Students of American history (or those lucky enough to have seen the musical Hamilton) will recall that a decisive event in the American Revolution was the defeat of the British army at Yorktown, Virginia, in October 1781. After offering his formal surrender to General Washington, Lord Cornwallis led the defeated troops of the most powerful military force in the world out of Yorktown, marching to the tune of the old and appropriate British ballad “The World Turned Upside Down.”

Fast-forward 235 years, and a British departure has once again turned the world upside down, although this time as the result of a popular vote rather than defeat on a field of battle. On June 23, in response to the question “Should the United Kingdom remain a member of the European Union or leave the European Union?” 51.9% of voters opted to leave, while 48.1% voted to remain. Fully 72% of eligible voters cast a ballot, which speaks to powerful emotions on both sides of the issue. The last time a U.S. election topped 70% in voter turnout, William McKinley defeated William Jennings Bryan for the presidency in 1900.


The referendum revealed sharp geographic differences of opinion between the four political entities that comprise the United Kingdom. England voted to leave by a margin of 53.4% to 46.6%, and Wales voted similarly (52.5% vs. 47.5%). In Northern Ireland, 55.8% of voters opted to remain part of the EU, and Scotland topped that mark with a “remain” vote of 62.0%. Age was a strong predictive factor. Younger voters were strongly in favor of remaining, whereas older voters opted to leave.


A Brief History of Brexit

How did this happen? In early 2014, U.K. Prime Minister David Cameron committed to hold a nationwide referendum on EU membership if his Conservative Party retained power in the next election. He carried through on that promise after the May 2015 general election gave the British Conservative Party an outright majority in Parliament. Before scheduling the referendum, however, Cameron engaged in further negotiation with the European Union to address a variety of issues that had fostered opposition to continued membership.

The United Kingdom already enjoys a number of opt-outs from European Union initiatives: Among other things, it retains its own currency, central bank and monetary policy and is not a member of the Schengen Area that allows for the borderless movement of people in 26 European countries. In addition to existing opt-outs with the EU, Cameron sought tougher restrictions on immigration, sovereign veto power over proposed EU laws, a general reduction in regulations on businesses and the assurance that the United Kingdom would not have to participate in closer European political union. In February 2016, Cameron reported success on some fronts, progress on others and stalemates on a few. He scheduled a date for the referendum on EU membership. Slightly more than half of voters found the deal Cameron had made unappealing, and the rest is now history.

Exit polls reveal the rationale behind the decision. The vote to leave the EU was primarily motivated by the desire to reassert U.K. sovereignty over centralized decision-making by unelected and unaccountable bureaucrats in Brussels. Simply put, those who voted for Brexit think that decisions about the United Kingdom should be made within the United Kingdom. Furthermore, a vote to leave the European Union was believed to offer the United Kingdom the best chance to regain control over immigration and its own borders. Voters who wanted to remain in the union cited as their motivation the risk and uncertainty that leaving would pose to the U.K. economy, markets and jobs. In the end, the desire for more sovereignty and less immigration trumped the appeal of a status quo and the ill-defined risk of change.

The Aftermath

The political reaction to the outcome of the referendum was swift. The morning after the vote, Cameron announced his intent to resign as prime minister as soon as his party identified a successor. The leading candidate to assume leadership of the Conservative Party was initially Boris Johnson, the colorful and popular former mayor of London who had campaigned energetically to leave the EU. Indeed, Cameron seemed to acknowledge this likelihood in stating that the process of leaving the European Union needed to be led by someone who thought it was a good idea. In a week already full of twists and turns, Johnson removed himself from consideration within days due to infighting in the party, leaving the way open for Theresa May to become the second woman to serve as prime minister after Margaret Thatcher.

Jeremy Corbyn, the leader of the opposition Labour Party, was nominally in favor of staying in the EU, but in advance of the referendum candidly admitted to the BBC that his commitment was only “seven, or seven and a half” out of 10. This is hardly a resounding voice of support from the leader of a party that voted 72% to remain part of the European Union. Within days of the referendum, Corbyn lost a vote of no confidence by Labour Party members of Parliament by a vote of 172-40, but as of this writing has not stepped down from his leadership position. Several Labour members of Parliament have announced their intent to challenge Corbyn for leadership of the party. His days seem numbered.

