Posts tagged Brexit
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.
It was almost three years ago to the day. On July 1, 2013, Croatia became the 28th country to join the European Union. “Joyous Croatia Joins Europe Amid a Crisis” ran the New York Times headline of that day. The article noted that the accession of the Balkan republic represented a “rare moment of satisfaction” for an EU beset by stagnant economic growth and a chronic financial crisis. Today there is little in the way of satisfaction or joy in Brussels, as Europeans digest the reality that their club is set to shrink in numbers for the first time since representatives from France, West Germany, Italy, Belgium, the Netherlands and Luxembourg met in a sumptuous room in the French foreign ministry in April 1951 to sign the Treaty of Paris. The British have spoken, and they plan to go it alone.
Of Polls and Pain Trades
Longstanding readers of our weekly commentary will be familiar with our general view on event-driven trades, which is easily boiled down to two simple words of advice: do nothing. The Brexit vote is a compelling case in point for this view. One week ago, poll numbers were showing a slight momentum trend towards “Leave,” risk asset markets were pulling back and volatility was up. Then, a new batch of polls over last weekend suggested that momentum was shifting back towards “Remain,” perhaps in the wake of the brutal shooting of Labor parliamentarian and strong Remain supporter Jo Cox. The momentum shifts in both cases were fairly tempered, with most poll-of-polls composites showing a likely outcome within statistical margins of error either way.
Of course, that did not stop the punters from placing their bets. As the week progressed those bets – now skewed heavily towards a “Remain” outcome, looked more and more like a sure thing. As markets closed for trading on Thursday, the odds as reflected in financial betting markets were over 95 percent for Remain (despite the fact that actual polls still showed nothing remotely that convincing). Global equities closed sharply higher, as did the pound sterling. Then the results came out. There will be pain trades aplenty today, and hopefully a useful reminder about the non-existence of free lunches. Sometimes “do nothing” really is the most prudent course of action.
There is still much that is unknown about the economic impact of Brexit; first and foremost, what specific kind of relationship the UK will have with the Continent going forward. Will Britain be part of a free trade area framework similar to what Norway has with the EU now? Or will there be some kind of customs arrangement for certain goods and/or services, similar to Turkey’s current arrangement? Or something altogether different? There would appear to be plenty of free-lunch thinking among Leave supporters who imagine they can somehow benefit from favorable trade with the EU while restricting the free movement of people (anti-immigration being perhaps the strongest motivating sentiment behind Brexit). Much was promised by the Leave campaign of a highly questionable nature.
That thinking is likely to be disabused by EU negotiators not inclined to be overly accommodating, lest Britain’s example set the stage for further referenda (chatter about France and a “Frexit” lit up the Twitterverse almost instantaneously following last night’s outcome). Article 50 of the Treaty of Lisbon sets forth (very briefly) the terms of disengagement from the union; at this point, all that is clear is that the time frame for leaving is two years. We don’t even know who Britain’s point person in the negotiations will be, as current prime minister David Cameron intends to step down in October. All of which is to say – we would caution against getting too deep into any one particular scenario ahead of even knowing opening gambits on the key issue of ongoing coexistence.
The View from the Corridor
Meanwhile, even today’s frothy market of pain trades and a spike in the VIX volatility index may not drive the S&P 500 below the floor of the corridor where it has been stuck for more than twenty months. So far, at least, the pullback in stocks is relatively contained while bond yields and currencies have also settled down from the more frenetic activity levels seen earlier in Europe, before US markets opened. There is essentially no doubt that central banks the world over are prepared to flood the markets with as much liquidity as they think necessary to stave off a collapse in asset prices (Fed funds futures markets, however improbably, even allow for a 10 percent chance that the FOMC’s next move will be a rate cut). The policy floor is firmly in place. Meanwhile, the next several months may prove even tougher for stocks on the upside, if uncertainty in Europe sets the stage for another strong run by the US dollar. We were just starting to see more corporate management teams gently guide sales and earnings up in expectation of more forgiving currency conditions. Stiffer currency headwinds imply more resistance at the valuation ceiling.
