§ PERSPECTIVES ON THE UK -- The UK accounts for 13% of the EU’s population and about 15% of its economic output. To put this into perspective, Brexit would be akin to the entire Northeast region of the United States, including the financial hub of New York, choosing to secede from the union because they pay a lot more in taxes to the center than the benefits they receive in return. The key issue is that while the British people are aware of the pros and cons of being in the EU (at least on the face of it), there is considerable uncertainty about the counterfactual, i.e. what British life would look like outside the union.
§ HOW THE UK GOT HERE -- Membership in the EEC was in fact put to a referendum (the current Brexit vote is not the UK’s first official poll on EU membership) in 1975, and was overwhelmingly supported by 67% of the British public. Since the 1970s the UK has had an uneasy relationship with the EU. On February 7th 1992, UK Prime Minister John Major, signed the Maastricht Treaty along with leaders of eleven other members of the European Council, essentially creating the European Union and the Euro currency (which Britain opted out of). The Brexit vote is a direct result of Prime Minister David Cameron’s promise in January 2013 that, if his Conservative party were reelected in the May 2015 elections, he would renegotiate Britain’s membership in the EU and hold an in-out referendum by 2017. While Cameron did attempt the renegotiations after his re-election, a final deal was elusive, and on February 20th of 2016 he set June 23rd as the date for the referendum.
§ ECONOMIC INDEPENDENCE -- Another argument being made is that the UK has reached a point of economic strength and confidence relative to the EU that makes it possible for it to thrive, let alone survive, unencumbered by EU institutions. Since the second quarter of 2009, after the Financial Crisis, growth in the UK has been comparable to growth in the US, and significantly higher than overall growth in a Euro area crippled by austerity and seemingly jumping from one crisis to the next.
§ NATIONAL SOVEREIGNTY -- The idea of restoring full national sovereignty to Britain as opposed to living under the auspices of a supranational European council - especially one that cannot directly be removed by the British electorate if they so desired, unlike in a more democratic system. By leaving the EU, the UK would regain control over various aspects of social and economic policy that were ceded to the European Union under the terms of the Maastricht Treaty.
§ TRADE AND ECONOMY RELATIONSHIPS BETWEEN THE UK AND EU – European Union countries remain the chief export destination of British goods, absorbing about 51% of the UK’s export volume. Note that exports made up about 28% of UK GDP as of 2014. Since 1973, the UK has benefited greatly from membership in the European single market. Under its rules, goods can move freely between any of the twenty-eight member states, unhindered by tariffs and other barriers. By proxy, the UK also profits from the fifty trade agreements the EU has signed with nations outside Europe. In the event of an exit, the UK must either negotiate a comprehensive Free Trade agreement (FTA) with the EU, or engage with the single market under WTO rules. If Britain is unable to secure a deal with the EU, it will be forced to rebalance its exports away from Europe and towards the United States and other large markets like India and China. Thus, the future of the UK economy heavily depends on the adoption of a liberal, post-exit trade policy, as well as on reaching some sort of an agreement with the EU. The UK should not expect any good will or compromises (again, as in the case of Greece), if they choose to leave.
§ SETTING A PRECEDENT -- The idea is that Britain, or any other member state, entertaining the notion of leaving the EU sets a dangerous precedent and must be made an example of with devastating consequences. Germany, and perhaps even France, it seems, will have no qualms about employing the EUs set of economic weapons to ‘punish’ Brexit. At the same time, this is exactly the sort of rhetoric that will continue to push the UK further away - if not now, then at some point in the future. If the UK were unable to strike a deal with the EU, they would find themselves facing an incredibly uncertain economic future. Under such a scenario, there would be even more pressure to pursue free trade agreements and deregulate extensively. Of course, this would be a struggle.
§ FUTURE ECONOMIC ESTIMATES -- All of this points to an alarming truth about the British economy. If cut off from the EU’s single market, it possesses very little bargaining power in the international trade environment, and will need to undertake substantial reform in order to be competitive. The Economist Intelligence Unit (EIU) estimate that the economy would experience at least a 1% reduction in 2017, and that by 2020 the nation’s GDP would be 6% smaller than it would have been had it remained in the EU.