The most vocal proponent of leaving the EU was Nigel Farage, founder and leader of the unambiguously named U.K. Independence Party, or UKIP, whose members cast 96% of their votes to leave. On the ironic date of July 4, Farage declared victory in his political ambition to win U.K. independence from Europe and announced his resignation as party leader.

So when it comes to British politics, just about all the leading figures have changed in the past fortnight. One exception is Larry the cat, who is responsible for mouse control at 10 Downing Street and is widely believed to enjoy a substantial degree of job security. Larry stands as one of few political survivors of the Brexit vote.

Financial markets have been as variable as political fortunes. As polls and betting markets leading up to the referendum indicated a close outcome but likely decision to remain in the EU, markets were caught off guard as they reopened following the vote. Sterling fell more than 10% against the dollar, and the large-cap FTSE 100 equity index slumped over 5% in the first two trading sessions following the referendum. On July 8, 10-year U.S. Treasury yields fell from 1.75% to a new record low of 1.36%, and gold rallied to a three-year high of $1,366 per ounce in a classic flight to safety. The S&P 500 sold off 3.5% on the day following the referendum, and the Chicago Board of Exchange Volatility Index (VIX) spiked to 26, the highest level since the market volatility of early 2016.


As the nearby graph illustrates, however, some markets have recovered as sharply as they sold off. Although currency and bond markets are still trading at levels established in the wake of the decision, the U.K. FTSE 100 has regained all of the ground lost in the aftermath (at least in local currency terms), and the U.S. S&P 500 index has set new all-time highs.

We view this sell-off and rebound as evidence of continued financial market volatility, exacerbated by the lack of clear support from earnings growth or compelling valuations. Market reaction over the past few weeks is similar to what we experienced last summer when the Bank of China adjusted its exchange rate bands, or earlier this year when concerns about global economic growth caused a sharp correction. In both cases, a sharp sell-off was followed by a quick recovery, and history seems to be repeating itself this summer. This is not to deny the longer-term challenges posed by the referendum’s outcome. Nevertheless, subsequent to the Brexit vote, the Bank of England, European Central Bank and Bank of Japan have soothed investors’ nerves by promising further monetary stimulus, and that has served to improve sentiment – at least for now.

It has also become clear that, whereas the Brexit vote was the end of one process, it is but the beginning of another, much more protracted effort to put the vote into effect. That might provide some near-term relief, as investors conclude that Brexit is not the immediate catastrophe that some feared.

What Comes Next?

The June 23 referendum was momentous, but not legally binding. The United Kingdom remains a member of the European Union unless and until it formally notifies the European Council of its intent to withdraw. Despite his pledge to provide precisely that notification immediately following a “leave” vote, Cameron opted to allow his successor to determine that timing, and Prime Minister May has committed not to notify the European Council until next year at the earliest.

May and her new cabinet have their work cut out for them. Everything about Britain’s departure from the European Union will be “for the first time,” as a member nation has never before left, voluntarily or otherwise. The mechanism for departure is captured in a mere 260-word Article 50 of the Lisbon Treaty on the Functioning of the European Union, which opens with the recognition that “Any Member State may decide to withdraw from the Union in accordance with its own constitutional requirements,” and “A Member State which decides to withdraw shall notify the European Council of its intention.” These first 32 words already raise interesting issues, particularly for a constitutional monarchy such as the United Kingdom which lacks a written constitution.

Once notification is received, “the Union shall negotiate and conclude an agreement with that State, setting out the arrangements for its withdrawal, taking account of the framework for its future relationship with the Union.” Article 50 provides a two-year window to conclude these negotiations, which can only be extended by a unanimous vote of remaining members. In other words, the U.K. has to tell the EU that it intends to leave, after which it has two years to figure out precisely what that means and make it happen. It’s never been done, the process is vague at best, and the “constitutional requirements” that the U.K. will apply to the undertaking are even vaguer. Anyone who says they know how this will play out is fooling themselves.

