Brexit – Overrated?
Defying most predictions and polls, Britain on June 23 voted to leave the European Union (EU). Choosing independence over economic and financial uncertainty, global markets reacted violently. At the epicenter the British pound fell 11% intraday against the US dollar, setting a 30-year low, and 5% against the euro. At its low on Monday, the S&P 500 was 5.6% below its close on June 22. US Treasury yields fell across all maturities as foreign funds sought safety. By close of the market on Monday, the Volatility Index (VIX) dropped from 26 to near 20 as equities firmed. From the lows until the close on last Friday the S&P 500 regained almost all losses from the Brexit shock. While this rapid reversal surprised most doomsayers, a note from S&P Capital IQ found “that shocks normally cause stocks to bottom in six days or less, with a median drop of 5.3%. The fourteen shocks since WWII took a median of 14 days to recover all of its losses.” Investors should not be fooled by this rapid market turnaround. Uncertainty remains and traders stand ready to take advantage of the summer doldrums. We remain cautious as 2Q2016 earnings season begins. (See Investment Policy)
Immediately following the vote, the European markets went into panic mode. Traders caught on the wrong side of the referendum quickly unwound or hedged their positions. Taking a page from the Sovereign Debt crisis, only negatives were discussed in the media and financial blogs. Mention of a global slowdown and a European recession was a logical consequence. Little or no mention was given for the timeline for the exit or for any potential negotiating leverage by Britain. As the market rallied, it became more apparent the problems are European centric and largely Britain’s. The process will take at least two years from the irreversible notification to withdraw as set forth in Article 50 of the Lisbon Agreement. The Article also allows extensions. Against the wishes of the EU leaders to move swiftly, the UK will wait until a new Prime Minister is chosen. Piling on, Moody’s and Standard and Poor’s downgraded the UK sovereign debt on Monday June 27. The likelihood of a recession in Britain is high, but Central Banks are tailoring intervention. The Bank of England is set to cut interest rates and the European Central Bank (ECB) stands ready to introduce more stimulus. The Federal Reserve has already stepped back from raising rates pending the outcome.
The current risk to markets is not the “what or when” the agreement between an independent Britain and the EU is reached, but rather the political posturing and its effect on economic growth. Britain is rudderless at least until October. By the time a new Prime Minister is chosen, the country may already be in recession. For the EU there is declining member support in country Parliaments and among the general EU population. This fragmentation underscores the potential that other countries may exit the Eurozone. Greece is at the top of the list along with Austria, France, Italy and the Netherlands. Currently, there are no signs of contagion, as protest parties must first assume leadership and only then initiate a process culminating with a referendum. The political risk premium will be in the market until formal negotiations begin and to a lesser extent, as the long, long exit process continues. For investors, the risk will remain in Europe, but recent history has shown European problems are somehow always perceived as global.
Pushing aside the politics of London and Brussels shows a declining portion of world trade attributable to the EU. Needless to say this is due to the growing role of developing nations, primarily China. According to the US Census Bureau, in 2015 the UK was 3.8% of the Total Export Value for US Goods. A slowdown or
recession in the UK would barely move the needle for US growth. Imports from Britain, which now are
cheaper given the relative strength of the dollar against the pound, are 2.5% of US imported goods. It is quite
possible that this number will rise as additional cheap imports create value for US consumers. Inside the EU,
according to Eurostat, Britain is the third largest importer and the sixth largest exporter. Only France and
Germany are bigger intra-EU importers. Britain will highlight in the negotiations that 54% of their imports are
from EU members, while exports account for 47% of total EU exports. The EU has an ongoing problem that
may tilt the scales during negotiation more to Britain’s favor than is generally anticipated. Economic
stagnation has reduced the value of leading EU companies. Of the 50 largest companies by capitalization in
2015, only seven are European, compared to 17 in 2006. US companies lead with 31 and eight are Chinese.
Against a diminishing role for the EU, how ready is Brussels to forsake Britain’s size and stature? For now,
trade is second to a unified EU. The opposition is led by a broad consensus in Germany not to grant the UK
single market status (unfetted access to EU markets, also known as the Norway Agreement). Even if there is
any possibility it would come with a “freedom of movement” acceptance, an anathema to the “Leavers.”
According to the most economists, financial services are the most vulnerable to Brexit. This problem is limited
at this time to Britain. Most troubling is that financial firms in London will no longer easily serve EU members.
Companies with offices within the EU have “passports” enabling them to do business with any other EU
country without setting up local branches or subsidiaries. According to “TheCity UK,” there are 250 foreign
banks and 200 law firms in London, most of which are doing business via passports. For US banks, the
question is where is the office now headquartered in London to be located? JP Morgan warned that up to 25%
of the jobs in Britain will disappear. Sounds bad, but this equates to 1.7% of the current 237,400 total
employees. Morgan Stanley is rumored to be moving 2,000 investment bankers to Dublin and Frankfurt.
Goldman Sachs, with 6,000 of its European staff in London, already has a presence in Frankfurt. The shift to
Ireland and the Netherlands has been mentioned by global banks as preferable to Germany or France, because
of more flexible labor laws. The mechanics of the shift are clearly set out and for US financial institutions, the
two year clock, when started, should give ample time for a smooth transition. Meanwhile, Britain is faced with
the possibility that it may no longer be the financial capital of Europe.
Our investment policy is short-term cautious as the effect of Brexit works its way through the financial markets. Today, there is no reason to be overly bullish or overly bearish. Markets will resolve the problem and a buying opportunity will result, but for now “Sit and Wait.” The seasonal light volume of summer with the concentration of money in large traders (algorithmic and hedge funds), periods of volatility are to be expected, we view any selloff as a buying opportunity. The transition into a more consumer-oriented economy is on schedule but not fully reflected in corporate aggregate earnings. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap Consumer Discretionary and Technology companies. Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends. We would avoid companies deriving substantial revenue from Europe.