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By Timothy Strauts | 06-24-2016 09:00 AM

Brexit Shockwaves May Linger

Questions over the U.K.'s separation terms, possible economic fallout, and the future of the EU itself could upset the markets in fits and starts for months to come, says Morningstar markets research analyst Tim Strauts.

Jason Stipp: I'm Jason Stipp for Morningstar. The markets don't like surprises, and the markets hate uncertainty. They got a big pile of both overnight as the U.K. population voted to leave the European Union. Here to talk about the impact of that vote is Tim Strauts, a senior markets research analyst for Morningstar.

Tim, thanks for being here.

Tim Strauts: Thanks for having me.

Jason Stipp: This was a big surprise because leading up to this, it seemed like the "remain" camp, voting to stay in the EU, had the momentum. What happened? Why was the market so surprised?

Tim Strauts: Earlier this week, the global markets were positive every day as some of the more recent polls looked like "remain" was going to win. And actually even to the very end, "remain" seemed like it was in the best position. There was a YouGov poll that came out right when the polls closed in the United Kingdom that said 52% remain, 48% leave. Even after that, the head of the UK Independence Party, who was leading the push to leave, he actually said that he thought they were going to remain. He even said, "I think we've lost." And then the numbers started coming in, and it was a complete flip.

Jason Stipp: There were a lot of bets on "remain." We saw it in the stock markets earlier this week, we saw it in the currency markets. And then when suddenly everyone was surprised, now those bets are unwinding, and that's why we are seeing the big drops that we are seeing.

Tim Strauts: Yes, because everyone who bought earlier in the week, betting on "remain," now they are unwinding those positions, and they are unwinding them very quickly.

Jason Stipp: In a big way.

Let's talk about the impact of this decision. This is likely to play out over months, if not longer, how this separation actually comes about. There's a lot of uncertainty. When you are thinking about the economic situation in the eurozone and U.K., how do you start to do a scenario analysis of what can happen, because there is so much we don't know right now about how this separation is going to occur?

Tim Strauts: That's the thing: We don't know a lot. Europe is already dealing with very low growth, rising unemployment in some regions, and this is not going to help that situation. This may push the United Kingdom into a recession; it's uncertain. But with all the uncertainty, businesses are probably not going to expand; they're not going to be hiring. It's going to put a hard stop on some of these businesses. There is a chance that the U.K. goes in recession and potentially pushes Europe into recession, too. Europe is a very big part of the global pie, so that has knock-on effects for the U.S. and Asia, too.

Jason Stipp: When we are thinking about the bigger risks here, I think a lot of the worry that people have is, "Well, if the U.K. wants out of the EU, who is next?" And we started to see some polls elsewhere from big member countries suggesting that another country could be next and another country could be after that. So how do you think about a possible dissolution of the EU factoring into this mix?

Tim Strauts: I think it's a little too early to think that the European Union is going to go away, but it does give other countries the idea: If you don't like the deal you are getting or you don't like what the bureaucrats in Brussels are telling you that you have to do, you could say, "Well, I think I might want to leave."

There was a poll indicating that over 60% of people in France would like to leave the EU. Now, I don't think France is next, and there's unlikely to be any sort of vote in France, but it does mean that the control and power of the EU is greatly diminished now.

The next thing to think about is, there is this negotiation now between the United Kingdom and the EU as far as how you actually separate. And no one really knows how that works because the Union wasn't set up for anyone to leave. They didn't plan out, "If you want to leave, here are the five things you've got to do." So now, there is going to be a multi-month negotiation, and it's to the benefit of the European Union to make it hard, make it very difficult for the United Kingdom.

Jason Stipp: Because they want to dissuade other countries from going down the same path. So that could be another headwind potentially on the UK in trying to negotiate because EU wants to send the message. "Hey, other countries, it's not going be easy if you want to leave."

Tim Strauts: Definitely.

Jason Stipp: Given that there is so much uncertainty and given that markets like to understand what's going to happen, should we buckle in for a protracted period of time where, as news dribbles out, as these negotiations happen, we're going see a lot of ups and downs potentially in the global markets?

Tim Strauts: Yes. Right now it's early in the trading day in the U.S., but Europe, the last I saw, it was down 9%, looking at the Europe ETF here in the U.S. Asia was down 4%. The U.S. dollar is rising dramatically, which is actually going to have real knock-on effects for the U.S. economy, because that hurts our exports when the dollar rises. The British pound was actually at 30-year lows versus the dollar last night.

So volatility is rising. Look at the VIX to gauge volatility. There's been a dramatic increase in the VIX. I would say, this will calm down. The real big moves will calm down. Today will be very volatile. Next week may calm down a little bit, but there are going be new stories as this transition happens that are going move the markets. And so I would say. yes, this is definitely three to six months of heightened volatility.

Jason Stipp: Obviously market valuations are changing, but do you think the actual underlying values of a lot of these companies and a lot of these markets are changing as dramatically as we are seeing the market changing?

Tim Strauts: I think a lot of these moves are more short term. When we looked at valuations before all this happened, we thought Europe was going to be undervalued by maybe 3% to 5%, but you've got to throw that out now. There's going be a hard stop on a lot of these companies, they're not going be growing, so those valuations are definitely going to change. So I would definitely lower the valuations.

Whether it's down as much as 9%? Probably not. So there may be some opportunities out there, but I'd be very cautious right now. There are going to be a lot of big moves. If you're going step into this, you've got to think long term. I definitely wouldn't want to day-trade this type of market. It's a really good way to lose some money. If you want to rebalance your portfolio, I wouldn't do anything like say, "Oh, I'm just not going invest internationally." You definitely still need to maintain your international investments, and even Europe investments. You've just got to be a little more cautious.

Tim Strauts: If you have a long-term, asset allocation-based strategic portfolio plan, there's probably no reason at this point to blow up that plan. You might be able to rebalance, you might be able to do some small opportunistic moves on the margins if you're comfortable doing that, but probably no reason to make big bets right now or blow up that plan right now.

Jason Stipp: Definitely.

Tim Strauts: Tim, thanks so much for your insights on the Brexit vote and for joining me today.

Jason Stipp: Thanks for having me.

Tim Strauts: For Morningstar, I'm Jason Stipp. Thanks for watching.

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