The Palantir - Vol 4 Issue 1
Brexit: The Classic Known-Unknown by Bryan C. Taylor, CFA
There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know. --Donald Rumsfeld
I believe that Donald Rumsfeld’s famous quote is particularly applicable in this instance. In our mind Brexit was the classic “Known – Unknown”. The markets were aware of the event, they knew the timing, they simply didn’t know the outcome of the vote. Perhaps more importantly neither we nor the markets know exactly what is going to happen from here. In short, we were wrong! We thought that the British people would vote to remain in the European Union, and in this belief we were comfortably backed by the majority of the investment public. Both professional and private traders alike believed that Brexit, the departure of the U.K. from the Eurozone, was extremely unlikely. Despite relatively tight polling results, many odds makers put the chance of a British exit at 20% or below, as the vote approached. However, the British public surprised us all by voting, convincingly if not overwhelmingly, to leave the European Union. Further, David Cameron the British Prime Minister announced his planned resignation shortly after the results of the referendum were known.
For many U.S. investors today’s market volatility may have come as something of a surprise. After all many market participants might reason: if the U.K. wishes to leave the European Union…what’s the big deal? The various individual countries still exist, the Euro still remains a respected currency, the U.S. deals with individual countries regarding geopolitical concerns all of the time. Why should we be concerned about England’s exit from the zone? They were not even part of the common currency….These thoughts and others like them were no doubt running through the minds of U.S. investors and perhaps others around the world as a surge in volatility rocked currency markets and global stock markets tumbled. For those of us aware of the close linkages between markets it was a “Known – Unknown”. The markets hate uncertainty, if Britain were to leave the European Union then markets would react in a volatile fashion. The initial results are exactly what was expected: significant currency volatility, declines in global equity markets, commodity price declines, rising gold prices (often a safe haven when investor uncertainty grows), and a rally in safe haven assets, like U.S. Treasury Bonds.
The question remains: what now? Now that the vote is cast, and England has given notice that she will go it alone, what are the ramifications for investors, the United States, the U.K., the Eurozone and for the World? Research teams around the world are all scrambling to provide their constituency with a comprehensive summary of the British Referendum and its effect on the investment universe, the world economy, and the geopolitical environment. To develop each of these topics thoroughly would require reams of paper and no doubt many of our readers are happily breathing a sigh of relief to hear that we will only provide an abbreviated summary of the likely impact of the “Exit” vote on each of these components.
Initially, global investors must be prepared for additional volatility. The uncertainty resulting from Brexit is significant and it impacts U.S. and global investors alike in a number of significant ways. In the short-term currency volatility brought about by changing trade agreements and the relative strength of an independent British Economy will directly impact global investment portfolios. Initially, this currency impact will likely be positive for U.S. investors as the dollar rallies against both the British Pound and the Euro. Dollar denominated portfolios that experience a loss as foreign equity and fixed income markets decline will see that loss offset by a strengthening dollar. Other safe haven currencies such as the Swiss Franc and Japanese Yen may also benefit from perceived weakness in the Euro and Pound Sterling. We should note that as the dollar has strengthened there has been a growing trend toward hedged international exposure. Many investors have added hedged exposure to their portfolios to protect against a decline in the dollar. In the current environment hedged investors will not benefit from the safe haven currency status of the dollar and its subsequent rise during this period of instability. In addition to the challenges brought about by increased currency volatility, most developed equity markets around the world face significant headwinds including relatively high valuations, falling profit margins, growing protectionist sentiment, and very modest GDP growth. While many developing markets may be more attractive from both a valuation standpoint and in light of current and expected economic growth, they are somewhat hampered by the impact of dollar denominated debt service, weaker legal protection/rule of law concerns, the decline in commodity prices, and the slow-down in Chinese growth which has been the engine for much of the developing world in recent years. Brexit does not necessarily change, these issues, but it adds an additional level of uncertainty to investment markets at a time when global growth prospects are not exactly rosy. We believe that U.S. equities may weather the Brexit storm rather better than their global counterparts, at least in U.S. dollar terms, however we also believe it is likely that the short term dislocations brought about by Brexit will undoubtedly provide unique investment opportunities for global investors.
