Putting Brexit Vote in Perspective – Part 2

Let me follow up to Saturday’s note about putting the Brexit in perspective.  Much of the following comes from the “Up & Down Wall Street” column in the June 27, 2016 issue of Barron’s.

Positives for Britain

Economic Strength – Britain is the 2nd largest economy in Europe, 5th largest in the world and one of the two healthiest major European economies. London, not New York, is the largest financial center in the world.

Reduced Contribution to EU Budget – Britain had been paying 13 billion pounds annually into the European Union budget and received 4.5 billion of spending in Britain in return. That 8.5 billion outflow will disappear.

Less Regulatory Burden – Britain also frees itself of the regulatory burdens Brussels imposed. The size of that benefit of that is uncertain but what is certain is that the European Union’s (EU) regulation is very large and growing and hinders business profitability in Britain.

Vulnerability to New EU Tariffs – Concerning the potential for tariffs being imposed on British exports to the EU, the World Trade Organization (WTO) forbids unfair or punitive tariffs among members, an organization to which Britain the EU belong.

While new trade deals will have to struck between Britain and other countries since Britain will over the next 2+ years be withdrawing from the EU, Britain’s size and location a few miles from continental Europe and it’s excellent relationship with the US, make it a priority for the US and other countries outside Europe. For the EU, Britain is a very close trading partner with whom they are used to doing business.

This point about it taking 2+ years is important. Britain did not leave the EU last week – it voted to start the process and that will take a maximum of 2 years after the prime minister. Cameron has said he will not invoke Article 50 of the Lisbon Treaty but will let the new PM do that, and elections are currently scheduled for October. The British Parliament can call for earlier new elections but it takes a 2/3 majority.

But, realize that any tariff at all gives a disincentive for companies to ship products to Britain that are intended for the EU, reducing that trade in favor of shipping to another European port.

Negatives for Britain

Uncertainty – When businesses are uncertain about the future they tend to hold off on investing. Thus business activity is likely to slow, both local businesses and continental businesses considering investments in the UK. So, an economic slowdown is likely, with estimates of 0.5- 1% over the next year.

The EU Making an Example of Britain – Populist parties in Denmark, Sweden and Italy also favor Brexit-type votes and Rome just elected a young, anti-establishment mayor. Marie Le Pen, head of the French National Front party and who has been gaining in popularity, called for a similar vote there. The EU will recognize that this vote may embolden those efforts to split up the EU and may try to demonstrate that doing so will lead to sizeable negative consequences, for example, tariffs by the EU on goods imported from countries that leave.

Trade between all EU member countries is tariff-free and about 50% of Britain’s trade is with the EU. Tariffs would make those imported goods more expensive. More than that, imports might decline if worldwide shipping to Europe via Britain means tariffs are slapped on those goods. World exporters might then ship things directly to the EU rather than to Britain as they often do now.

Effect on London as a Financial Center – In the same way, the EU could make it tough on Britain to remain the biggest center for financial trading in the EU. That would cost a lot of high-paying jobs in what is one Britain’s fastest growing and important economic sectors and reverse the momentum London now enjoys in that area.

Capital Flow – Another effect of a reversal of growth in London’s financial industry is on the flow of money for the UK. The UK currently imports 7.4% more than it exports, leading to an outflow of money, what economists call a deficit in the country’s current account. That means that the UK must significantly rely on the world to fund a portion of UK economic growth. The US does too, but its current account deficit is 2% of the economy. The decrease in a flow of money into London as a financial center obviously makes this problem worse and could lead to higher British interest rates, which are a drag on the economy and could lead to higher taxes.

An EU Breakup?

Whether this is the first step in the breakup of the EU is the biggest issue in all this discussion of the Brexit and the reason other world stock and bond markets have sold off. Most think it unlikely, but those who think it will include a person I think is the savviest commentator on world markets that I know of.

His name is Felix Zulauf, a Swiss investor and over the years, the most prescient of the highly esteemed Barron’s Roundtable members. Barron’s is the best financial periodical and I never miss the writeup of the semiannual roundtable. Zulauf is neither a perma-bull nor perma-bear and he has correctly made some big calls, some of which seemed unlikely at the time, such as his 2007 prediction of a 30% drop in US housing prices. The drop ended up being 33%, according to the Case-Schiller Home Price Index.

Over the better part of the last year, Zulauf has said that 2016 would be a down year for world stock markets. Halfway through the year, he is certainly correct about international markets and the US market is now negative for the year as well.

Zulauf thinks the Brexit is the start of the European Union slowly disintegrating. He cites the rising anti-immigrant and antiestablishment wave across Europe I mentioned before and has long felt that the very sizeable differences in culture and economic management between European countries, especially between northern and southern Europe, was too great. Just contrast Germany with Italy. Italy is the world’s 7th most indebted nation and its economy has grown a total of 5.4% since it joined the EU in 1999, 17 years ago. Germany enjoys the largest capital surplus in the world and its economy has grown 67% since 1999, or about 4%/year, even with the huge 2008-09 recession.

Investments

What does this have to do with investments? Markets dislike uncertainty and there will be a lot of that in Europe, especially for the next few months. If Zulauf and others are correct about the slow disintegration of the EU that would likely mean a long downtrend in European markets.

The US market has fared much better than most European and other world markets, although the last three years have been poor here too. The Wilshire 5000 Equally Weighted Total Return Index, which treats all US stocks the same, has had the following returns – 2014 4.9%, 2015 -4.6%, 2016 -0.3% (estimate), giving a net return of 0% for 2014-16.

You may find worldwide allocations to European stocks declining for a while, and to avoid that, I plan to further reduce client positions in international funds that focus on Europe, which most do, though I would like to see a bounce to sell on. While I don’t favor in and out market timing, I do shift allocations within an asset class from time to time. This summer is a time to be cautious and that’s the plan.

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