Weekly Economic Update: Post-BrexitJune 29, 2016
The British are leaving! The British are leaving! – Maybe. Friday provided a profound shock for the financial markets as the UK voted to leave the EU in the Brexit referendum. Over the past week, following the assassination of Labour MP Jo Cox, polls had shifted from favoring Leave to favoring Stay – right up until the last polls before voting. Indeed, even UKIP party leader Nigel Farage was indicating Thursday that Stay would scrape out a victory. The unexpectedness of the outcome generated substantial volatility and market angst in part because over optimism had led some to exit protective positions and they were forced to run to cover. What we learn from this is that predicting the future is never easy. Now economists have both weather forecasters and pollsters to joke about.
Are the British leaving? Prime Minister Cameron is. He only held the referendum to fulfill a campaign promise to the hard right of his party – and campaigned to stay. After losing, he indicated that the decision to exercise Article 50 – the formal request following the approval by the UK Parliament to leave the EU – and the subsequent Brexit negotiations should be handled by new leadership. He suggested he would help stabilize the markets and pass the baton no later than the Conservative conference in October. Note, picking a new Prime Minister does not require a new election in the UK as the Conservatives remain the party in power, as they were elected just last year.
We doubt Cameron will last more than a few weeks. If the financial markets remain weak or volatile, he will be pushed aside in favor of a new broom. If they stabilize, Boris Johnson, the former Mayor of London and leader of the Leave campaign, will want to consolidate his own elevation to Prime Minister before others can rally supporters to back their election. Either way, maintaining a lame duck position is unlikely to benefit anyone – including Cameron.
Yet, prospective Prime Minister Boris Johnson in his initial victory speech indicated there was no rush to exercise Article 50. Note that his power base is as the former Mayor of London – a region strongly for Stay – and many have argued that his decision to back Leave was purely political as a path to Prime Minister. Regardless, he now is very much like a union leader who now has an affirmative strike vote in his pocket, and so hopes he can bargain from a position of strength with the management.
So, let the game theory, begin. Negotiations require two or more parties to play, and each participant will attempt to maximize their outcome relative to all parties and for both the present and the future. Thus, the first issue is whether this is a repeatable game or a one and done situation. Many in the UK who voted for Leave do not appear to know the answer to this question. Google Trends top questions yesterday were: What does it mean to leave the EU? and What is the EU? Hmmm…. The easy answer is that if Article 50 is exercised a two year negotiation follows before actual exit occurs. Since no one has done this, it is best to assume that everything will ultimately be on the table – including the rules on whether the UK can rejoin, and under what conditions and subject to what vote by EU members.
In the short run, we expect all parties to adopt their most extreme positions. As noted, the UK already appears open to trying to use the threat of leaving to extract concessions that might allow it to stay. They threatened this in the past but didn’t have a vote in hand. The 52-48 victory is narrow, but so have many recent elections around the world after which a clear mandate was declared. On the other hand, the victory is narrow enough to allow backsliding and delay if concessions are forthcoming.
However, the management (the EU leadership) is already taking a hard line demanding quick, even if sloppy, negotiations. This is not unlike companies threatening to lockout if the strike isn’t called. It is unclear how much leverage the EU has to punish the UK until a strike is called. In the meantime, they have to take a hard stance lest any of the several other euro-sceptic nations choose to emulate the UK. Think of an airline facing a pilot’s strike. Even if they wanted to settle with the pilots, they must consider their position with mechanics and attendants as well. Like recent events surrounding gun control in the US, the first positions are extreme and public while the real negotiating happens behind closed doors – yet may not always be fruitful. Given Europe goes on vacation in August, we expect little real progress until September.
This can stretch out for a long, long, time, like a trade negotiation, because so far nothing has changed. This is not a Lehman moment. There is no immediate disruption to economic commerce including banking and finance. Until Article 50 is exercised, it is buy the rumor without any facts. Rather, we are entering into a long period of gaming for advantage. One new variable is how long the negotiations can be strung out with the populous now backing Brexit?
Nor are the UK and EU the only players. Scotland has already indicated that it would part ways with England if a Brexit were to occur. Scotland voted a year ago to stay in the UK in part so as not to face an uncertain situation perhaps outside the EU. Subsequently Nicola Sturgeon, new leader of the Scottish National Party, was overwhelmingly elected – but committed to no new partition vote. Friday, Scotland voted Stay 62-38 – even stronger than London. Obviously well prepared for this event, Sturgeon immediately put patrician back on the table and sought to begin negotiations directly with the EU. Will Scotland leave? As they say, another country heard from.