§ HASHING OUT THE TERMS -- the UK will continue to retain the benefits of membership for two years to hash out the terms of a divorce. This prevents the possibility of an abrupt, hard restructuring of the economy, mitigating adverse economic effects as firms, households and markets adjust their expectations over the interim period. At the same time, members of the EU will be reluctant to make things easy for Britain. They will in all likelihood reject any proposal to allow the UK to remain in the single market without continuing to maintain an open door pass for EU citizens. This will obviously create political havoc in the UK, especially since a prime motivator for Brexit is closure of the very same door. Not having access to the single market will also have dire consequences for London’s status as a financial center. This is a key reason as to why business services and the finance sector were in favor of Remain amongst industries, while construction, agriculture, forestry and fishing are most in favor of leaving.
§ IMPACT ON CAPITAL MARKETS -- In February, after the date of the referendum was announced, the pound fell to a seven-year low against the dollar. Since then, the currency had rallied on market expectations that Britain would vote to remain in the EU, but the Leave result has induced a further significant drop in the pound. UK’s FTSE 100 saw a drawdown of more than 7% between April 20th and June 14th, a period in which Leave gained significant momentum. Only about 25% of companies listed on the FTSE 100 come from within the UK, the rest are multinationals that will benefit from a devalued pound. Bond yields across the world have continued to plunge, as investors look for safe assets amid increasingly pessimistic views on the global economy and the ability, or rather inability, of Central Banks to provide sufficient and/or effective monetary stimulus. While investors are worried about the implications of Brexit on the UK economy and trade relations, these concerns do not extend to the full faith and credit of the UK government to repay its bondholders.
§ MONETARY POLICY -- The Bank of England issued a fresh warning on Thursday, June 16th, saying that Brexit could result in the UK sliding into a recession. The central bank said that spending has already reduced over the threat of the UK leaving the EU. Lower spending can subsequently lead to lower demand for labor and raise the unemployment rate (currently at 5.1%). Governor Mark Carney warned that Brexit could send the pound sharply lower, raising inflation and unemployment. The Bank of England was already in the process of implementing contingency measures in the event of Brexit. The central bank plans to hold additional auctions of sterling to ensure that the banking system has enough funds to operate under that scenario. The UK is also facing its largest current account deficit in peacetime since 1772, standing at 7% of GDP at the end of the first quarter of 2016, versus 5.2% for all of 2015.
§ POLITICAL IMPACT -- The other issue is that of Scotland, which is significantly more proEuropean than the rest of the country. We may well see another push for independence should Brexit occur. The last referendum for Scottish independence, held on September 18th 2014, ended with 55.3% voting against it. However, the result may be different if Britain chooses to severe ties with Europe. In any case, the political turmoil promises to be considerable, along with a not insignificant likelihood of the United Kingdom itself breaking up, with Scotland eventually choosing to go its own way. European Union laws course through several veins of British law currently, including immigration, asylum, employment, agriculture, competition, regulation and environmental laws and standards, amongst others. These laws touch every facet of life in the UK. A Brexit vote will not instantly extricate the UK from this web of influence. In a recent report on Brexit, Lord Bosewell, chair of the House of Lords EU committee said:
All this would have to be done without creating a slew of new legal vacuums. EU provisions, including standards and regulations, will have to individually reviewed and subsequently retained, amended, or repealed. All the while keeping in mind that Britain’s largest trading partner would continue to be the EU, at least in the short to medium-term.
§ WRAPPING IT ALL UP -- Britain leaving the EU may well emerge as one of the most consequential events in recent history. Post-withdrawal, Britain is likely to experience difficult structural transformations that will almost certainly contract economic growth in the short-term. The labor market may well face significant constraints if a new immigration policy that is more restrictive is enacted. Trade relations will also have to be rebalanced, causing considerable chaos and uncertainty for business in the UK, and for Europe as well. We discussed scenarios that lay out the multiple routes Britain’s political economy could take with respect to their relationship with the EU and the rest of the world.
Investors Should Keep a Very Close Eye on These Areas:
1. Continued Volatility. The days and weeks following the UK’s decision to pursue an exit from the European Union will certainly test investors’ tolerance for risk, as global markets try to digest what the impact will be of a UK departure. While the majority of investors claim to be “long-term investors”, the re-introduction of volatility into the markets and ultimately their portfolios will test their resolve to maintain their course. Buy-and-hold or long-term investors should take note that in times of crisis, correlations across numerous asset classes become closely correlated, so the asset allocation approach that was thought to be the only risk management process needed may disappoint. Integrating investment approaches designed to reduce volatility by moving to a cash position or taking inverse positions to hedge current positions could significantly improve the likelihood of investors stomaching such events and staying committed to their investment plan.
