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 August 2016 

Craig R. McKinley

True Costs of Brexit Remain Unknown

August 2016

By Craig R. McKinley
 

As it pertains to national security and the defense industrial base, there has been no larger story over the past month than the surprise vote in the United Kingdom to exit — or to begin the process of exiting — the 28-nation European Union.

Dubbed by the media as “Brexit,” meaning a “British Exit” from the EU, the polls preceding the June 23 vote indicated a close vote between those wanting to “leave” the union and those wishing to “remain.” The conventional wisdom was that “remain” would prevail, but regrettably the conventional wisdom was wrong.

The final Brexit result took nearly everyone by surprise. Placed before the citizens of the United Kingdom as a national referendum, 52 percent voted to leave the EU compared to 48 percent voting to remain. When asked to explain how the polls and the U.K. political establishment were so wrong, former British Prime Minister Tony Blair commented that, “If I could answer that I would still be running for office.”

The impact on the financial markets was immediate and negative. On the day following the vote, markets around the world dropped sharply. The Dow-Jones Industrial Average went down over 600 points on its way to dropping 4.8 percent before bottoming out the following week. For the S&P, a broader index, the drop was even more pronounced as it fell by 5.3 percent before leveling off and starting to climb back as the realization settled in that nothing immediate would actually happen following the vote, which was reinforced by the confusion that quickly engulfed the British governmental process.

During this turmoil, the leading U.S. defense stocks did relatively well, once again showing their quality as a stable investment even in moments of great uncertainty of the type that financial markets deplore. As National Defense Industrial Association board member Jim McAleese, president of McAleese Associates wrote, investors should expect “further investor rotation out of commercial aerospace, [and] into pure defense stocks because of longer visibility, strong cash flow, and aggressive return of cash to investors (share repurchases and dividends). Expect broader commercial investors to park funds temporarily in defense stocks as defensive measure.”

McAleese has, as usual, proven to be prophetic. During the period between June 23 and the July 4th holiday break, only The Boeing Company, whose commercial aircraft sales account for nearly two-thirds of its annual revenue, finished with a lower stock price. The other major defense firms were either higher or essentially unchanged. There is, however, one caution to be observed: the S&P Defense Index remained slightly down, reflecting the relatively greater sensitivity that smaller firms have to market mayhem.

There is another important dimension to Brexit that must be kept in mind. For a variety of reasons this is an era where there are tremendous centripetal forces at work within major nation-states and within the institutions of international order that developed in the post-World War II era. It may be that older generations see current circumstances unfavorably compared to a past they feel was more comfortable and stable, a condition suggested by the fact that in the Brexit referendum, the young voted overwhelmingly to remain while older voters preferred to leave, a rather stark difference in generational perspectives. But the major question is what other forces might surface?

Having lost the vote that he had vigorously supported, Prime Minister David Cameron announced his resignation, a step that has led to an unusual scramble to replace him as the potential Conservative Party successors are seemingly reluctant to actually initiate the two-year process of EU withdrawal by invoking Article 50 of the 1993 Treaty on European Union, more commonly known as the Maastricht Treaty. Indeed, in both the British Conservative and Labour Parties, many who championed the “leave” movement, now seem reluctant to actually leave. Many have quietly resigned from their posts, while others have initiated calls for another referendum to reconsider the earlier vote, or to delay the formal steps of the actual implementation of the unprecedented British vote until it is more fully understood.

Meanwhile, Scotland and Northern Ireland, both of which voted strongly to remain in the EU, are now making noise about either leaving the United Kingdom itself, or negotiating their own separate membership arrangements with the EU. In short, in addition to the financial uncertainty that may result from the Brexit vote, a large amount of political uncertainty may linger for some time, confusing the future role of the world’s fifth largest economy and the United States’ most trusted ally.

All of this is occurring during a period of great strategic stress. We have witnessed an increase in terrorist attacks from Bangladesh to Istanbul seemingly supported by the Islamic State. As the territory ISIL actually controls compresses, its resort to external terrorism seems to be growing. In addition, Europe faces the threat of continuing Russian aggressiveness, behavior some western leaders have called “reckless.”

Although Brexit has no immediate impact on NATO, there are inevitable consequences to its efforts to increase defense spending and expand cooperative developmental programs such as the joint strike fighter and other important modernization efforts. As Anne Applebaum of the Washington Post noted about Brexit, “the real damage will be done by things that will now not happen.” Hopefully efforts over the past decade intended to expand, integrate and further modernize NATO will not be among those things that “will now not happen.”

We are obviously in a period where voting publics, certainly in the United Kingdom and possibly in the United States, are more concerned about perceptions of independence and sovereignty rather than influence and importance. A diminished U.K. is not in America’s economic and security interests, but it will be unclear for at least two more years whether others, particularly the citizens of the United Kingdom, agree with that proposition.

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