Posts tagged Brexit
It’s not Thanksgiving week over in London, but British prime minister Theresa May is likely in a mood to give thanks anyway. The object of May’s thankfulness would be the spectacle of hardline Eurosceptics in her own Tory party, led by the decidedly odd duo of Boris Johnson and Jacob Rees-Mogg, doing their best impression of a rafter of turkeys cluelessly scampering this way and that in a ham-fisted effort to unseat the PM and torpedo the much-unloved Brexit deal she is trying to sell to Parliament.
A Comedy of Errors
The tragi-comical mess that is Brexit has percolated in and out of the news since the referendum nearly two and a half years ago produced the shocking (at the time, not so much any more) decision to quit the EU. With the Article 50 deadline of March 2019 looming, the recent headlines have been decidedly unkind to just about anyone involved with the negotiation process, most of all from the UK side. Concerns about the potential global impact of a no-deal crash-out from the EU have joined other festering concerns – about tech stocks, interest rates, China and others – to keep market sentiment on the side of risk-off. As we write this, the S&P 500 is hovering just at the technical correction threshold of a 10 percent decline from its last high (reached on September 20). If the May government collapses in the coming weeks, which is not a zero-probability event, then confidence may be shaken further still.
Under the frothy headlines, though, there is at least a case to make that the worst outcome will be avoided. Amid all else going on in the world right now, we think it is worth one’s time to understand where things currently stand on Brexit and why they might not be quite as dire as they seem – why, in other words, Theresa May might truly be in a thankful mood.
The Artlessness of the Deal
Exceedingly few kind words, to be sure, have been penned about the deal currently up for approval. A “rotten prawn” opined British journalist Quentin Letts in a recent Washington Post opinion piece (the piece is also notable for likening PM May to an “Atlantic mollusk” in a way that was actually meant as a compliment). The deal keeps the UK in a threadbare customs union with the EU that at once displeases Remainers (stuck in limbo is worse than being part of the EU) and Leavers (stuck in limbo is worse than the clean break that was voted for in 2016). It gives discretion to Brussels over future decisions about the very contentious and seemingly intractable issue of the Northern Ireland border. In the minds of not a few observers it is nothing short of a transfer of decision-making power on a great many issues from the British Parliament to the European Commission.
The Worst Option, Except for All the Others
Rotten prawn though it may be, the May deal has gained some important sources of support including Bank of England head Mark Carney, leaders in the UK business community and establishment media organs such as the Financial Times and Economist. The common theme being that, as bad as this deal may be, it is infinitely preferable to an abrupt ejection from the EU next March with no Plan B. The real-world implications of a hard, no-deal Brexit have not, in any meaningful way, been manifestly evident to date. The pound sterling today is just 15 percent weaker versus the US dollar than it was right before the Brexit vote happened. The FTSE 100 stock index has gained about 10 percent since June 2016 – much less than the S&P 500, say, but still positive. Headline macroeconomic numbers from jobs to inflation and GDP have also held up reasonably well – again, not going gangbusters but neither going into recession.
A hard Brexit, many believe, would be the end of these relative good times and the beginning of something much worse. The Bank of England plans to back up its support for the May deal next week with a more detailed assessment of the economic consequences of an abrupt Brexit crash-out. Paramount in the minds of those supporting the deal is the transition period it provides – anywhere from two to four years – after Article 50 kicks in next March for both sides to work out a detailed agreement for trade and economic cooperation. Wait, you say, wasn’t that what they were supposed to be doing for the last two years? Fair point – but an “extended transition period” is actually what the EU does best – it kicks the can down the road to be fixed at some future date. Meanwhile, businesses and investors at least have the assurance of continuity for a measurable period of time.
Vox Populi, Redux?
