Bruce Cooper is chief investment officer, TD Asset Management, and senior vice-president, TD Bank Group.
British voters have voted to leave the European Union, making theirs the first country to do so in the union's history. While the hotly contested referendum is now over, Brexit is only just beginning. There is a great deal of uncertainty surrounding how and when British membership will officially end because of the lack of precedent and the lack of comprehensive departure guidelines.
Until it can negotiate a formal separation agreement, Britain will likely remain a member of the EU, subject to all its regulations and budget requirements. Given the complexity of the negotiations, we believe this may take years, leading to a protracted period of uncertainty. This is concerning as financial markets dislike uncertainty, and it may well cause investors to take a cautious approach.
Safe-haven assets have already seen meaningful inflows in the weeks leading up to the Brexit vote, with British and global yields declining. Last week, investor demand pushed German 10-year bonds below zero for the first time ever. Brexit is expected to put further pressure on yields, extending the existing lower-for-longer rate environment. Amid the turmoil, even the U.S. Federal Reserve, which had been signalling rate increases during 2016, will likely be forced to put them on hold for the time being.
Investors are expected to feel Brexit's effects in the short term, as the shock of the "leave" decision will likely lead to an increase in market volatility, particularly in Britain and Europe. British and European equities are likely to decline, with global equities following suit to a lesser degree. The pound and euro are also likely to weaken while safe-haven assets such as government bonds, the U.S. dollar, Japanese yen, and gold are all likely to strengthen amid a cautious sentiment. Given Canadian markets' high exposure to gold companies, rising bullion prices should help these markets outperform many of their global peers.
In the longer term, a key issue for investors is whether Brexit marks a turn toward deglobalization. We have already been hearing a more nationalistic tone recently, with the Trans-Pacific Partnership facing stiff resistance and presidential hopeful Donald Trump voicing his staunch opposition to the North American free-trade agreement. Globally, companies would face significant earnings headwinds if Brexit were to cement these nationalist sentiments.
A number of organizations have studied the potential macroeconomic impact of Brexit, but until the terms of the separation agreement are known, it will be difficult to predict the full economic and fiscal effects. Broadly, there is agreement that it will weigh on British GDP as business investment and exports will probably suffer. The GDP hit will depend in large part on the trade agreements Britain is able to negotiate. Establishing favourable trade terms with the EU or specific member states will be critical as the EU is Britain's largest trading partner. Britain will also need to renegotiate trade agreements with other countries, because it will no longer benefit from existing EU/third-party free-trade agreements, such as the Canadian and European Union Comprehensive Economic and Trade Agreement (CETA).
Weaker British economic growth is only one concern. Europe is already facing serious issues that will require significant structural reform, including fiscal and productivity disparities between member nations and weak domestic economic conditions. Will Brexit exacerbate these challenges? Will it make it easier for other countries to leave the EU? It's difficult to know at this stage.
Easier to predict is a period of political instability. British Prime Minister David Cameron, who is steadfastly pro-EU, has announced his resignation, and the Scottish independence movement may well see a surge in support as Scotland is also pro-EU. Across Europe, Brexit may fuel anti-euro, anti-immigration and anti-austerity sentiments and may provide support for populist parties, such as Greece's Syriza, Podemos in Spain, and France's National Front, which could undermine established political parties.
The uncertainty means a broad range of potential outcomes for investors, and we believe it is crucial for them to retain a long-term perspective and maximize diversification benefits within their portfolios.