Here's a piece I ran this morning for Hedgeye's "About Everything." My bottom line is that markets have responded appropriately to Brexit: This is a big deal for both the UK and the EU. One can sketch many plausible scenarios for how this will play out, but most of them have risky downsides and none of them will resolve uncertainty anytime soon. You're welcome to watch the following Hedgeye Q and A I did on this topic earlier today.
Last Thursday's Brexit vote was high drama. In a game of sacrifice bunts, this was a grand slam. In a political universe full of evasion, compromise, and incremental process, we were able to witness a great democracy make a critical and (apparently) irrevocable choice having far-reaching global consequences.
Given the magnitude of this event, this issue of “About Everything” will be longer than usual. I want to offer readers an overview of all the economic, political, and market sequelae that are likely to issue from Brexit. There are many moving parts. We will start with the impact of Brexit on the UK and then move to its impact on the rest of the world.
Brexit and the UK
On Friday, Britain was in a state of shock. Brexiteers were jubilant. The Remain Camp was sullen. Yet whatever their mood, it gradually dawned on every Briton that their nation was entering a new and challenging era. “All these people careering around with their Union Jacks, jabbing their fingers in your face,” quipped Labor pundit Alistair Campbell. “Fine, you can have that, but there’s consequences down the track you haven’t thought about.” Well, let’s think about them. Let’s think about the quadruple whammy now hitting the UK’s economy.
Whammy One: Trade Shrinkage. An island nation with an entrepot economy, the UK thrives off trade. The UK’s goods and service exports amount to 28% of its GDP—of which roughly half (14%) goes to EU members. (That’s slightly more than total U.S. exports as a share of U.S. GDP.) A large share of this 14% is thrown into question by Brexit.
How large? No one knows. No one has any idea yet what sort of post-Brexit trading relationship the UK will be able to negotiate with the EU. One model (the Norwegian-style European Area Agreement), while minimizing trade losses, almost certainly won’t fly because it would require the UK to slavishly abide by all the EU standards and regulations the Brits dislike—only now with no voice to object. The UK is more likely to try to negotiate a totally new FTA (free-trade agreement, like the TTIP) with the EU. Or, if this fails, the UK will try to forge Swiss-style multilateral accords on individual sectors. And if all talks fail, the UK could still trade with the EU (and pay their tariffs) as just another WTO nation.
The outcome is thus utterly unclear. Even in a worst-case scenario, there will continue to be substantial trade between the UK and the EU. But even in a best-case scenario, many UK exporters will face hardships. Some will find themselves totally barred from the EU because they can no longer subject themselves to the EU’s regulatory process. Others may be forced to incur higher costs to demonstrate compliance with EU regs or to advertise, market, sell, or enforce contracts in a now-foreign economy. These costs may in turn cause global corporations to pull the UK out of their supply chains. For centuries, London (the City) has developed a reputation as a frictionless, low-cost insider and networker—able to provide top-notch financial and business services to clients all over the globe. That reputation will suffer if the UK’s financial “passport” into the EU is revoked.
Only time will reveal the bottom line. The Centre for European Reform did a careful, multivariate analysis in 2014 of the growth in UK global trade over the past 25 years. Their conclusion: Roughly one-third of the UK’s trade with other EU members can only be explained by the UK’s political integration within the EU. One-third of 14% is just this side of 5% of GDP. Sure, that has to be regarded as an upper estimate of what the UK might lose. But it’s also a really big number. Much of the recent FX fall in the pound is the market’s estimate of how much the UK will eventually need to cut its export prices and/or raise its import prices to balance its current account once it’s out of the EU.
Whammy Two: Capital Flight. The City of London (OK, along with Edinburgh, Leeds, and Glasgow) constitutes the undisputed financial capital of the EU. Fully one-quarter of all EU banking assets are managed by UK-based banks. London banks dominate the wholesale trading of euro securities. Within the EU, they account for 85% of hedge-fund assets and 70% percent of OTC derivatives trading. In FX trading and certain insurance lines, London is not just an EU leader, but a global leader.
