Britain Has Spoken

It's over.

The votes have been counted, and at 4:40 AM GMT, with Leave ahead by 847,815 votes and 308 of 382 areas reporting, the BBC and ITV called it: The UK will leave the EU. With turnout lower than expected in Scotland and London, the rest of England overwhelmingly rejecting the EU and Wales unexpectedly swinging to Leave, the projected tally is Leave 51.9%, Remain 48.1%. Bond, currency and equity market futures markets swung wildly overnight. UK stocks opened sharply lower, and the S&P 500 looks poised to do the same (the FTSE regained a bit of ground as the morning progressed). In overnight trading, Sterling hit 30-year lows before stabilizing as the sun came up. With each constituency that declared for Leave, more questions swirled. Who will replace PM David Cameron, who announced his decision to stand down Friday morning? Will the UK have a snap election this autumn? Will the economy weather the storm? Will the divorce with the EU be a Czechoslovakia-style "velvet divorce" or Paul-and-Heather messy? Will Brexit be followed by Czexit, Frexit or Nexit? How long before Scotland will hold another independence referendum? Will Northern Ireland follow? Can the divided country heal?

Many of these questions will take time to resolve. Once the government invokes Article 50 of the Lisbon Treaty, they'll technically have two years to negotiate exit terms and a new relationship, though such treaties have acted more like guidelines than strict law in recent years. After initial volatility, we expect markets to move on, once the vote fades from headlines, though volatility and a correction (a sharp, sudden, sentiment-driven drop exceeding -10%) is possible. Yet corrections by their nature are highly unpredictable, and a correction now in global equities is far from certain. At times like this, it's vital to keep a longer perspective and resist the temptation to react. Events and sentiment can hit markets hard in the short term, but over longer stretches, fundamentals hold the most sway-and the UK being outside the EU shouldn't hugely change the global economy's course. Now, we know that may be a surprising statement, particularly since this vote came on the heels of a vitriolic campaign packed with misinformation. Yet today, June 24, the UK is still a member of the European Union, with free trade and free movement with the other 27 member-states-and free trade with all the EU's free-trading partners. It will remain so, most likely, for at least two years as the negotiation process plays out glacially.

Past the initial, short-term reaction, markets should get relief as uncertainty and the campaign fade, allowing markets to more clearly assess Britain's fine economic fundamentals (as discussed here) and its bullish political gridlock. UK stocks might struggle for a period, but maybe not. The UK has underperformed the MSCI World for several years, and it's quite possible referendum fears contributed to the lag. With Brexit fears already priced in UK equities, greater certainty could prove a relative tailwind once knee-jerk reactions have faded. Either way, Brexit doesn't qualify as the sort of sudden, nasty change likely to trigger a bear market. It creates winners and losers, but markets will have a long time to gradually price in an independent UK. In the meantime, with the vote now over, businesses and investors can at least start planning, and that clarity is a positive.

Sterling's immediate reaction was extreme, but give it time. Trading in the heat of the moment is always dangerous. Fears for the pound and gilts' longer-term viability are trumped up and largely hinge on misperceptions stoked by the IMF, OECD and pro-Remain politicians. Leading the vanguard was Bank of England Governor Mark Carney, who suggested (wrongly, in our view) that Britain running a current account deficit means it must rely on foreigners' generosity to prop the pound and keep interest rates low. This, to us, smacks of pro-Remain bias. The bond vigilantes are no more likely to ding Britain today than they were when the US, UK and other countries ran big deficits resulting from the Global Financial Crisis. Simply, UK debt is attractive because Britain is a developed market with strong property rights and rule of law, as well as deep and long-established financial markets. It is quite creditworthy and able to service debt, not only at today's rates but even higher ones. As we've written, were this a real threat, markets likely would have priced it in for months, and investors would have been unwilling to snap up gilts at auction. Neither happened. Besides, right now more than $10 trillion of similarly high-quality, liquid sovereign debt is trading at negative yields, so we are betting many large global investors see gilts as a dazzlingly attractive option at roughly 1.37%.^[i]

As for stocks, the Brexit negotiations and lingering political uncertainty could hang over sentiment for a while. But none of the underlying issues qualify as a bear-market-inducing wallop. Markets move on surprises, and none carry sudden surprise power. Usually, as slow-moving events play out publicly, markets discount the outcome gradually, chewing over various outcomes as the conversation evolves. We've seen this the past four-plus years in the eurozone, which has pursued major architectural changes since the debt crisis calmed down. We've also seen it in America with the gradual implementation of the Affordable Care Act and Dodd-Frank. The questions and changes become part of the long-term backdrop, allowing other cyclical factors to have a greater influence on returns.