Although she was personally opposed to leaving the EU, May has said that “Brexit means Brexit” and has ruled out a second referendum, a general election or even a parliamentary vote that might overturn the initial outcome. Proponents of remaining within the EU have contested these claims, however, arguing that triggering Article 50 without a vote of Parliament would be illegal. Since May plans not to invoke the article until at least next year, the U.K. and its newly appointed secretary of state for exiting the European Union (yes, that’s a real cabinet position now) have time to form a strategy before starting the clock on the two-year negotiation period, but this also gives the Brexit opposition time to find ways around it. Indeed, as the obstacles to a smooth exit mount ever higher, the likelihood that Article 50 is never invoked rises. Time would seem to favor those who still hold out hope of remaining in the European Union.

The European Union, on the other hand, is eager to get on with it, perhaps out of irritation that the U.K. has thrown such a wrench in the EU works. In a press release issued the morning after the referendum, the European Council stated that “We now expect the United Kingdom government to give effect to this decision of the British people as soon as possible, however painful that process may be. Any delay would unnecessarily prolong uncertainty. … We stand ready to launch negotiations swiftly with the United Kingdom … .” To make the separation unequivocal, the same press release makes it clear that the agreement reached with (former) Prime Minister Cameron earlier this year “will now not take effect and ceases to exist.” In other words, thanks for the memories, good riddance, and don’t let the door hit you on the way out.

The statement was signed by Donald Tusk (President of the European Council), Martin Schulz (President of the European Parliament), Jean-Claude Juncker (President of the European Commission) and Mark Rutte (Prime Minister of the Netherlands and President of the Council of the European Union for the first half of 2016).

Whereas this litany of signatories presents a firm European front on the issue of Brexit, this multiplication of leadership roles and bureaucracy is a timely example of what motivated many “leave” voters. Most European Union citizens would be unable to make a distinction between the European Council, European Parliament and European Commission and are probably unaware that the presidency of the Council of the European Union rotates among member nations on a six-month basis. Indeed, Rutte stepped down from the presidency at the beginning of this month as Slovakia assumed the role for the second half of 2016. One is reminded of the words of former U.S. Secretary of State Henry Kissinger, who once (we assume rhetorically) asked, “Who do I call if I want to call Europe?”

What Does Success Look Like?

What does Britain – or at least those Brits who voted for Brexit – hope to achieve? The exit polls quoted earlier in this article identify greater control over borders and immigration as a primary motivation to leave the European Union. This is clearly an issue throughout the Western world and is exacerbated in Europe due to the combination of the humanitarian crisis in the Middle East and the free movement of people throughout Europe. Newspapers are full of the tragic images of refugees risking injury and death to establish a new and safer life within the European Union. The nearby graph depicts the scale of the immigration crisis that arrives daily on European shores. Monthly applications for asylum surged from about 60,000 in early 2015 to a peak of 167,000 last October, with 90% of that increase due to immigrants from the war-torn countries of Syria, Afghanistan and Iraq.


Applications tailed off during the colder months of the fall and winter but are still up over 50% on a year-over-year basis – and are likely to rise again this summer. These figures, of course, ignore the unquantifiable portion of refugees who do not formally apply for asylum, which implies that the real scale of the immigration crisis is even greater than the data reveal.

European citizens have the right to live, work, study or retire in any member state, and members of the Schengen Area have furthermore abolished national border controls, allowing for the full and free movement of people without documentation. As noted, the United Kingdom, importantly, is not part of the Schengen Area. Equally importantly, however, is that Greece is and stands as the nearest European landfall for refugees from the Middle East. Once in Greece, immigrants may move freely throughout the Schengen Area, although some countries have imposed tighter controls in the wake of the immigration surge of the past few years.

“Leave” voters would like to see the United Kingdom’s borders tightened further to protect the country from this surge of immigration, both legal and illegal. The rise in terrorist incidents in Europe, whether directly attributable to immigration or not, heightens the anxiety over immigration. Brexit voters believe that a United Kingdom independent of the European Union will be better positioned to respond to these trends and protect the U.K. border.