It was once thought back in the 1990s that the UK’s refusal to adopt the euro would impair London’s financial supremacy. Didn’t happen. But Brexit? That’s another story. In no sector are EU leaders as adamant about strict regulatory and legal compliance as in financial services. From the perspective of Brussels, the trading wiles of “les Anglo-Saxons” must be closely surveilled. (Even before Brexit, for example, the EU was pushing hard on London to clear more euro-denominated trading in the Eurozone.) No way will the Eurocrats allow the City to do banking business on the continent under their own maverick rules.
And it’s not just finance. Let’s make the plausible assumption that the UK’s post-Brexit trade regime—whatever that looks like—will disproportionately injure the operations of UK-based multinationals that are partly or wholly foreign-owned. Again, these are mainly London-based firms that sell (or may want to sell) a full range of goods and services to EU customers. Consider that nearly 50% of foreign direct investment in the UK comes from other EU members. Consider as well that, under the EU’s Parent-Subsidiary Directive, these companies will no longer enjoy favorable tax treatment.
Or reflect on another fact: Fully half of all European HQs of non-EU firms (many of them U.S. firms, like Caterpillar, eBay, and Ford) are located in the UK. Typically, they choose London as a gateway for their EU operations. Post-Brexit, how many of them will want to stay? In nearly every survey, UK business managers overwhelmingly agree that Brexit will severely impact incoming FDI and foreign office location.
So let’s cut to the chase. That giant sucking sound you hear is the withdrawal of investment from the UK. According to Fortune, the London branches of five major U.S. banks are already planning to move 10,000 jobs elsewhere. According to PwC, eventual UK job losses in financial services alone will hit 100,000 by 2020. Across the board, firms are moving funds, reconsidering advisors, putting plant and office expansion plans on hold, and reconsidering their location options. There are exceptions of course. Many smaller, labor-intensive firms that export mainly outside the EU will see the fallen pound as a huge profit opportunity. They may thrive. Indeed, their success over time will put an FX floor under the pound. But for the big integrated multinationals—and certainly for financial firms—the overwhelming theme will be capital flight.
Whammy Three: Real-Estate Crash. London is not just another big city. It dominates the national economy. With 12% of the UK’s population, it accounts for 22% of the UK’s GDP. The UK’s global reputation in fashion, media, advertising, technology, law, and (as noted) business and finance is all centered in London. More to the point, nearly one-third of the UK’s three million foreign-born residents live in the London area. Many of these are highly paid professionals. Many others are wealthy emigres from all over the world who choose London as their residence of convenience.
Post-Brexit, as jobs are cut and investment is pulled, these immigrants are likely to lead the “Brexodus” out of London. They tend to be the most mobile and least attached to the UK by family or childhood. They also are the most likely to value London’s multicultural vibe, which means many will be put off by the new anti-immigrant mood of the Brexit-voting countryside. Just after the vote, London’s mayor Sadiq Khan (himself the son of Pakistani immigrants) tried to reassure London’s foreign born that “You are welcome here.” That may satisfy some. It won’t satisfy all.
In any case, the near-certain post-Brexit downsizing of the London economy comes on top of a real-estate boom that has buoyed London home and office prices over the last eight years. (It’s down a bit over the last year, but not by much.) Home prices in most of the rest of the UK are today only back to about where they were in 2007. In London, they are 40% higher than what they were in 2007.
London real-estate brokers report that demand started fading just as the odds of Brexit started rising. And post-Brexit they say that the bottom has dropped out of the market. Most FTSE 350 companies that specialize in anything related to home construction or real estate were down 20% to 30% on Friday. At long last, the London-centric UK real-estate market is blowing up in glorious fashion. This may be good news to any American looking to buy a townhouse in Chelsea. It may even bring grim satisfaction to many hinterland Brexit voters who probably agree with the Brussels regulators on this one point only: The City’s financiers are overpaid decadent scum. But it’s bad news for the UK economy, because it’s happening at just the wrong time.
