A few days after the Brexit vote, which caught most people by surprise, us included, we believe that there are two questions which really matter for investors:
1) Will policymakers succeed in stabilizing a violent, negative market reaction in the short-term?
2) What will happen to the process of European integration and to the European Union, as we got to know it, in the medium to long-term?
There is no doubt that the vote opens a new period of uncertainty for the future of the European Union’s original design, but it is extremely difficult at this stage to make any prediction on the likely path that European leaders will take in order to repair the damage done to the EU (ie, the new idea, after the vote, that European integration project could become reversible).
So let’s start with the first question. The consensus view – that a long Brexit process could result in two or more years of difficult negotiations between a new UK political leadership and Brussels – may increase the probability of recession in both Europe and the UK. In fact, uncertainty around the UK’s future trading relationships could affect economic activity, reduce investment and hurt consumer confidence. The sterling devaluation could continue as uncertainty could lead to an interruption of the flow of capital to the UK and eventually lead to lower growth.
Are We Facing a New “Lehman Event”?
We do not believe so, for a simple reason: leverage. By 2008, a massive amount of leverage had been accumulated in the private sector, based on the assumption (subsequently proven false) of risk spreading in a myriad of structured products. Post-Lehman it was the subsequent chaotic unwinding of the positions that lead the global financial system to a sudden stop.
Nothing like this has ever happened with reference to the European integration project, and if anything, any major exposure to European assets has been based on the assumption that the Euro, as a common currency, will always have the backing of the ECB, especially after the famous “whatever it takes” speech from ECB president, Mario Draghi.
Therefore the real question is whether financial markets, in risk-off mood, will continue to have the backing and support of Central Banks’ action and whether this will continue to be considered credible by investors. We believe that Central Banks (like the ECB) currently engaged in Quantitative Easing could make adjustments to their purchasing programs, while others (like the Fed) which have started a path of policy normalization could delay expected rates hikes, and so on.
In other words, the activity of supporting financial assets through massive injections of cash and with zero/negative interest rates could be prolonged.
However, markets may question the efficacy of additional monetary policy, putting the credibility of Central Banks’ action under scrutiny. Meanwhile the political impasse could still impede the articulation and implementation of effective fiscal policies and long-needed incentives to private investments in the “real” sector.
What is important to note is that the policies implemented in the years after the Great Financial Crisis, while absolutely necessary to save the sound functioning of the financial system in the immediate aftermath of the crisis, have ended up contributing to the current problems distorting liquidity and valuations on major segments of financial markets (government bonds, credit). They have added further divisions to the long-term trends of wealth and income inequality and sluggish growth with disappointing progress in employment, which have been in place for many years, and which electorates are starting to rebel against, not only in the UK, but also in the rest of Europe and the US.
A Vote against Exclusion
The vote for a Brexit is better interpreted as a vote against exclusion (from the benefits of globalization, financialization(1) of the economy, and so on) than a vote against Europe per se.
Seen in this light, the second question, about the long-term future of the European integration project, is not a question around the institutional mechanisms of “in” or “out” of Europe. It is a more existential question about the benefits, in terms of economic and social welfare, for European citizens, stemming from a more (or less, depending on the views) united Europe. It is the real question that European leaders and citizens will have to solve in the next few years, radically rethinking the “raison d’etre” of a European integration, and the consequent economic, social and security (both internal and external) policies.
A Historical Crossroads
We do not have any ambition to answer this question in these pages. We just observe that Europe currently stands at a historical turning point and we believe there (logically) are two possible, but opposite, outcomes:
- The first is a move towards a broader fragmentation of the EU, resulting in the break-up of the free trade market and also in the failure of the long-term project of a political Union.
- The second is to see a renewed effort towards a higher political integration, beyond the pure monetary and economic integration. Only in the next several months we will understand which of the two roads Europe will take.
Turning to the investment implications, in the immediate future political leaders (not just in Europe) have to face the growing discontent of their electorates, which underpins not only the increase of anti-EU sentiment, but of a more general rise of populism, anti-immigrant sentiment and so on.
As such, it is possible that part of the political agenda of “moderate” leaders will have to include a portion of the populist agenda such as: an increase in taxation of corporations and higher earners, protectionism (i.e. import tariffs), and an increase of welfare benefits for low earners (i.e. minimum wages). All this means less growth and downward pressure on corporate profitability, which is a negative factor for equity exposure.
On the other side, we believe that monetary policies engaged in negative rates and QE for a longer period mean that a larger part of the bond universe will remain in negative (or close to zero) yield territory.
Finally, it is quite likely the adjustment mechanisms during the phase of transition will take place through the exchange rate mechanism, especially if monetary policies of different areas remain, at least partially, divergent.
Opportunities for Active Managers
Consequently, the investment landscape is less than exciting. But it does not mean that long-term opportunities, that can be exploited though active management, will not exist. Actually, we think that active management will have an edge over passive in a world of zero or low beta(2) , where most, if not all, total returns should come from alpha(3).
The current market dislocation may create opportunities for active managers to identify undervalued companies and sectors that may be unjustifiably penalized in this phase of market turmoil.
In the meantime, we remain committed to manage the risk side of the equation in order to preserve, as much as possible, the stability of our client portfolios and to take all the decisions needed to mitigate the current volatility.