The challenge is that the pursuit of this objective may be irreconcilable with the desire to retain free trade with the rest of the European Union. The single European market is based on the so-called “four freedoms”: the free movement of goods, services, capital and people. These are inextricably linked principles, not a menu of freedoms from which individual countries can choose. If Britain genuinely wants to restrict the free movement of people across its borders, the European Union is not likely to allow it to retain the current freedom of movement of goods, services and perhaps even capital.

As a member of the European Union, the United Kingdom enjoys free movement of goods and services with the rest of the EU and trades with the rest of the world under EU trade agreements. What are the economic implications of losing some of that freedom once Brexit takes place?

First, some context. In 2015, U.K. exports totaled just over £250 billion, or about 14% of GDP. Fully 52% of that went into the European Union, but the destination of U.K. exports is geographically well diversified. Three of the top five export markets are not EU members (the United States, Switzerland and China), and exports outside the EU account for 48% of the total. Imports totaled £353 billion in 2015 and are slightly more skewed to the European Union. In 2015, the U.K. imported £85 billion more from the EU than it exported there. This trade deficit implies that the EU is more reliant on U.K. demand for its exports than the U.K. is reliant on the EU. It is in the interest of the EU to remain on good trade terms with the U.K.



The U.K. currently trades with the rest of the world as a member of the EU. As that membership comes to an end, Britain will need to negotiate its own arrangements with all of its trading partners, including the EU. The U.K. is well integrated into the global economy, and we believe that it will succeed in arriving at favorable deals with its trading partners over time. In the interim, however, the lack of clarity about trade deals is likely to impose a constraint on economic growth. Uncertainty is the enemy of activity.

The Future of the U.K. in Europe

Although there is no precedent for a member nation leaving the European Union, there are a variety of examples of how non-EU members relate to the union, and those models (or, more likely, a combination of them) provide some indication to the path that the U.K. may pursue in establishing a post-Brexit relationship with the EU.

Norway, like the United Kingdom, has retained its own currency and central bank and is a member of the European Economic Area (EEA) but not the European Union. This allows it access to the single European market (with some tariffs for specific industries) but little regulatory independence from Brussels regarding trade. Norway furthermore makes contributions to the EU budget and allows free movement of people across its border from other EU member states. These last two conditions were central issues in the Brexit vote and make it unlikely that a strict “Norway” model would work for a post-Brexit United Kingdom.

Switzerland is also not a member of the European Union but is in the European Free Trade Association (EFTA), along with Norway, Iceland and Liechtenstein. In exchange for access to the single European market, these countries contribute a reduced amount to the European Union budget, but also accept some restrictions on free trade (in financial services, in particular). As a member of the Schengen Area, Switzerland allows for free movement of people from EU member nations, although other EFTA members do not. This potentially solves the border issue for the U.K. but establishes only limited independence from EU regulations.

The EU Customs Union (EUCU) includes Turkey, Andorra, Monaco and San Marino in addition to all members of the European Union. The EUCU allows for semi-free movement of goods (some tariffs are imposed on certain products) but not services. There are no contributions to the EU budget and no free movement of people.

The problem with any of these models is that they are all customized for the countries in question and in every case apply to economies that are substantially smaller than the United Kingdom. The U.K. is not likely to apply an “off-the-shelf” solution to its post-Brexit relationship with the European Union, but instead borrow ideas from other models and construct a genuinely new model. The two-year negotiation period outlined in Article 50 is precious little time to craft a bespoke solution for such an important economy.

The Future of the U.K. at Home

The future of the United Kingdom itself is also up in the air. As noted earlier, citizens in Scotland and Northern Ireland voted to remain within the European Union. Although part of the U.K., both Scotland and Northern Ireland have already gained a certain degree of autonomy and might seek to expand that to the point where they remain part of the EU. Scotland held a referendum on independence in 2014 and decided by a margin of 55-45 to remain part of the United Kingdom. First Minister of Scotland Nicola Sturgeon responded to the Brexit decision by hinting at a second vote on Scottish independence, an idea that Prime Minister May quickly ruled out. Having said that, she also committed not to invoke Article 50 until she could do so with a “U.K.-wide approach,” which would require the consent of the Scottish Parliament. On the surface, these seem to be two irreconcilable positions – the irresistible force of Brexit colliding with the immovable object of Scotland’s desire to remain part of the European Union.

