“The best argument against democracy is a five-minute conversation with the average voter.” – Winston Churchill
Anyone who has ever had the misfortune of going through a divorce knows that the actual decision to get divorced is just the beginning of a long and uncertain road. There are a lot of unanswered questions and too many possible outcomes that bring with them a variety of ramifications. Rarely is the ultimate outcome of a divorce clearly distinguishable on the night the decision is made.
So after only three full days since the UK voted to “divorce” themselves from the European Union, it is not surprising that the world still has more questions than it does answers.
We do know two things at this point; (1) this vote was yet another example of the anti-establishment sentiment that is dominating political campaigns and referendums worldwide; and (2) the voters themselves really didn’t understand the issues on which they were voting and the realization of what they have done is beginning to set in.
Two hours after the polls closed, the Google Trends Twitter account reported a 250% increase in people searching “what happens if we leave the EU.” Nearly 3 million UK citizens have signed a petition requesting a re-run of the referendum and, hopefully, a reversal of the decision. Many now believe that the “pro leave” party mislead voters with claims and promises that they cannot fulfill.
In short, a cloud of uncertainty has fallen over the entirety of the European continent.
There is a sense of disbelief and a growing anger – not just between the UK and the EU, but within the UK itself. The divisions fall along age and geopolitical boundaries.
We now know that the so called “Grey Vote” (voters aged 50+) carried the referendum to victory over the younger, more progressive population. We also know that Scotland and Northern Ireland strongly voted to remain in the EU. This growing discontent within the United States’ strongest ally, and the uncertainty about its future, has every major financial institution and market on edge.
While many are focusing on the direct implications of the referendum vote, second order implications (indirect but related) have also entered the discussion. Of specific concern is the risk of contagion, or this type of movement spreading to other parts of the European Union:
- Within the UK, Scotland, whose citizens overwhelmingly voted in the referendum to remain in the EU, is considering its options; including seceding from the UK which it had previously attempted to do.
- Sinn Fein, the far left party in Ireland, is calling for the reunification of Ireland.
- In France, Marie Le Pen, head of the left wing National Front Party, has called for a referendum on France’s continued participation in the EU.
- Populist parties in Denmark and Sweden all favor similar referendums.
- In our opinion, the most significant risk in a further deterioration of the EU lies with Italy. According to Christopher Wood’s Greed & Fear newsletter, since 1999, Italy’s real GDP has grown a paltry 5.4%, even trailing Japan’s lackluster economy, which grew 14% over the same period. The dissatisfaction of Italian citizens with their lot in life is palpable.
The fragility of the EU needs to be, and likely will be, front of mind as the EU negotiates the UK’s exit. Offering too favorable terms could entice other EU members to follow the same path, while taking too hard a stance could damage the economies of all involved.
Will Brexit Ever Happen?
While the voters have sent a clear message, the idea that Brexit is inevitable is looking less and less likely. As the new reality begins to set in, we are starting to see a number of strategies emerge for blocking, or at least pulling back from a full blown exit from the EU.
The referendum was not binding, meaning that Parliament could choose to ignore the will of the people and block the triggering of Article 50. This would, of course, be a political nightmare and is unlikely to occur, but it is possible.
Another scenario that has been talked about is a second referendum to override the first. In short, a do-over. Most informed sources say that this is unlikely in the immediate term, as it may backfire politically with the 52% of the country that elected to leave.
On Tuesday, Former Prime Minister Tony Blair said that he felt a revote was unlikely, but left the door open slightly saying that he believed nothing would change unless there was clear evidence that the vast majority of citizens were against it after having seen the ramifications.
A more likely scenario is that the UK will begin the process of exiting the EU, and as the negative ramifications of the move become more evident and concrete, public opinion will turn against the Brexit – giving enough political cover to either have another referendum or for Parliament to block the exit. This approach would also likely buy the UK some time with Scotland and Ireland. This idea seems ideal, but has its own challenges.
Who will lead Britain?
David Cameron will not remain in office until October as he has pledged. The Tory party announced that his replacement will be in place by September 3. The question of who replaces him will be pivotal to the future of the Brexit movement.