There is a certain cunning logic to that kick-the-can trick in the EU playbook: things can change, maybe to the extent that a final decision on Brexit will never be made. Currently there is quite a bit of chatter in Britain about a so-called “People’s Vote” (good marketing!) that would effectively revisit the entire premise of Brexit. Voters in this scenario would have three options: choose the May deal currently on the table, choose a hard Brexit along the lines of what Johnson, Rees-Mogg and the rest of the Tory turkeys claim to want (the details of which are, to be charitable, foggy), or choose…to stay in the EU. While the notion of a second referendum has been bandied about since the immediate aftermath of the first one, this People’s Vote idea seems to have quite a bit of cross-over support from erstwhile Leavers and Remainers. According to at least one recent poll on the topic, the cohort preferring to remain in the EU was 54 percent. Recall that in the original vote 48 percent supported Remain, 52 percent were for Leave.
So could the whole unseemly mess just go away, like a bad dream that finally dissipates with morning’s light? That would not necessarily be the way to bet, nor would it solve the very real, very partisan divide among Britons about their place in Europe and the world at large. Sadly, we are too far down the road of populism and blinkered, tribal nation-first thinking in too many parts of the world for that toothpaste to go back into the tube. But there are three possible, practical alternatives in front of the UK today. Of the three, one would very likely deliver a great deal of economic pain within a very short period of time. Either of the other two would be far more palatable – and could helpfully reassure global markets that the world’s humans have not yet completely gone off their rockers.
We wish all of you and your families a very happy Thanksgiving.
Ah, to be alive at a time when “hey, did that really just happen?” can be the go-to phrase of any given day. To be perfectly honest, we did not give much more than a perfunctory review to the news some time back that UK prime minister Theresa May was calling a snap election in a bid to strengthen her Tory Party’s majority in Parliament. May’s insistent mantra of “steady and calm” seemed much more in keeping with the mood of the moment than the unpredictable antics of Labor leader Jeremy Corbyn, unloved even by much of his own party’s senior figures.
But while the good citizens of Washington, DC were filling up the local bars at 10 am for the much-hyped James Comey testimony, our British friends across the pond went to the polls and delivered yet another insouciant slap in the face of conventional wisdom. May’s Conservatives failed to gain a parliamentary majority, while Corbyn’s Labor Party bagged a sizable number of new seats and all sorts of other counterintuitive things happened… suffice it to say that “Democratic Union Party of Northern Ireland” was probably NOT on the tip of your tongue before now.
Does Someone Need a Time Out?
As of this moment the only hard data point we can affirm is that Britain has a “hung parliament,” meaning that no single party has a majority of seats from which to form a government. The most likely outcome, from the initial flurry of horse trading, will be a coalition between the Tories and Northern Ireland’s DUP, which also picked up a couple seats on Thursday night. But that is not definite; observers expect at least an attempt by Labor to form its own coalition. May’s own future as head of her party is anything but certain, and there is a better than average chance we will see another election called before the end of the year.
What this means for Brexit is also spectacularly unclear. What seems apparent, though, is that the “hard Brexit” approach favored by May, expressed by the sentiment that no deal (i.e. a nasty divorce) is better than a bad deal, is headed for the dustbin of history. Brexit is not off the table – Article 50 has been invoked and the game is afoot – but in the fog of confusion produced by the election outcome, some kind of a time-out may be in the cards.
L’Europe, En Marche!
Britain’s position vis à vis Article 50 negotiations is made more difficult still by the marked contrast of fortunes across the Channel. In his brief tour of duty as France’s president Emmanuel Macron has established himself as a strong leader whose En Marche (forward!) party – which did not even exist 14 months ago – is positioned to capture an historic majority of parliamentary seats in this weekend’s upcoming regional legislative elections (so many elections, so little time to cover and process them!). The Old Continent, plagued for so long by political sclerosis and the travails of the single currency region, suddenly looks ascendant under the M&M (Merkel & Macron) leadership star.
A stronger economy, though still not equally dispersed among all regions, may help the pro-EU center solidify its recent gains at the expense of far right populism. A more vibrant Europe will likely have the effect of making a decisive Brexit even less appealing to the nearly half of Britons who would still prefer to remain. Now, it is very difficult to tease out any kind of a clear Brexit message from the confusion of Westminster seats gained and lost on Thursday night. But with ten days to go before formal Article 50 negotiations are set to begin, a British negotiating team that has given short shrift to the many complex details to be worked out in the split would be well advised to take a deep breath and – perhaps – buy some additional time before engaging the battle.
