law and renegotiate trade agreements with third parties.

Until a new government is in place and the exit path more clearly known, U.S. dollar assets are likely to outperform U.K. and European assets. This of course poses a conundrum for the Federal Reserve, where officials are focused on the countervailing effects of a stronger dollar on inflation and wage growth, which will reinforce caution.

To defray a systemic meltdown, the G-7 nations will have to address the instability in the currency markets and central banks might have to deploy liquidity backstops. Mark Carney, governor of the Bank of England, has emphasized both the health of the U.K.'s financial system and the bank's willingness to provide support where needed, and it has dawned on investors that a long period of negotiation, rather than sudden upheaval, now lies ahead. In the eurozone, there was a marked spike in sovereign yields in the European periphery.

A sharp rise in the Chinese yuan, with a sustained appreciation of the U.S. dollar, would also be deflationary. However, the yuan's trade-weighted weakening over the past 12 months gives the People's Bank of China some leeway to allow the currency to track the dollar higher if necessary in order to avoid a repeat of the panic seen earlier this year. In the event that the yuan weakens against a globally strong dollar following the vote, this could rekindle devaluation fears.

The Brexit vote emanated from extreme polarization on a national issue of existential importance that could actually exacerbate social and political tensions rather than mollify them. If Brexit increases inflation and slows growth, public anger would likely grow worse.

Populists are revolting against established political parties, predominantly supported by elderly, poor or undereducated voters angry enough to tear down existing institutions and defy the “elite” politicians and economic experts who warn against leaps into the unknown.

More generally, rising income inequality and slow economic growth in many developed countries have triggered a backlash against globalization. This is already shaping up to be a key issue in November's U.S. presidential election, with presumed Republican nominee Donald Trump threatening to start a trade war with China and to build a border wall with Mexico.

Rising protectionism and resurgent nativism represent a stunning reversal from the post-World War II era of internationalism, undergirded by American hegemony. Since the 1980s, robust growth and stable inflation were further buoyed by global trade and financial integration. Therefore, if such populist policies are enacted, one would also expect higher inflation (as limitations are placed on companies' ability to source production from low-cost destinations), less robust growth and increased premiums demanded on risk assets. Additionally, emerging and developing economies, which have been able to rapidly climb the growth curve through trade, also would be challenged.

Now that the credit-fueled illusion of broad-based and shared prosperity has been dispelled by the global financial crisis, both political and business leaders must address the fact that globalization bypassed and increased the economic vulnerability of large swaths of their populations.

Policies that redress stagnant real wages as well as retraining programs to address the growing skills gap caused by technological advances in production are now not only important for reducing income inequality and economic exclusion; but they are becoming critical to the very stability of our democratic institutions.

Tina Byles Williams is CEO and chief investment officer of FIS Group, Philadelphia.