2. Currency Fluctuations Will Have a Wide-and-Far Impact. Commodity prices, which tend to move in the opposite direction of the dollar, could fall and emerging market stocks, fueled by concerns about dollar-denominated debt plus tighter financial conditions, could weaken. But gold, unlike industrial commodities, should gain firm support. Owning commodities in your portfolio is not enough in and of itself. Investors must know which commodities they own and which will benefit or suffer from actions in the global marketplace.
3. International Investors are Officially on Notice. Brexit is very bad news for the UK economy. It is bad news for the euro area as well. Investors should not be surprised to see the UK to quickly enter recession. Some analysts expect Brexit will shave 0.5% to 1% off European GDP. Investors with exposure to Europe should look to evaluate the role of these positions within their portfolio. Whether it’s scaling back in position size, moving to a temporary cash position or implementing hedged positions to better protect existing positions, both European equity and fixed income investors should explore ways to protect their portfolios – if they’ve not done so already.
4. Low Rates are Here for the Foreseeable Future. The Bank of England is expected to cut rates at least 0.25% and could possibly renew bond purchases in an effort to avert recession, according to many analysts. Uncertainty will likely be prolonged. Downside economic risks are large, so the ECB and Federal Reserve are also expected to maintain low rates. The Fed released a statement noting it is “prepared to provide dollar liquidity through its existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for the U.S. economy." Don’t expect the Fed to raise rates in July, maybe not even this year, but do expect continued low interest rates and bond yields.
Investors have moved into the fixed income asset class in groves over the last few years in a flight to safety. However, many of these investors do not realize the amount of risk they are taking for the “perceived safety” and meager future returns of these assets. Owning fixed income assets today requires investors to protect themselves from multiple threats, such as credit risk, default risk, interest rate risk, liquidity risk and ultimately reinvestment risk. Utilizing tactical approaches in today’s fixed income environment is essential for protecting capital and not being devastated from a traditionally “safe” alternative.
5. SPILLOVER EFFECT. The reaction of U.S. stocks, especially financials, could play a big role in the overall impact of Brexit on the U.S. economy. The keys to whether the U.S. economy is affected significantly will be whether equities tumble enough to have a major impact on business and consumer confidence and whether banks are affected such that they pull back on lending. The significant drop in U.S. stocks the day following the UK vote was enough to put the S&P 500 back to where it was in mid-May and negative for the year. While the Brexit event had an immediate and large impact on global equities, events like these can quickly disrupt investors’ portfolios in a negative way. While events like these happen a low percentage of the time, the amount of destruction they can bring to a portfolio can happen before investors know what has hit them. Investors who cannot stomach large drawdowns in their portfolios should always look to manage risk first and produce returns second. Many times, it’s the management of risk that will produce the often satisfactory rate of returns over the long term.
6. Opportunities Still Exist. Unfortunately, there has often only been two camps in the investment world – Buy-and-Hold and “Under the Mattress”. The one ends up being a byproduct for those that cannot stomach the other. Modern Portfolio Theory places a huge emphasis on asset allocation and diversification. In that, over time the utilization of the most efficient asset allocation will produce acceptable rates of return given your stated tolerance for risk. However, there are times of volatility and principal drawdown during this approach that will test the stomachs and commitment of investors to “stay the course”. Upon being tested numerous times, and often times with less investment principal than which they started, some investors move over to the “Under the Mattress” side of investment approaches.
There are successful investment approaches that have typically been reserved for the wealthy individuals, endowments and institutions of the world that are now available to the “common” investor. These approaches utilize strategies that focus on risk management first, can deliver a smoother and less volatile experience and produce attractive rates of return. These approaches seek to exploit numerous opportunities in the markets – regardless if the markets are going up, down or even trending sideways. At Horter Investment Management, we refer to these as tactical strategies. We utilize these strategies to help our clients stay committed to their investment plans. Through low risk and lower volatility, our clients enjoy a much more enjoyable experience than the traditional “balanced” or buy-and-hold approach. Speak to a Horter Investment Management Financial Advisor today to see how these strategies can help you navigate today’s challenging markets.