Why US financial markets may not be immune to Brexit&x27s ripple effects

Three, two, one … Panic! With less than a week to go before British citizens have to decide whether they want to remain part of the European Union, investors in the United States are finally waking up to the fact that the outcome of that Brexit vote will actually have an impact on already-struggling financial markets at home.

True, whatever happens to the Standard & Poor’s 500 stock index on 23 June, in response to the vote results, probably will pale in comparison to either the sigh of relief or the ripples of panic that will flow through Europe’s financial markets. But this is the 21st century; in less time than it takes to blink, much less read these words, news travels from one corner of the globe to another, and hedge funds and other large investors will respond equally rapidly.

US investors have an unfortunate tendency, encouraged by the fact that the country’s stock market makes up at least half of the world’s market capitalization which makes it easy for us to never venture into foreign stocks, to forget that what happens abroad can take a toll on our returns. Indeed, we sometimes wake up to important global economic events – the near implosion of the European Union due to the catastrophic economic problems in Greece and the related problems in countries like Spain and Ireland; China’s slowdown – only when spills over into our own world.

That’s why polls showing the Brexit vote may result in a majority of Britons voting to leave the EU are only now starting to rattle US financial markets, months after British and European stocks and bonds began feeling the chill.

The tragic killing of British parliamentarian Jo Cox, shot and stabbed by a suspect who may have shouted “Britain first!”, a slogan associated with a far-right group and anti-immigrant protesters who also support Brexit, has led to a pause in the campaign, and the resulting lull in the heated debate may yet cause some to reconsider their votes. (Many Britons who say they will vote in favor of Brexit may end up doing so more out of a desire to curb immigration than any other factor.) But in the US, investors should take advantage of this opportunity – as well as a chance to contemplate the horrible extremes that heated political debate can produce – to contemplate what may be the short – and longer-term impact of a pro-Brexit vote, and prepare ourselves accordingly.

Laurence Wormald, head of research at FIS, a financial technology company, has run a “stress test”, or a hypothetical scenario analysis, and calculated that if Britons vote in favor of Brexit, the S&P 500 would fall 5% and banking stocks would fall 8%, while volatility in the broader stock market would soar 40%.

That’s the simple and straightforward scenario, however. If such a Brexit vote prompts other anti-EU parties in other countries to renegotiate their relationship with the European Union, that would create what FIS refers to as “exit contagion”. That would send British stocks down 20%, European stocks down 15%, and US stocks down 10%; volatility in British and European markets would double, and in the US market it would soar 60%. That would make the stock market a very, very uncomfortable place to be for the remainder of the year.

There are plenty of reasons why the Brexit vote matters to US companies. Nearly a third of sales that these firms make throughout Europe are executed by their British subsidiaries; these tend to be their European headquarters. Paris, Frankfurt, Berlin, Amsterdam and other cities run distant seconds and thirds when it comes to establishing a European toehold for a US firm. But if Britain leaves the EU, companies will have to increase their costs and restructure their resources, maintaining access to both the EU and to Britain.

It’s a particularly costly problem for the banks, since London – despite fierce and combative efforts by Milan, Paris, Frankfurt and Dublin – clearly has become Europe’s financial center. Banking analysts have already calculated that in the short term, at least, this would be yet another financial headwind for big banks such as JP Morgan Chase, Goldman Sachs and Citigroup, which would see their revenues slump (in response to the Brexit turmoil and the transition) and their costs climb as they have to relocate and lay off personnel. Little wonder that the banks have been putting forth some of the most dire warnings of what would happen following a pro-Brexit vote, with Goldman Sachs, at one point, arguing that the British pound could crash in value by as much as 20%.

If you’re very worried about Brexit, you might want to take a look at your portfolio for a handful of stocks that have British subsidiaries that generate a hefty proportion of the parent company’s revenue. (Alternatively, these are companies whose stocks might be poised for a rebound if voters reject Brexit.) Helpfully, JP Morgan’s equity strategy team has put together a list of 22 companies that fall into that category, led by firms such as Penske Automotive, PPL Corp (an electric utility), PRA Health Sciences, investment firm Invesco Ltd, Xerox , Ford Motor, eBay, PayPal Holdings and Legg Mason.

All of these companies rely on the UK to some extent, but we can’t really anticipate how they’ll respond to Brexit, however. That’s part of the problem. The Brexit-related market volatility relates to what investors think will happen in the future; it is the uncertainty that is making markets jittery today. Then, too, the referendum’s results aren’t binding; Britain’s parliament would have to develop and pass the necessary legislation, and that will at least take time.

Only after both voters and parliament approve Brexit, and it becomes law and is implemented, will we be able to gauge what it means for business and financial markets. While the latter always try to anticipate, rather than react, to events, an event as seismic as Britain’s departure from the European Union simply can’t be compared to trying to predict, say, a company’s next quarterly earnings.

There are twin risks associated with Brexit right now for US investors. The first is to simply ignore the looming vote, and its short-term risks and the potential longer-term ramifications of a “yes” vote. The second is to give it too much weight. The trick for at least the next week will be walking that very fine line.

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