The two current front runners are Boris Johnson, the most prominent Leave campaigner, and Theresa May, a Remain supporter. If Johnson is elected, the emphasis is likely to remain on exiting the EU. If May is given the job, she will likely take a more cautious approach.
When will the UK pull the trigger on Article 50 and can it be taken back?
The EU is calling for the UK to trigger Article 50 as soon as possible to avoid a prolonged period of uncertainty. David Cameron has said he will not trigger it before his departure, effectively handing it off to the next Prime Minister.
The EU cannot compel the UK to trigger the Article and there is no clear answer on whether it can be repealed once it is triggered – it is simply untested.
So the question before the government of the UK is – Do we trigger Article 50 and start the process formally, or do we have a round of informal negotiations with the EU before it is triggered? The goal here would be to generate as many negative ramifications as possible to help sway public support away from a Brexit.
The answer to this question will almost certainly lie with whoever is elected the next Prime Minister. If Johnson is elected, we will likely see a faster triggering of Article 50. If May is elected, the approach will likely be more cautious.
Most agree, however, that the more time that elapses between the referendum and the triggering of the Article, the less likely it is that it will ever be triggered.
Will the European Union Play Along?
Even if Parliament elects Teresa May (or any other Remain supporter) and takes a more cautious approach to the process, we cannot forget that there is still another party in this divorce.
Imagine telling the world that you want to divorce your spouse, publicly highlighting all of their faults and flaws, and then whispering “Hey, lets go to marriage counseling and talk about this. I’m not sure it’s what I want, I just can’t let everyone else know it’s not what I want.”
That is essentially what the UK will be asking the EU to do. The UK will want to delay a formal exit conversation and the EU will want to expedite it.
Not surprisingly, many of the EU’s most prominent members are already calling for the United Kingdom’s swift exit. One can almost see the EU throwing the UK’s metaphorical belongings into a giant heap on the front lawn.
Fortunately, buffeting these calls for a swift exit has been German Chancellor Andrea Merkel, who is advocating a calm and deliberate approach. Ultimately we expect that the influence of leaders like Merkel will quell the (somewhat justifiable) negative sentiment coming from the EU.
Impact on the Markets
From an investment perspective, while the near term and longer term impact of these events remain uncertain and will keep the world’s investment markets on unstable footing for the remainder of 2016, consensus in several areas have begun to emerge.
The Brexit has given the US Federal Reserve the cover they need to hold off on raising rates for the remainder of 2016. After raising rates in December 2015, the Fed indicated that five additional rate increases were likely in 2016. However, they soon realized that the economy was not on solid enough footing to justify those increases. With no rate increases through June, they were losing credibility as each month passed.
Brexit gives them the ability to put any future rate increases on hold without repudiation.
The dollar, viewed as a safe haven in times of uncertainty, has strengthened as a result of the Brexit. Raising rates will further strengthen it. A further strengthening of the dollar would reduce the demand for our exports as they become more expensive to foreign purchasers. This, in turn, hurts our economy.
Expected Impact on the Markets and Investment Returns
Immediate Term – Next 3 Months
The immediate impact of the Brexit vote will be market volatility. We witnessed this on Friday and Monday and we expect this to persist into the months ahead, as investors digest new information.
This volatility is likely to be enhanced as institutional investors and hedge funds adjust their portfolios to reflect to potential change in the relationship between currencies and assets. With little factual information available as the EU and the UK work through the particulars of the exit, investors need to remain focused on the longer term and avoid the temptation to react to headlines.
Intermediate Term – Next 12 Months
We are in uncharted territory and we expect opinions and positions to change as the concept of “exiting” sinks in. The world’s central banks are on alert and have pledged to add liquidity to the system so as to avoid a repeat of the panic surrounding the Lehman failure in 2008.
This will help mollify the impact on the US and Global markets. Volatility is expected to persist over this time and could be accentuated if there are near term economic implications that result from the uncertainty.
One concern we have over this period is that consumers and, as importantly, corporations curtail spending and investment as they await a clearer direction. We believe the odds of global recession have increased. While the US is in a better position than most, it is not immune to this risk.