Whammy Four: Paralyzing Uncertainty. Markets detest chaos. Just let me know how all of this is going to play out, traders will say, and I’ll take a position. But with everything in limbo, I’m out. Unfortunately, indefinite limbo just this side of hell is precisely what Brexit promises to deliver.
In principle, the leadership on both sides of the English Channel understands that political delay is economically destructive. At an emergency meeting on Saturday, the ministers of the EU’s six founding members, led by Chancellor Merkel, urged the fastest possible resolution of the UK’s departure. But according to the EU’s Constitution, the UK must first initiate the process by invoking Article 50 of the Lisbon Treaty. And the UK, well, the UK just can’t get around to it quite yet.
For starters, the leadership of both of the UK’s major two parties is in disarray. Pro-Remain David Cameron has just tendered his resignation as the Tory PM, which means the Tories will have to choose a new pro-Leave Tory PM (it will probably be Boris Johnson) to lead the negotiations with the EU. That will take two or three months. So Article 50 will have to wait at least until the fall. Meanwhile, Jeremy Corbyn’s leadership of the Labor Party is also up in the air. Depending on how all these top-dog issues are resolved, the House of Commons may feel they need to call a whole new election. That may delay pushing the Article 50 start button until the beginning of next year.
Oh, and did I mention that the Scottish Independence Party (SIP) has announced that they will refuse to take part in any Brexit proceedings until they are assured that Scotland will get another referendum on independence? Most Scots don’t want to leave the EU. And what about Northern Ireland? They don’t want to leave the EU either. (London, Scotland, and Northern Ireland voted for Leave; every other region in England and Wales voted for Brexit.) So the new PM may have to tell Brussels, s’il vous plait, we may need to resolve this minor matter of the total dismemberment of our nation before thinking really hard about Brexit. No timetable possible here.
But let’s be optimistic and assume that all the secession questions can be bypassed. Even then, another knotty timing issue arises—a sort of prisoner’s dilemma problem. Each side (UK and EU) knows that both sides would benefit from a quick resolution. But each side gains for itself by holding out until the other side makes concessions. Because the UK is the smaller party, it has most to gain by delaying.
What the UK wants to gain is very simple: a generous new FTA agreement that would grant it close to the same trading rights it has now—but without the need to comply with all those EU decrees it doesn’t like. Some EU commissioners, in fact, are worried that the UK may never actually invoke Section 50, and keep trading as before, but meanwhile have Parliament start striking down all the objectionable EU laws. The EU would then have to find some way to penalize the UK for its flagrant treaty violations. It could get really ugly.
But again, let’s be optimistic. Let’s assume that the two parties complete their negotiations within the two-year window envisioned by Article 50. So we’re looking at, say, January 2019 for all the final signatures. Would that be the end of it? Almost certainly not. Most scholars agree that a negotiated agreement would only settle the basic framework. Further negotiations lasting perhaps through most of the 2020s would be needed to disentangle Brussels and Westminster in every area of trade, finance, law, and security. Who knows? These negotiations may outlast the EU itself.
One last point. We’ve looked at these four areas—trade, investment, real estate, and uncertainty—in their basic order of causation. It’s the certain prospect of huge changes in the UK-EU trading relationship that gives rise to all the rest. But their timing in markets is just the reverse. Uncertainty is what initially motivated traders to sink the pound and move drastically risk-off since the vote. We’ll see the UK real-estate downdraft and personal capital flight play out over the next few weeks. Still later we’ll see changes in business investment. Fundamental shifts in trading patterns will show up last. Economics moves from policy changes forward. Markets move from expectations backward.
Brexit and the EU
On the day after the Brexit vote, many were surprised that the biggest stock market declines weren’t in the UK (FTSE 100 down 3%). They were in all the other non-exiting EU member states (most of them down well over 6%)—making this truly a negative-sum divestiture! To be sure, much of this difference is explained by the plummeting pound, which drained value from UK firms through FX markets rather than through the bourse. But the basic question is worth asking: Why are EU markets so traumatized by the departure of a member that constitutes only 17% of EU GDP?