The U.S. Economy will undoubtedly be impacted by Brexit in some fashion. Perhaps most notably by the impact of a rising dollar on exports to both the U.K. and Europe. While such trade is not insignificant, the currency effect alone is not likely to dramatically change U.S. exports in the short term and will actually encourage both U.S. imports and travel abroad by U.S. citizens. In that respect it is likely to have a somewhat negative affect on U.S. GDP from a balance of trade perspective, but we do not believe that Brexit alone is likely to cause a U.S. Recession. As our clients and many of our readers know Cornerstone has outlined its concerns regarding the U.S. Economy and Equity Markets in both our quarterly economic summary and other missives. Suffice it to say, we remain concerned that we are closing in on the end of the U.S. economic cycle and that a recession may not be as far away as many seem to think. Additionally, U.S. equities are closing in on their 4th sequential quarter of declining corporate profits. While the U.S. job market seems to be chugging along, and other areas of the domestic economy, most notably housing and consumer spending are solid it is unlikely to be enough, in our view, to push domestic GDP growth up much more than 2% and much more muted growth is probable.
The United Kingdom is facing a significant degree of both economic and political uncertainty following last night’s referendum. In our view the most salient point to note is the fact that, at a minimum, Britain will remain in the Eurozone for another two years as she orchestrates her exit. While this may not be enough time to fully restructure various trade deals, expat arrangements, and security arrangements, it is a significant period of time from a market perspective. The U.K. isn’t going to stop trading tomorrow! Therefore, rumors related to the demise of the U.K. economy are likely to be significantly exaggerated. Particularly because, the very government that was fear-mongering to stoke the “remain” vote now has to quiet the volatility and potential geopolitical turmoil brought about by an “exit” vote. The Bank of England has already commented on its willingness to help insure stability and to take the necessary steps to insure liquidity. It is quite likely that the central bank may actually lower interest rates and perhaps increase its current QE campaign. We should note that Britain is one of the few current EU countries with positive real interest rates so there is actually room to loosen monetary policy. In the longer term it is difficult to know whether this vote will ultimately prove beneficial for the British economy or result in the debacle that many politicians feared. We expect that the result will neither be as rosy as the “Exiters” proclaimed or as negative as the “Remainers” feared. We certainly see the ultimate positive of additional national sovereignty relative to immigration, security, fiscal, and monetary policy. Further, it is quite possible that the removal of European Union governmental regulation may actually stimulate both the economy and trade. However, there are certainly risks that accompany the vote. England’s banking sector may be negatively impacted by the withdrawal. Further, England may not be able to negotiate reasonable trade arrangements fast enough to preclude significant negative impact to GDP.
European Union markets are likely to remain volatile and, in total, the economy of the Eurozone is quite fragile. In our view the disturbance to trade brought about by the potential exit of England is not the main concern. The bigger concern is the cracks that this “Exit” brings about in the wall of trust that surrounds the European community. Other countries are already advocating for their own referendums and the technocrats that believe that a tighter union perhaps even a fiscal union should be the ultimate objective for the Zone facing a significant challenge over the upcoming months. The value of the Euro is likely to decline as trust ebbs in its continued efficacy. Initially this may prove helpful from an export perspective, but if it ultimately leads to the dissolution of the common currency or the Eurozone itself then additional volatility and geopolitical uncertainly will likely be the result. Initially, we expect markets to decline as they try to digest the impact the British exit on trade and the future viability of the Zone. However, at some point there may be a buying opportunity as both currencies and equities hit valuations that are unquestionably attractive.
On a macroeconomic basis, Brexit adds uncertainty to a global economy that is already sputtering. Chinese growth has, at best, moderated and at worst declined significantly. Its adjustment to a more consumer driven economy will not come easily, and in fact may falter significantly in the face of demographic challenges. The potential protectionist sentiment exhibited through the U.K. referendum suggests that the steady trend toward increased globalization is facing significant headwinds. Such protectionist sentiment is likely to negatively impact global trade and may prove particularly negative for the increased liberalization of property rights and the inclusion of the emerging world in developed market trading arrangements. While the objectives of national sovereignty and decreased governmental regulation are laudable from a free market perspective, we are concerned that growing populist movements around the developed world may result in growing protectionist sentiment and a net decrease in global trade integration. The Brexit vote provided a boost to populist movements around the developed world and there are certainly parallels between the frustration felt by many “disenfranchised” British citizens and their angry American counterparts. Such parallels suggest to many in the developed world that the governing elite have grown insensitive to the demands of their constituency and that democracy is weaker as a result. Perhaps, this event coupled with events in the U.S. and elsewhere in the developed world will prod politicians toward the economic reforms necessary to improve the corresponding developed world economies.