Whether the UK is better or worse off outside the EU is a matter of debate. The societal implications are vast, and emotions are running high. But markets look past sociology. They care about the economic implications, and while opinions are strong on both sides, we can see arguments both ways. The EU is a free-trade marvel, and the UK benefits from unfettered access to the Continent. At the same time, its trade relationships are strong enough outside Europe-and the negotiation window is long enough-that trade should hold up fine post-Brexit. Exports to the EU have fallen as a share of total UK exports for years, showing the country's economy depends less on EU membership than many believe. Overall, Brexit will create winners and losers, but it is not an automatic negative (or an automatic positive). The impact will depend on what emerges from the negotiations, and that will take time.

Time is markets' friend. For an event to wallop a bull market, it generally must be big and sudden enough to wipe trillions off world GDP in short order, catching the entire world off guard. Brexit doesn't qualify. It is neither sudden nor a surprise. Yes, markets rallied this week as Remain regained ground in the polls, and some have interpreted this to mean a Leave victory wasn't priced. But that isn't how markets work. Markets have been pricing in the possibility of Brexit since the Conservatives won last May's election, making the referendum a certainty. UK stocks have underperformed the world since then, and this week's activity only partly reversed the sharp downdraft as Leave gained momentum earlier in the month. Don't presume an overreaction to polls means markets were caught unaware. Not when headlines have discussed the purported economic risks of Brexit ad infinitum for a year. These headlines-studies from the IMF and OECD, sharp warnings from the BoE and Treasury and so many others-have set expectations ultra low. Thanks to this, for markets, the question isn't, "Is Brexit negative?" Rather, it's, "Will the eventual divorce be as disastrous as so many fear?" Hard as it may be to fathom now, when the results are raw and angst is high, anything short of disaster will be a relief, and relief is a positive force.

Having clarity on the vote's outcome is also a positive. Some uncertainty will persist throughout the Brexit negotiations, as we'll discuss below. However, the will-they-or-won't-they question is now resolved, which helps. Surveys suggested many businesses put off investment decisions pending the outcome. Not because they were worried about Brexit, but because they didn't know what to plan for. Would they need to invest in a post-Brexit strategy, or for the status quo? Now, with the future somewhat mapped out, they can get on with it. Don't underestimate the importance of this mentality, for business owners as well as investors. The more the immediate sentiment sucker punch fades, the more investors and businesses will carry on, and that carrying on is a positive.

All that said, there are several question marks, and these could impact sentiment over the foreseeable future. Here is a brief rundown on some of the major issues.

The Next Prime Minister

The most immediate question: Who will lead Team UK in the divorce proceedings? In his Friday morning speech, Cameron-who had staked his political future on the Remain campaign-said "the British people have decided to follow another path. So they need a new Prime Minister." He said he will do everything in his power to "steady the ship" for the immediate future, and he is not stepping down immediately, but he believes the Conservatives should have a new leader in place by the Conservative Party Conference in early October

Leadership contests take time, and it's impossible to know today who will win. Former London Mayor and leader of the Tories' "Leave" vanguard, Boris Johnson, is widely tipped as a candidate. So are Home Secretary Theresa May and Brexiter/Justice Secretary Michael Gove. More candidates will likely emerge from the woodwork. Chancellor George Osborne, once widely mooted as Cameron's successor, is likely out of the running, as voters clearly rejected his analysis of the economic implications and his warnings of a draconian post-Brexit emergency budget, likely damaging his credibility beyond repair. A noisy leadership campaign could impact sentiment, but whoever wins, the result should be largely the same: gridlock. The Conservative party is deeply split, and divisions won't heal overnight. The leadership change could also trigger new elections-allowable under extraordinary circumstances under the Fixed-Term Parliaments Act-as Tory leadership remembers the flak Gordon Brown received for not asking voters for a new mandate after he took the reins from Tony Blair.

While political uncertainty likely lingers as this situation develops, a gridlocked government-regardless of its leaders-is a positive for markets. Uncertainty over personalities impacts sentiment. But it also forestalls radical legislation, which, all else equal, reduces legislative risk for markets. The leadership contest will also delay the start of official negotiations with the EU, as Cameron said his successor will be responsible for invoking Article 50. This slows the process further, giving markets even more time to slowly discount the eventuality of Brexit.

