What does the vote to leave entail for investors? The result could leave the UK in an isolated position. The lower value of Sterling is already starting to push up inflation given the amount of goods we import. Politicians will need to minimise the negative impact of the new need to develop 40+ years of economic and trade legislation.
Does leaving the EU entail more risks for Britain than opportunities? We are about to find out. What’s already clear is that the risks will be priced very quickly, whereas the opportunities remain in the distant future. The Pound has already collapsed and stockmarket volatility has exploded to historic proportions. Brexit was a shock - while most thought the vote would be close, I had not come across one serious political analyst or academic expert who thought Brexit would actually succeed. The betting odds on the day before the referendum implied a 90% probability of remaining. The scale of the shock is comparable to Trump’s successful run for the Republican nomination, and highlights a growing discontent among populations worldwide with the establishment. Will this popular movement end in political upheaval, or will it fizzle? The European stockmarket fell more than the FTSE on Friday, suggesting investors already fear that Europe will be next to rebel, once again threatening the break-up of the Eurozone.
Our portfolios have remained relatively stable, their foreign assets benefiting from the weakness of the Pound. The gains on foreign currencies have, so far, more than offset the losses on underlying assets. The benefits of an internationally diversified portfolio are most powerful when the home currency is in the eye of the storm. As discussed below, it seems likely that foreign currencies will continue to be stronger than the Pound, stabilising the portfolios. However, unless events intervene, it may be some time before a significant appreciation in asset values can take place.
Brexit shock may take some time to ripple through the financial system. Quite apart from the resignation of the Prime Minister, and the increased likelihood of Scottish secession from the Union, the fact that Brexit entails a lengthy exit-negotiation with the EU means an awkward limbo for Britain and financial markets. During this period investors will begin to reconsider Britain as a stand-alone state, without full access to the world’s biggest economic bloc. Given the initial response of capital markets, investors are likely to see the threats more than the opportunities. And, in our modern world, it is the views of global investors that decide the success or failure of national projects, not our own.
Given the initial response of capital markets, investors are likely to see the threats more than the opportunities. And, in our modern world, it is the views of global investors that decide the success or failure of national projects, not our own.
There will be much talk of Britain’s trade deficit, the biggest among developed countries, and currently at a post-war peak. Put simply, Britain imports far more than it exports. It is said that Britain’s currency is dependent on the kindness of strangers: absent foreign investment, a trade deficit this large can only be remedied by currency devaluation. As the Pound depreciates those imports cost more, leading to inflation. Inflation can be combated by higher interest rates but, with our economy uniquely sensitive to interest rates via variable-rate mortgages, higher rates would hurt home-owners and slow economic growth. An economic slowdown would lead to an increase in government deficits. Such an increase would inevitably be debt-funded, but few foreign or domestic investors would be willing to buy that debt on the existing terms. Yields would have to go up or maturities shorten.
It’s possible that Britain could find substitutes for those imports from among its own producers and manufacturers. Ideally, Brexit would prompt a surge of domestic productivity, innovation and entrepreneurialism. But the timing of the Brexit process is against us: capital markets move instantaneously to price in risk, whereas an economically successful Brexit would take years of structural reform, planning and development. That surge of productivity might have to take place against a potentially difficult economic environment, the kind that deters entrepreneurs.
Little thought has been given to the scale of the Brexit process, but it is also against us. Her Majesty’s Government must now dedicate more resources to Europe than it ever did while a member. It is thought that Brexit will dominate even the EU’s vast administrative functions for the foreseeable future, so where is Britain going to find the legions of experts in trade negotiations necessary to handle an exit from the EU and consequent entry into a multitude of bilateral trade treaties? An increase in the size of the public sector seems inevitable. The UK risks being overwhelmed by the scale of a project that it has not had any time to plan for.
The trade negotiations themselves will be difficult, operating from a new, politically less powerful position. They would be doubly difficult if we are also operating from a position of economic weakness. We would inevitably have to make significant concessions to foreign manufacturers, leading to more unemployment in our own manufacturing industry.
Let’s not forget that trade treaties are not just about encouraging free trade - they are also about imposing constraints so that the free market cannot operate freely! All end up with some utterly absurd quotas, constraints or regulations (‘straight bananas’ in EU folklore). The Uruguay Round of the World Trade Organisation’s (WTO) negotiations took seven years and resulted in 22,000 pages of agreements. Each one of those ‘agreements’ was equivalent to a straight banana, deflecting free trade off its unfettered, natural path. The WTO’s Doha Round has been stuck for 15 years - that is the queue that Obama was referring to.
Senior figures in the European establishment want to make an example of Britain as a deterrent to other potential leavers. They want a tough deal, done quickly. This would be the wrong approach. The EU should seek to defuse the populist surge by acknowledging its democratic deficit. Certain issues (immigration being one) should be decided at a national level. Better for the EU to address that reality, devolve power on immigration back towards national governments and offer Britain an olive branch in the event of a second Brexit referendum. There is a precedent for this: the Maastricht Treaty was changed in 1992 to accommodate Denmark, following its rejection of the treaty in a referendum (a subsequent referendum approved the treaty). Such an approach would also make it easier to also give future potential leavers a second chance, bolstering EU stability.
Cameron unleashed the genie of ‘direct democracy’ in order to stifle rebellion within his own party. As a result, we are about to embark on a project that puts ourselves at the mercy of capital markets and risks the nation’s well-being.
A referendum is not the ideal place to debate complicated issues such as membership of the EU, something that has been 40 years in the making. EU membership is so entwined in our society that we can no longer define the issue clearly, let alone debate it at a national level. The public does not reward complicated explanations of the benefits and costs of state decisions. Cameron unleashed the genie of ‘direct democracy’ in order to stifle rebellion within his own party. As a result, we are about to embark on a project that puts ourselves at the mercy of capital markets and risks the nation’s well-being. Moreover, that project has just been rejected by nearly half of the electorate. This will create, rather than heal, divisions within our country. Brexit will not satisfactorily address the immigration issue, which is more driven by demographics and economics than politics. It will not ‘un-straighten’ our bananas. We hope that opportunities lie ahead but, for the foreseeable future, we have our work cut out managing the risks.
Chief Investment Officer
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