On June 23rd, the electorate of the United Kingdom voted in a referendum to leave the European Union, opting for “Brexit.” The impact on the global economy has been predominantly negative, and Canada has not been immune.
In the aftermath of the vote, equity and currency markets, which had priced in a “remain” decision, reacted negatively. And throughout the summer, we saw a climate of ongoing uncertainty:
- As of late August, the pound was down almost 10% from pre-Brexit levels against the Canadian dollar, a level likely to be sustained going forward given the Bank of England recently reduced the base interest rate to 0.25%;
- Stock markets have rebounded somewhat, though they remain depressed when currency movements are considered;
- Several UK real estate funds have closed due to uncertainty in the market and the wider economic outlook.
With Theresa May replacing David Cameron as UK Prime Minister, and no clear timeline, nor manifesto, for Brexit, it appears that the volatility will continue for some time. This uncertainty in the UK, combined with the fear of contagion of EU-exit sentiment throughout Europe, has led major economists, including the IMF, to revise down their projections for global economic growth.
The Canadian economy should expect similar impacts. The weaker pound and reduced economic outlook for the UK, for example, may lead to weaker demand for Canada’s exports. Given the UK is Canada’s third-largest export market, after the U.S. and China, this could have a meaningful impact. Brexit is more bad news for the Canadian resource sector as approximately 80% of Canada’s exports to the UK consists of precious and base metals. Manufacturing is also likely to suffer, though perhaps not to the same extent given the lower proportion of sales.
Brexit may also mean lower returns for Canadian pension plans, which have historically invested heavily in the UK, most notably in infrastructure assets. On average, the eight largest Canadian plans have about 7% of their net assets invested there (see accompanying table). For the CPP Investment Board, Canada’s largest single plan by assets under management, that adds up to $19 billion, representing the largest absolute Canadian dollar value exposure by any single entity. The highest concentrated exposure, however, is with OMERS, which has more than 13% of its assets in the UK market.
On the real estate side, several UK property funds have temporarily suspended redemptions due to the lack of liquidity in the commercial real estate market post-Brexit, an asset class with significant foreign investment. Canada Life is one of at least six funds that has exercised its right to defer redemptions for up to six months, a mechanism that safeguards all shareholders, due to liquidity pressure and concerns about the price of commercial properties.
Canadian insurers are also exposed to Europe and the UK with Great-West Life leading its peers, according to Scotia analyst Sumit Malhotra. The rm has invested assets of around 18% in the UK, which compares to only around 2% for Manulife.
At the very least, insurers will be impacted by macro factors such as currency, bond yields and lower economic growth despite how well assets and liabilities may be matched and whether property exposures have long-term leases with low loan-to-value levels. A potentially more significant impact would be felt if declines occur in parts of the portfolio due to reduced credit ratings on UK bonds or fair-value adjustments to British real estate holdings. On the other hand, there may be some offsets to these potential negative factors in the parts of the insurance business that pay out annuities.
Canadian businesses, especially banks, that set up European headquarters in the UK to access the continental market might be forced to rethink their strategies. Should they remain in the UK and adapt to any hurdles put in place following Brexit, or should they establish an alternative European headquarters, say in Paris or Frankfurt? Either option is likely to add costs and may increase risk through another layer of regulation and compliance.
Despite the apparent negative repercussions of Brexit, some are arguing that Canada may ultimately stand to benefit, most notably around being able to renegotiate the Comprehensive Economic and Trade Agreement (CETA)—which was agreed to with the EU earlier this year but not ratified. Furthermore, the UK’s bargaining position will be weaker when it renegotiates its trade deals with all countries after it leaves the EU, including Canada, which could lead to a more favourable outcome than under CETA.
Those Canadian companies that have manufacturing operations in the UK, most notably Bombardier, may also see a bene t from Brexit. Bombardier recently won a $1.7-billion contract to build railway cars at its Derby, UK, factory, effectively securing the jobs of 1,000 employees. The weaker pound provides a cost advantage for exporters, and the prospect of increased government spending to improve the economy is becoming more realistic as there are few monetary policy levers left to pull.
What we can say for sure at this point is that the current climate of uncertainty is unlikely to change soon. The UK has two years to exit the EU following the motion passing parliament, which is itself not anticipated until 2017. Unfortunately, continued uncertainty is negative for the global economy and therefore for Canada’s economy—and there is no easy exit from that reality.
Robert Olsen is Deloitte’s national Corporate Finance leader. E-mail firstname.lastname@example.org. Andrew Luetchford is the national leader of Deloitte’s Debt & Capital Advisory Practice. E-mail: email@example.com. Paddy Farrant is an executive director in Deloitte’s Debt & Capital Advisory Practice. E-mail: firstname.lastname@example.org.