There is also direct impact to US companies who utilize the London as their gateway into the EU. London is unlikely to retain its status as a Global Financial hub, requiring many US financial institutions to reconsider their strategies. This, and the fact that further rate increases are unlikely this year, was one of the major reasons why US financial stocks experienced their worst day on Friday since 2011.
Longer Term – Beyond 12 Months
Given the wide range of potential outcomes, predicting the long term impact is difficult. It should go without saying that a further weakening of the EU and/or a contentious exiting process would create a negative environment surrounded by uncertainty, while an amicable exit combined with a strengthening EU would be the closest to the current environment. As the exiting process actually takes shape, we will be monitoring the potential impacts for both opportunities and risks.
Did LAMCO take any steps in advance of the vote to adjust portfolios they manage?
No. While we spent significant time analyzing the impact of a “Stay” vs. “Leave” vote, there was a lack of consensus as to which side would prevail. Polls of voters prior to the vote showed a dead heat, while odds makers favored a “Stay” vote. Early voting results also favored “Stay” by a margin of 52% to 48%, the exact opposite of the actual ending tally, 48% to 52%. We do not make portfolio decisions when the odds of being right are no better than the odds of being wrong.
What adjustments are you making now?
As you are aware, the portfolios we manage have been defensively positioned for the last two years. Our concerns about expensive valuations, soft economic growth, excessive central bank intervention and macro risks such as this have weighed heavily.
We are remaining defensively positioned for the time being while also attempting to identify opportunities that result when assets become mispriced during market dislocations such as this. In particular, European stocks appear inexpensive relative to US equities, with a P/E ratio of 13x earnings, which is significantly lower than the S&P 500 which trades at 17x earnings. While we are not making any immediate adjustments, our curiosity has been piqued.
It is also important to remember that the Brexit will impact companies differently and a one size fits all approach (ie. embracing or avoiding entire regions) is an oversimplification. For example, Scotch manufacturers stand to benefit from a weakening Pound Sterling (the UK currency) which makes their exports less expensive, potentially increasing sales. On the other hand, luxury German auto manufacturers depend on the UK for sales. Given a possible contraction in the UK economy and the potential for tariffs, gross and net revenue could come under pressure.
Despite the dramatic events that took place last week, the UK is still part of the EU and will likely be for the next 12 – 18 months. As the markets open this week, little will have actually changed. Over the coming months, however, we expect governments, corporations, and consumers to alter their behavior in preparation for the actual exit as more and more of the unknowns become known.
Trying to predict how this will unfold is like trying to guess the conclusion of a novel by reading the first chapter. Europe, if not the world, is at a cross roads. This situation is a painful reminder of what can happen in the absence of true leadership. When a large enough population of people feel their voices are not heard it opens the door to opportunistic individuals who will use inflammatory rhetoric and mistruths to inspire populist uprisings.
Unfortunately, there is only a tiny but critical difference between a true change agent and an anarchist, and voters can’t always tell the difference.
What the UK, Europe, and the World needs now is genuine leadership – reasoned, collaborative leadership. Unfortunately, reasonability and moderation are not characteristics typically associated with politicians, especially not those who lead populist uprisings.
This is an entirely politically created problem and therefore, how it will be resolved will only become more evident once the immediate emotions subside and we know who will be steering the ship.
We believe that the EU and the UK have an opportunity to push Europe forward as a result of this referendum. What happened in the UK could have happened in any other European country right now…. therefore the EU might be wise to use this as an opportunity to address the things that are making people feel this way.
If the EU and UK approach this situation in a collaborative fashion, positive reforms to the EU may be possible, and the impact of a Brexit would be minimized. However, if the focus of the parties is the destruction and misery of their former partner, everyone, including the United States, stands to lose.
Governments and politicians around the world – specifically in the United States – should take careful note of this situation and work to resolve the underlying problems of government before a populist uprising forces the issue to be addressed in a hasty, contentious and economically damaging fashion.
If you have any immediate questions, please feel free to contact us.
Written by: Mark Lamoriello, AIF®, President/Chief Investment Officer and Andrew Zito, AIF®, Executive Vice President, Retirement Plan Services