These conditions may change, of course, and we will be closely following the nuts and bolts of how Brexit plays out in the coming weeks. For now, though, we are comfortable with where our portfolios are positioned. We maintained a somewhat more defensive than usual position even as asset markets rallied strongly in March and April, with underweight positions in small caps and non-US stocks while favoring higher quality, dividend-paying large caps. We continue to maintain a modest cash buffer to augment a fixed income allocation of mostly high quality short and intermediate durations. That persistent corridor serves as a useful metaphor in our opinion: neither is it time to go into a super-defensive crouch, nor to let the bulls run rampant. Stay in, but stay cautious.
One week from today we will (probably) know the answer to the Big Question: Are they in or are they out? Britain votes on the future of its relationship with the European Union on June 23, deciding whether it wants to continue to be part of an organization it joined in 1973. While the vote is technically a referendum, not a binding obligation with legal force, a Leave vote would likely require the government to set the wheels in motion for a proposed exit within a two-year time frame. What the terms of any actual deal would look like remains unclear, despite the impression created by much handwringing this week that the economic pain of a Brexit is precisely quantifiable.
Most of the conversations we have had with clients over the past several weeks have, understandably, homed in on the practical implications of Brexit for their portfolios. From our standpoint, the playbook ahead of June 23 is very much in line with our usual advice about event-driven market movements, which is to say do nothing. Make no mistake, if the Leave vote prevails next week there is a very good chance of an immediate volatility spike in asset markets. Much of that volatility would likely be concentrated in ground zero exposures like the FTSE 100 stock index and the British pound, which could see double digit declines, but risk asset markets worldwide would be vulnerable.
The reason we advise our clients to do nothing in situations like this is that, far more often than not, the tempest surrounding the actual event blows over rather quickly. The volatility is driven mostly by short-term money positioned one way or another before the event and algorithms wired to react immediately upon the outcome being known. That flurry of activity will settle down as the winners lock in their gains and the losers bite the bullet on pain trades to cut their losses. Markets will then adjust over time as investors assess the practical implications of Britain outside the EU for the future cash flow generation potential of the companies in which they invest.
Here is one practical example of what we mean by separating the short-term tempest from the longer term market adjustment to new information. Much has been made this week of the spike in volatility for the pound sterling, with commentators noting that the risk spike is higher than anything seen since the 2008 market crash. But an excellent article in Bloomberg carefully points out what other pieces have glossed over: the volatility spike relates only to what traders expect in the next 30 days. In other words, while 30-day futures for the pound sterling are more volatile than those for the Russian rouble or Hungarian forint, one-year sterling futures are virtually unchanged. The market for sterling futures today is a textbook definition of an event tempest: rough seas today, calmness further ahead.
None of this is to say that Britain’s leaving the EU would be unimportant, or have no implications down the line. We are of the opinion that the Leave arguments are largely misguided and shaped more by emotion and fear than by real facts. To that end, our longer-term concern is less about how Britain finds its economic footing outside the EU, and more about how Brexit is part and parcel of a larger global trend – a backlash against trade and globalization in general that seeks refuge in – depending on where in the world one happens to be – appeals to nationalism, authoritarianism and populism. Such sentiments swirl about in locations from Peoria to Paris to the Philippines.
But trying to put a specific price on anything as vague and variable as anti-globalism is a fool’s errand. In a very practical sense we are not prepared to adjust our strategic allocation targets to various asset classes on the basis of events that may or may not transpire. Sometime in the future economic historians may look back at June 2016 as an important milestone towards a new world of less trade and weaker economies. Alternatively, they may write that the populist anger of this age finally forced global elites to wake up and meaningfully address key imbalances and inequalities feeding that anger. Either way, we will follow the same approach as always: evaluate the data as they come in and let the data, not ill-defined emotions, drive our ongoing portfolio decisions.