It is said that the Battle of Waterloo was won on the playing fields of Eton. Today’s Old Etonians, and their negotiating team peers, would do well to consult instead Sun Tzu -- on when to engage, and when to pull back and reassess.
This year, the month of March will serve up more than an endless succession of college basketball games and unappealing concoctions of green beer. Almost nine months after the surprise vote last summer, the United Kingdom will finally get to show the world what its exit from the European Union may look like as it triggers Article 50, formally kicking off divorce proceedings. Inquiring investors will want to know how this piece of the puzzle may fit into the evolving economic landscape over the coming years. We take stock of where things stand on the cusp of this new phase of the Brexit proceedings.
Here – Catch This
The UK’s economic performance in the second half of 2016 turned out to be not quite what Remain doomsayers predicted. Real GDP growth for the third quarter – the immediate period after the Brexit vote – was twice what the economists had forecast. With a further strong performance in the last quarter, the UK economy ended 2016 with year-on-year real GDP growth of 2.0 percent, the strongest among the world’s developed economies. Not bad for a would-be basket case!
For most of that time period – from July through November – the main growth driver was consumer spending. For whatever combination of reasons – giddy Leavers on a shopping spree right alongside gloomy Remainers stocking up for the apocalypse, maybe? – households let their consumer freak fly. The pattern changed in the last month of the year. A string of impressive reports from the industrial production corner of the economy in December showed that manufacturers finally appeared to be taking advantage of the sharply weaker pound to sell more stuff, including to key non-EU export markets. That in turn has led to talk of a rebalancing. Consumer spending is unlikely to continue at its recent fervid pace as inflation kicks in and wages fail to keep up – a trend that is already underway. If the services sector can pass the baton onto manufacturing, perhaps the UK could continue to overachieve and make a success of Brexit?
Your Check, Monsieur
The Bank of England has now twice raised its 2017 growth estimate for the UK, so maybe there is some cause for optimism (though it is somewhat hard to see how Britain sustains a competitive advantage as manufacturing powerhouse). A strain of optimism has certainly been coursing through policymaker veins. Prime Minister Theresa May has assured her constituents that the UK side of the negotiating table will push for a most favorable outcome and will fight any EU pushback with nerves of steel. Her government has even hinted at a Plan B should negotiations collapse; a sort of “Singapore on the Thames” financial haven with low tax rates and other incentives for global businesses. But there are a number of potentially thorny roadblocks between here and the promised land.
First off will be an unwelcome bill likely to present itself once the UK team shows up in Brussels. In the eyes of EU budget handlers, British liabilities for things ranging from pension scheme contributions to commitments for future spending projects run to about £60 billion. That is a large chunk of change that (for obvious reasons) has been given short shrift by the UK government in its white papers and other communications with the public on Brexit’s likely cost. EU negotiators give every indication they will insist on the settlement of this account as an up-front divorce payment before any further negotiations on market access, tariff holidays etc. can take place. The British side will be unlikely to go along with that, as it will be in their interests to hammer out a comprehensive solution before they think about a reasonable way to settle accounts. So talks could go off the rails before they even get to the serious issues of economic substance.
What if the negotiations fail? Again, that question has gotten very little focus to date but remains a distinct possibility. An animosity-filled parting of ways between the UK and its largest trading partner (worth about £600 billion per year) would likely not be in anybody’s interest. But each side has its own expectations, its own problems and its own unruly constituents not inclined towards compromise. Bear in mind that, ever mindful of the potential outcome of elections on its own territory, the EU side will be wary of showing any kind of blueprint for easy exit.
And there is a larger picture as well; the Brexit negotiations will be going on during a particularly fraught period for world trade. The Trump administration is hell-bent on scrapping multilateral deals and going after what it imagines to be opportunities for bilateral “wins” (using curiously befuddled and plodding scoring metrics like “surplus-good, deficit-bad”). China would love to lure more scorned partners into its Asian Infrastructure Investment Bank and consolidate supremacy in the Pacific. Brexit, then, will be a big part of an even bigger variable: the rapidly changing face of global trade. However this variable winds up affecting asset markets in 2017, it is likely to have a profound effect on growth and living standards for quite some time to come.