Access to the EU's Single Market

Will an independent UK still be able to trade freely with the EU's single market? Leave campaigners peddled rosy promises of a Norway- or Switzerland-style relationship, where the UK remains part of the single market without being part of the union. However, Norway and Switzerland accepted free movement of people in exchange for market access, and immigration was the swing factor in UK voters' decision to leave. Further complicating matters, German Finance Minister Wolfgang Schäuble and others on the Continent have said out means out, a la carte Europe is a nonstarter, and the UK should expect tariffs and administrative barriers when shipping goods cross-Channel.

This seems more like a campaign tactic and opening gambit than anything else. Expect more similar talk in the coming days as both sides stake out their territory and try to strengthen their hands. Some have noted the German, French and other governments' desire to discourage Continental euroskeptics creates an incentive to give Britain the cold shoulder, but politics cuts both ways. As do tariffs, and Continental voters-and the businesses they own and work for-probably wouldn't enjoy losing unfettered access to UK consumers. Talk is one thing, but the incentives point to an eventual compromise. Negotiations might be tense, but they will play out publicly and loudly, giving markets time to digest forthcoming changes before they actually take effect.

Continued Free Trade With the EU's Extant Free-Trade Partners

Re-upping free trade agreements with other nations (including Canada, Vietnam and many others)-and inking new deals with new partners-is doable but likely takes time. As many have pointed out, the UK doesn't currently have a trade representative, so they'll likely need to create and staff a new ministry. They certainly have citizens with the brains and policy chops to do it, but it won't happen overnight. Nor will the negotiations, and some (like the US) have warned Brexit will send the UK back to the end of the queue. But that, too, seems mostly like politicking. Some ask, "why would countries ever bother negotiating free trade with a small island nation representing just 4% of global GDP,"^[ii] but we mostly wonder why anyone wouldn't want to trade freely with a high-income nation full of happy consumers. Even if negotiations stretch out, it shouldn't take all that long for the UK to do whatever homework is necessary to retain "Most Favored Nation" status at the WTO once it's out of the EU. They've already done the hard part, reducing most tariffs and barriers to WTO norms. The rest is just administrative.

The Future of the United Kingdom

Among the four constituent countries, England and Wales voted to leave. Northern Ireland and Scotland strongly supported staying, and the split creates some constitutional questions. Unionist support could fall in Northern Ireland, which benefits tremendously from a lack of border controls with the Republic. Leaving the EU, as many have noted, likely means reinstating the border, ending the free movement of goods and people that has boosted both sides. Sinn Feín, the nationalist party, has said the vote nullifies Westminster's mandate "to represent the economic or political interests of people in Northern Ireland," and deputy First Minister Martin McGuinness has called for a referendum on a united Ireland. Some argue an essentially English decision to reinstate Northern Irish border controls would violate the Good Friday Accords. The security, political and economic implications for both sides are a big unknown.

Scotland, meanwhile, covets EU immigrants in the face of its aging population, and its industrial base depends on unfettered single market access. Here, too, voters will be pulled out of the EU against their will, raising questions about their future in the UK. First Minister Nicola Sturgeon and even Cameron have warned a Leave win will probably trigger a new referendum on Scottish independence. In a Guardianinterview earlier this week, Sturgeon said a Leave win means she will have a mandate to ask the Scottish Parliament to consider a second referendum. It might not happen immediately, but it's worth noting polls strongly imply the result would be different than it was in 2014. (Though polls also predicted a stronger Remain turnout in Scotland than we got.)

What About the Labour Party?

While the Tory infighting hogged most of the attention, Labour leader Jeremy Corbyn has also received criticism for what most viewed as a lackluster, half-hearted campaign. Most Labour Party supporters were pro-remain, but turnout was low. Compounding matters, the Welsh valleys-a traditional Labour stronghold-voted overwhelmingly to leave. Corbyn was already on relatively thin ice with the Parliamentary Labour Party, and senior figures-most notably, Shadow Foreign Secretary Hilary Benn and one-time leadership contender Chuka Umunna-were all over the BBC acting like leaders-in waiting, discussing the need to reset Labour policy in light of the results. If Corbyn takes the fall for Labour's dreary showing, he could be out of a job.

Most of these questions, though, will not to be resolved nor impact markets in the very near term. It will take time, and play out under a bright media spotlight. Today, we believe the best thing investors can do is remain calm and avoid reacting emotionally to market volatility. That is likely the bigger risk now than anything directly linked to Thursday night's vote.