Northern Ireland has had its own troubled past with the United Kingdom. What was historically a conflict between Protestants and Catholics could become a conflict of a different nature, as a majority of the population wishing to remain part of the EU is overruled by voters in England and Wales who wish to leave. Indeed, the Good Friday Agreement of 1998, which established a truce in the fight for Irish unification, explicitly acknowledged that Northern Ireland would remain part of the United Kingdom until a majority of voters in Northern Ireland and the Republic of Ireland decided otherwise. Might disagreement over the European Union lead to Irish unification?

The Brexit vote poses a geographical challenge as well, as the border with the Irish Republic would be the only land border that an independent U.K. has with the European Union. That border right now is all but invisible: Road signs change from kilometers to miles, but other than that a driver has little indication that she has crossed a border into another country. Introducing border guards and passport controls would be a jarring change from the current ease with which people travel across the Irish-U.K. border and might provide further motivation for Northern Ireland to reconsider its relationship with the U.K.

It is hard to imagine Irish unification or Scottish independence, but when the history of the past few months and years is written, it will be replete with things that were hard to imagine at the time. The Brexit vote will prompt the U.K. to redefine relationships both within and without its current national borders.

Lessons Learned and Conclusions

First, the U.K. decision to leave the EU reminds us that history does not always move in a straight line. The history of the European Union is an ever-growing membership, albeit with the occasional threat that some country gets kicked out of the union for economic mismanagement. Events sometimes turn the world upside down in ways that could not have been imagined, and as the United Kingdom works its way through what it means to leave the European Union, further unimaginable events are almost certain to occur.

Second, citizens worldwide are increasingly questioning the role and effectiveness of government. The United Kingdom questioned its government in Brussels and held a vote that led to an overhaul of its political leadership at home – and, if implemented, will lead to a redefinition of its relationship with the rest of the world and parts of its own country. The U.S. presidential election reflects a similar dissatisfaction with the status quo, albeit without the dramatic redefinition of foreign relationships.

Third, political developments both in the U.K. and U.S. remind us not to put too much faith in polls and to pay close attention to the margin of error when consulting them. Most polls leading up to the Brexit vote indicated a “remain” outcome, while most polls in the U.S. considered it unlikely that Donald Trump would win the GOP nomination for president. Perhaps sampling methods are less effective in an age where people routinely communicate in ways other than answering the phone, or perhaps people are more honest in the voting booth than they are when answering pollsters’ questions. Either way, it hasn’t been a great year for the profession of political pollsters.

A final, and perhaps most important, observation is to remember that there is a difference between price volatility and value impairment. Brexit raises questions about both. The outcome of the referendum has certainly led to price volatility – and will likely do so again as Britain walks the uncertain path of establishing new relationships with the European Union and the rest of the world. At the same time, implementing Brexit may very well result in a more serious permanent impairment to the fundamental value of businesses that flourished due to the U.K.’s membership in the European Union. On the other hand, the impairment may be negligible or event nonexistent. Drawing a distinction between true value and mere price volatility will require a disciplined approach to investing in the post-Brexit world.

We believe that the best way to preserve and grow wealth over time is to understand the fundamental drivers of any asset in which we invest and then make that investment when the market presents an opportunity to do so at a discount to the intrinsic value of the asset. As we’ve seen with the financial market reaction to the Brexit vote, sentiment can drive prices up and down, but the disciplined investor focuses on the value inherent in any investment under consideration. Betting on the outcome of a referendum or what course history will take once the referendum is decided is an attempt to anticipate price movements. We would rather focus on the more durable concept of value and allow price volatility to be our friend as it presents opportunities to invest at an appropriate discount to intrinsic value. Although it is unclear at present what these opportunities might be, our managers are keenly aware that such an unprecedented development raises both risk and opportunity, and we will remain sensitive to both.

Former Secretary of Defense Donald Rumsfeld, in reference to another set of events that was turning the world upside down, once observed that “there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.”

Rumsfeld was widely mocked for the circuitous language of his reasoning, but his logic was spot on. The United Kingdom’s decision to file for divorce from the European Union will continue to present us with unknown unknowns for some time to come.


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