One reason is that the UK runs a large trade deficit with the continent—meaning that it buys a lot more from the other EU members than it sells to them. Germany alone runs a $30 billion surplus with the UK. Seven EU members (many of them in central Europe) run a surplus over 1% of GDP. Hungary may specialize in scientific equipment. But only the UK can transform that export into a product and sell it through global supply chains. Now let’s see how well all this works with the pound down 10%. Ouch!
Another reason is that EU banks, and EU financial institutions in general, are doing poorly—weighed down by nonperforming loans and squeezed by Mario Draghi’s negative interest rate vice. EU finance ministers in Brussels may not trust the London financiers—but can EU corporations really keep functioning without them? Unclear. In Germany, there is some hope that Frankfurt, Hamburg, and Berlin can steal some of London’s banking business. Elsewhere, there’s not a lot of optimism. The EU’s continental members, moreover, are a lot closer to stall speed and possible recession than the UK is. The Eurozone may not be able to absorb a body blow, which puts extra risk on the downside for firms. (Japan, where the Nikkei plunged 9% on Friday, is also navigating near the macro edge.)
Yet the biggest reason why Brexit is setting off so many klaxon horns on the continent is frankly political. The EU leadership is deathly afraid that the UK example will spread like a contagion among other members. Few EU electorates have ever had a clear opportunity to vote on the current EU constitution. And today, with Eurosceptic parties steadily gaining strength, the voting public in several countries (including Greece, France, Spain, Germany, the Netherlands, and Sweden) express roughly the same level of disapproval of the EU as voters in the UK. Marine le Pen of France’s National Front (who now dubs herself Madame Frexit) is celebrating the UK referendum and is suggesting that France’s turn will be next. Other Eurosceptic leaders are similarly congratulatory, including the Italian 5-Star Movement, the Dutch Party of Freedom, the Austrian Freedom Party, the Danish People’s Party, the Swedish Democrats, and the German Alternative für Deutschland.
This poses a dilemma for Chancellor Angela Merkel, President Francois Hollande, and the other heads of the European Council. If they were just thinking about the health of their own economies, they would gladly give the UK vast concessions in order to quell the crisis quickly and get the global economy back on track. Merkel in particular has to be worried (as every German leader is) about her economy’s export performance. Yet if everyone knows that the UK can get a good deal, then the floodgates of Frexit, Nexit, Spexit, Auxit, Grexit, and all the rest would surely follow. So the EU figures it must be conspicuously severe with the UK for its decision to leave.
As Voltaire once wrote with his usual touch of irony (after the court martial and execution of a British admiral following his defeat in battle), some must be punished “pour encourager les autres.” In another context, the Austria-Hungarian empire was once said to be a “prison of nations.” The EU leadership caste is apparently trying to enforce a similar regime. In other words, yes, it’s important that the UK suffer—and that it is seen to suffer.
It’s revealing that the equity crash on Friday showed much steeper losses for Spain and Italy, over 10%, than for the rest of the EU. Nation by nation, the market is clearly tagging political risk. It’s also revealing that the main goal of Italy’s anti-EU 5-Star Movement is not so much to leave the EU as to set up a new (and presumably devalued) currency for southern Europe. Facing the united opposition of Germany and France, however, it won’t be long before Italy too (both left and right) opts for outright exit along with the others. As for Spain, Sunday’s election showed most of the electorate veering toward the conservative People’s Party and veering away from a confrontation with the EU. Yet Spain remains deadlocked, with no side able to form a clear majority. Podemos, Spain’s new youth-led populist party, is the first Eurosceptic party since Syriza in Greece to challenge Brussels directly from the left.
We will learn in the next few months how rapidly the anti-EU rebellion grows or fades. If it keeps growing, there is nothing this time that ECB President Draghi can do to quell the threat. One never knows: Being Italian, he may in time join it.