“Money never sleeps, pal” said Gordon Gekko to his young protégé Bud Fox in the 1987 hit movie Wall Street. That sentiment rings ever more true nearly 30 years later; money not only never sleeps, but it races around in a hyper-caffeinated 24/7 frenzy from time zone to time zone, trading platform to trading platform, algorithm to algorithm.
Last evening around 7pm Eastern time, as Wall Streeters piled into their favorite happy hour watering holes, latte-gulping currency pros in Singapore and Hong Kong watched an unnerving spectacle unfold in the early hours of their trading day. The British pound sterling had been under pressure all week, slipping from $1.30 on Monday to what seemed to be a support level around $1.26 on Thursday. Just after 7:00 am Singapore/Hong Kong time, that support level crumbled and the pound plunged more than 6 percent in the space of two minutes to a low of $1.18. The chart below illustrates the suddenness and the severity of the latest addition to the annals of “flash crashes.”
As of this writing, trading authorities in Asia (where most trading in the pound at the time was taking place) and London maintain they have not pinpointed the cause of the flash crash. Sporadic volume and a multiplicity of private, proprietary trading platforms may make it difficult to identify the cause of the price spasm. It is possible the problem originated with one of those unfortunately-named “fat finger” trades – market jargon for a data input mistake in the volume or price of an order. At some point – traders on the scene seem to be pointing to when the price moved below $1.24 – it would appear plausible to lay blame on those algorithms primed to pull the trigger at certain volatility thresholds. Algorithm-driven programs dominate intraday trading volumes across a wide swath of asset and derivative markets from currencies to equities, commodities and bonds. The laws of supply and demand dictate that, when a trigger price unleashes a flood of orders, seemingly irrational but very explainable volatility ensues.
Crisis à la Hollande-aise
Not everyone is ready to lay all the blame for this particular flash crash at the feet (such as they are) of the machines. As we noted above, the pound was under pressure in the days leading up to the event, notably along the contours of a hardening turn of sentiment regarding Brexit. UK Prime Minister Theresa May gave a tough talk at the Conservative Party conference this past week clearly aimed at a political, rather than a business, audience. While there is still a vast gulf of time between today and the beginning of Brexit negotiations next March, markets widely interpreted May’s words as indicative of a “hard Brexit” – more of a clean break with the Continent than a Norway-style preferred trade arrangement with a few compromises on contentious areas like immigration.
French President François Hollande added his own thoughts about “hard Brexit” Thursday evening. At a dinner with EU Commission President Jean-Claude Juncker, another hardliner on Brexit negotiations, Hollande stressed that a tough stance was crucial to the very survival of the EU’s fundamental principles. The main point about this speech was the timing of its publication in the Financial Times: a few minutes after 7 am Singapore/Hong Kong time, or M-minute for the flash crash. Programmers have long since mastered the art of translating the digital sentences of online news reports into 1s and 0s for their trading programs, so presumably the Hollande comments could have piled onto and inflamed the already-negative sentiment.
Welcome to the World of Event Risk
Whatever the make-up of factors involved in the pound’s flash crash, this much we know with a high degree of confidence. Asset markets today are driven by discrete events far more than they are by anything else. And technology facilitates the amplification of these events so that what might have been a price movement of one percent back in days of old can easily turn into an instantaneous gyration of five percent or more today. Those are the necessary facts of today’s capital markets.
Events stretch ahead through 2017 as far as the eye can see. Aside from Brexit, there are elections in Germany and especially France next year that could have a major impact on those “fundamental principles” of the EU – particularly if France’s far right Marine Le Pen outperforms. There will likely be reckonings aplenty at the OK Corrals of the Bank of Japan, the ECB and the Fed. And there are no doubt a handful of “unknown unknowns” about which nobody is talking now that will flash onto trading screens over the course of next year.