Northern Ireland also voted to Stay, 56-44, but with a pro-British government currently in power the calls for separation are less likely to bring immediate change – or negotiations. The key issue is the open border with the Republic of Ireland. There is the issue of currencies, as the north uses the pound and the south the euro. More importantly is the impact on the flow of goods, as any open border will allow the UK to circumvent whatever agreements are made with the EU by transshipping through an EU nation. The Republic of Ireland is currently the fastest growing nation in the EU as it took the hard medicine after its bank debacle. Low tax rates and an open door to US companies seeking access to the world’s second largest trading block – in English – has lifted growth over 8% this year.
Ultimately, Brexit is a UK centric event with the ripples dissipating quickly as one moves away from that center. We do not believe it is a global event, though the special relationship between the US and UK will keep this discussion lively in our press. Roughly half of UK trade is with the EU and it runs a large trade deficit. The most immediate effect will be through currency, which plunged overnight but settled Friday at 1.37 – not significantly different than the 1.41 seen two weeks ago when Leave was leading. Many will argue that a weaker currency will boost UK sales. We expect only marginally. It typically takes a 25% devaluation against a competitor to make much difference. The UK devalued by that much against the Euro in 2008 to little effect because the pie was shrinking. We expect little growth in the pie near term, so you are not garnering more of the growth but rather trying to pry away existing sales. Individual firms will answer with discounts in their own currencies.
The more profound effect will come through asset markets as reflected in Friday’s market collapse. Compared to a year ago, the FTSE 100 is down 9% and the British pound is off 13% — making the average UK company 25% cheaper to buy than a year ago before Brexit started to become a reality. While the vote may have been to take back control of the country for the voters, the reality is that in our multi-national corporate world it is inviting foreigners to buy up the best future opportunities. We have argued many time before that devaluation is a horrible policy strategy. It forces everyone to work for lower wages on a global scale rather than identifying true underlying problems. All wealth in pounds just became worth 3% less Friday – more if it was in equities.
The hardest hit in the near term are the banks. Most UK and European banks were down 10% on Friday. This is a serious problem for a banking system that is already undercapitalized. The combination of increased uncertainty and capital inadequacy is likely to constrain lending and limit growth in an already slow growing environment. We do not think this is cause for concern about a recession, as there simply wasn’t much credit demand anyway. Moreover, we do not know of any companies in the US, UK or Europe that have been so optimistic in recent quarters and months that they have a surfeit of employees to let go and start a downward spending spiral. Rather, this development chops all of the potential upside off the EU economy and dooms them to no better than a muddle through a la Japan and US.
The blow back onto the US economy is likely to be limited by the fact that the UK is simply no longer a major trade partner for us. Roughly 4% of US trade is with the UK, and it represent 0.3% of US GDP. Certainly it matters for many individual business – but just as the recession in China in 2015 was barely felt in the US, a Brexit induced slowdown in the UK and even EU would be a smaller shock than the oil recession that is currently finishing up. The effects will be through asset markets rather than trade and jobs. There, it is the uncertainty on future rules and when we will know them that will have the greatest effect. No one likes to run into a dark room fast.
One clear winner in the US is likely housing. The flood of fresh money into the US pushed 10 year rates down to 1.56%. US housing and autos did not need another twenty basis points of stimulus. We were in Houston a week ago. It should be the weakest economy in the US – but it does not appear to be in recession (borderline). Then we were in Boston – which is on fire. Bottom line, with consumers starting to borrow, stronger credit demand here at cheaper rates should offset any weakness from ongoing weak investment.
The US press will be full of stories (but not news) about the consequences of the pro-populist Brexit vote on the odds of a Trump election. One thing is clear, polls once again missed the emotion of this issue for lower income and elderly voters. Were they underrepresented in polls? This is critical as we do not see the US elections over the next four months as a contest in convincing undecideds to vote for one of two very undesirable candidates. Rather it will be a contest in turning out more actual voters already dedicated to a candidate. The most recent polls (according to Real Clear Politics) have Clinton up by 6 – with 45 percent of the vote to 39. First question, where are the other 16% of voters? Adding in fringe candidates brings Clinton to 42, Trump 37, Johnson 7 and Stein 5, with 9% still probably going to skip the whole thing.
Until Thursday, Donald Trump had probably the worst month any candidate has ever had. From the judge, to Orlando, to an inability to raise money, and staff issues he was cudgeled in the press even by the conservatives. Yet he was down only six points to Clinton and dead even in PA and OH, two critical swing states. Thursday, the Supreme Court failed to support President Obama on immigration and Friday we had Brexit. In between, Trump forgave the $50 million he owed himself for his campaign clearing the way for fundraising. Hard to count him out yet. Meanwhile, Clinton saw her unfavorable rating climb steadily from 50 in December to 55.6 today. She is only fortunate in that Trump’s are higher at 57 in December and 61.1 today. Over this same period, President Obama’s popularity has climbed from 43 to 50.6. You can’t make this stuff up. The most likeable politicians are those that are no longer running.
The preceding is an abridged version of a commentary for McVean Trading and Investments, LLC and has been reposted here with permission of the author.
The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.