Brexit, the United States, and the Rest of the World
With investors worldwide fleeing risk in favor of safe-haven assets, the prices of precious metals and sovereign debt are rising almost everywhere. As the VIX climbs, so do credit spreads. And in the ultimate safe haven of the United States, the dollar is surging against nearly all other currencies while the 10-year Treasury yield is plummeting (to under 1.5%), a historic all-time low.
If we know anything about Janet Yellen and her data-dependent Fed, we know how it will respond to these developments: by swearing off any thought of hiking interest rates. According to the FedWatch Tool, the market is now writing off almost any chance of a Fed rate hike for at least the next year. In fact, there is a greater chance (7%) of a rate cut back to 0-0.25% over the next two quarters. If the Bank of England decides, as many expect, to cut its rate to 0-0.5%, Governor Mark Carney may personally ask Yellen to ratify the cut by joining him.
Yet at this point any course of action by the Fed is fraught with danger. If the dollar stays elevated and credit spreads keep widening, Yellen will have two major worries.
One is the continued health of the U.S. economy. A higher dollar will further hammer exports, causing real pain among U.S. manufacturers which (according to the BLS, ISM, and the five regional Fed surveys) have already been losing employment continuously over the past 12 months. Can services and retail continue to do all the heavy lifting? A higher dollar will also devalue overseas earnings, pouring more red ink into S&P 500 earnings statements already on track to show (in Q2) five consecutive quarters of earnings decline. Ever-thinner profit margins will discourage both investment and employment.
The other worry is the health of the commodity-exporting emerging market economies, especially those laden with dollar-denominated debt. Or forget health: We’re just talking about avoiding crisis—in Turkey, South Africa, Malaysia, Russia, Indonesia, Thailand, and a slew of Latin American economies, none of which were in very good health to begin with. A rising dollar and widening credit spreads will strangle these economies, especially if they are accompanied, as they usually are, by declining dollar prices of their primary exports.
The Fed could decide to cut rates back down to zero. But this too comes with worries. First of all, what if the Fed cuts and nothing much happens—to the dollar, interest rates, or equity markets? Then the Fed has further sacrificed its credibility (assuming there is much left to sacrifice) for nothing. Yellen may want to be a bit daring and combine a rate cut with a new round of QE. This sort of shock and awe will surely get the markets’ attention. And it may, at least temporarily, smash down long-term yields, jag equities, and reflate the dollar. But this too comes with a downside. As we become more dollar-competitive, the UK and the EU—which may by this time be teetering on the edge of recession—become less.
It’s becoming ever more obvious that the Fed cannot rescue the global economy (or even just the U.S. economy) on its own. It needs help from the sort of vigorous fiscal innovation and coordinated global leadership that only Congress and the White House together can supply. But of course this year the Fed will get no such help. A lame-duck presidency and partisan gridlock have pretty much paralyzed high-level economic policy—much as they did when the global economy was plunging into financial meltdown in the fall of 2008. Remember that? Remember when Barack Obama and John McCain were debating each other while saying almost nothing said about the free-falling Dow, even as George W. Bush was busy moving out of the White House? Ready for a replay with Hillary and Donald?
The world’s leaders have blundered into this impasse through serious errors of judgment. By trying to forestall any market downturn, central bankers have exhausted the stimulus they might have been able to use at a moment like this. By failing to tear down and rebuild such hapless and dysfunctional institutions as the European Union, political leaders have left electorates few options other than total disruption. And by failing to appreciate that ordinary people prioritize identity, community, and sovereignty ahead of money, financial leaders had no inkling of what was coming. Indeed, they doctored the evidence: It now seems clear that London banks were stacking the Brexit betting odds right up to the final day—hoping that this would either change the outcome or keep FX markets “orderly” to the bitter end.
Imagine that. The world’s elite believing that everyone is motivated only by income and wealth. This may explain why so many ordinary people are no longer listening to them.