As last night’s flash crash instructs, a price movement that wildly overshoots the likely material impact of the event in question does correct itself in short order, which is why our default position on event outcomes is not to trade into them. That being said, though, there were plenty of trades executed within those two minutes of panic that reflected genuine investor sentiment on the value of the pound sterling. Is the investor who dumped a pile of sterling at $1.18 a sorry chump or a cold-eyed assessor of Britain’s post-EU future, waiting to cash in his chips at $1.10? The “if/else” logic of future events will supply the answer. The problem with the “1 or 0” outcome of these events, though, is that they make farcical work of predicting the odds.
A deadly terrorist attack in Nice last Thursday was followed by a failed coup over the weekend in Turkey. China’s contentious “Nine-Dash Line” in the South China Sea is on a potential collision course with the U.S. military. A dismal post-Brexit PMI reading in Britain offers the first piece of data suggesting a possible autumn recession. Establishment institutions around the world reel from public distrust, and in politics it seems conventional rules no longer apply.
Yet stock markets appear blissfully dismissive of the planet’s woes. The S&P 500 has resumed its record-setting ways after a hiatus of more than one year. Meanwhile the CBOE VIX, the so-called “fear gauge” of market sentiment, fell to a two year low earlier this week, a stunning 54 percent plunge from the June 24 high in the immediate aftermath of Brexit. Do these signals – a placid VIX and a stock market upside breakout – signal the beginning of another extended run for the seven year old bull? Or are we in a brief calm before the next storm?
The VIX is subject to abrupt and dramatic mood shifts, as the above chart clearly shows. Those Alpine spikes tend to occur when something unexpected shocks investors out of complacency. Three notable examples in this chart, which goes back two years, were the Ebola freak-out in October 2014, the Chinese yuan devaluation in August 2015 and of course the Brexit shock last month. The Ebola and Brexit events appear similar in their brevity – less than a week of fear – and in the fact that in both cases stocks went right back to setting record highs. In both cases the market’s snap judgment appeared to be “nothing here, carry on”.
By contrast, risk and uncertainty lingered longer after the yuan devaluation last August, with the VIX staying at an elevated level for about five months until peaking again this past February. This is perhaps not surprising. The importance of China to the world economy makes it harder for investors to simply shrug off a negative surprise like the devaluation. Questions about China’s growth sustainability, debt overhang and impact on world commodity markets remain, even if they have mostly been out of the headlines of late.
A Tale of Two PMIs
Is Brexit really just an Ebola-like flash in the pan, an event unlikely to have much impact outside Great Britain’s borders? Since the vote one month ago (a month already, really?) there has been plenty of opinionating about what it all means, but not much in the way of data. Today we finally got a little quantitative morsel on which to chew. The July monthly purchasing managers surveys (PMI) came out for both Britain and the Eurozone, and they painted a distinctly diverging picture. In the Eurozone, both the manufacturing and the services PMI came in right about where they were a month ago, at 51.9 and 52.7 respectively. A PMI greater than 50 signifies an expansion while a number below 50 indicates a contraction.
In the UK, by contrast, the manufacturing PMI fell from 52.1 last month to 49.1 in July, while the services PMI fell from 52.3 to 47.4. Analysts have been quick to point out that the data are consistent with a scenario for a UK recession as early as this fall. We should note that PMI is only one measure of economic activity, so due caution is advisable before rushing to judgment. In our opinion, though, if there is anything substantive to take away from today’s PMI it is the Eurozone number. A British recession spilling over into a Eurozone recession would be cause for concern, but evidence in support of that scenario has not shown up yet. Indeed, while leaving Eurozone interest rates untouched this week, ECB Chair Mario Draghi expressed confidence in the current economic state of the union.
Not Worried, or Not Present?
Perhaps the market is right that, even with all the mayhem going on in the world, there is no compelling case to make for the bull to change course and reverse. It’s also possible that the lack of worry indicates that nobody is paying much attention. As we noted in our piece last week, we are in that time of the year when trading volume subsides and gives way to beach reads. Volume on the New York Stock Exchange has been well below average during the recent post-Brexit rally. Maybe investors are more concerned about leveling up in Pokémon than they are about world events. For now, in any event, this quiet spell appears fairly impervious to disruption.