Economic and Market Review - November 2016: After Brexit, what next?

by Gavin Graham, Chief Strategy Officer November 05, 2016 (Revised November 05, 2016)
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
On Thursday June 23rd, Britain voted by a 52% to 48% margin to leave the European Union (EU), after 43 years of membership. Electoral turnout was 71.8%, the highest since the 1992 general election, and more than 30 million people voted, with 17.4 million choosing Leave, 1.3 million more than Remain, and the biggest popular vote in British history. By comparison, the Conservatives received 11.3 million votes in last year’s general election and the opposition Labour party 9.3 million. The repercussions in financial markets were immediate, as investors had convinced themselves that Remain was the likely outcome, with the pound sterling hitting a 12 month high of U$1.50=£1 on Thursday, while the FTSE100 Index had risen 7% during the week up to close of business that day.

With opinion polls showing a small lead for Remain, and the betting markets reflecting less than a 1 in 4 chance of a Leave vote, most investors were dumbfounded as early results showed large leads for Leave in traditional Labour-supporting areas such as the North East of England, Wales and the Midlands, which, added to the votes of the prosperous southern districts, was enough to overcome those in London, Scotland and Northern Ireland who voted to Remain. England voted 53.4% to Leave, including London which voted 60% to Remain, and Wales also voted for Leave by 52.5%. Scotland and Northern Ireland voted Remain by 62% and 55.8% respectively.

The political fallout was immediate. Conservative Prime Minister (PM) David Cameron had only called the referendum due to pressure from the Euro-sceptic UK Independence Party (UKIP), which earned 4 million votes (13% of the turnout) in last year’s election. When he failed to gain meaningful concessions from the EU during late night negotiations at the beginning of the year and then ran a lacklustre campaign for Remain, dubbed Project Fear by opponents due to warnings that Britain would suffer a recession and house prices could fall, he was unable to carry on when the result went against him. He resigned on Friday morning, and announced the next leader of the Conservatives should be the person to negotiate the withdrawal.

Sterling plunged during the night by over 10%, touching a 31 year low of U$1.315=£1 on Friday morning, while the FTSE100 opened down 8%. European markets were even worse affected as German, French and Italian markets sold off by more than 10%, even as the Euro strengthened by over 6% to E1.21=£1. With Mark Carney, the Canadian Governor of the Bank of England, announcing that the Bank stood ready with £250 billion in liquidity to support any bank or financial institution that had issues, and the banks themselves in much stronger shape than in the 2008-09 crash, markets began to recover as calmer heads prevailed. While sectors perceived to be vulnerable to the effects of Brexit, such as housebuilders, airlines and banks, ended Friday down 20% or more, having briefly fallen 40% in some cases, exporters such as pharmaceutical, food, drink and tobacco companies and capital equipment makers were actually up on the day.

Meanwhile investors dived for the supposed safe haven of government bonds, with the yield on 10 year British gilts falling to an all-time low under 1%, and German and Swiss 10 year bonds yields becoming even more deeply negative at -0.15% and -0.55%. As I pointed out in my last commentary, and repeated in the BNN interview I gave on Friday (available elsewhere on this site), investors are so worried about volatility and afraid of deflation that are willing to buy investments that guarantee them losses over the next decade.

Negative long term bond yields mean the traditional balanced portfolio of 60% equities/40% bonds is now obsolete, and investors looking for long term assets with positive returns but low or no correlation with equities need to consider other types of income generating investments. These could include infrastructure, absolute return funds, or non-correlated countries such as frontier markets. They could also consider gold, which no longer has the disadvantage of not generating income compared to government or corporate bonds. In fact gold is guaranteed to out-perform the one third of the government bonds that have a negative yield, assuming it is the same price in a decade! Gold, often considered portfolio insurance or the ultimate refuge in times of tumult, jumped to over U$1,300 per oz. on Friday June 24th, bring its year-to-date increase to over 25%.

The Brexit vote reminded investors that the world is becoming increasingly uncertain. If the same protest vote at the failure of globalization and free trade to deliver benefits to a lot of the electorate is mirrored in the US, we could yet have President Donald J Trump! Certainly the Brexit vote has encouraged other Euro-sceptic movements in continental Europe, with Marine Le Pen, the leader of the National Front in France, demanding a Frexit referendum. With presidential elections due next May in France, and the economy mired in slow growth and a wave of labour disputes over revising such rules as the 35 hour working week, President Hollande would not even make it out of the first round of voting if the opinion polls are to be believed. Euro--sceptics in the Netherlands, Hungary and Poland are also demanding reform of the EU, while in Italy, the Euro-sceptic Five Star party won the mayoralty of Rome last weekend. With a constitutional referendum due in October, Italy, whose banks are staggering under the burden of an 18% Non-Performing Loans ratio (i.e. almost one in five of banks’ loans are in default) but cannot rescue them due to EU rules, could be the first major original member of the EU to give up on the project.

Since the post referendum sell-off, the FTSE100 has recovered all of its losses and is even higher than it was last August before the summer sell-off caused by China devaluing its currency by 5%. Given that 75% of its revenues are generated by exports or in countries outside the UK, this is unsurprising, but even the more domestically-oriented FTSE250 has recovered half of its 13% fall. Despite S&P downgrading the UK from AAA to AA due to the uncertainties caused by Brexit, the yield on the 10 year gilts continues to fall, down to 0.77% this week. Obviously, if you are an overseas investor, then the continued slide in sterling now at U$1.27=£1 at time of writing, will have offset most of the rebound, but that just means that the world’s fifth largest economy is on sale.

While exporters and defensive stocks have performed well, some sectors, such as insurance, banks, airlines and housebuilders remain 20-30% below their pre-Brexit level in sterling terms. Given that tourism to a much cheaper UK will undoubtedly increase, that an easy way to offset a downturn would be to increase housebuilding and that the Bank of England has been reducing capital requirements to ensure financial institutions remain liquid and providing credit, the continued sell-off seems overdone.

Political uncertainty will be resolved soon, as the next Conservative leader, hence PM, will be known by September 9th after a ballot of the 150,000 Conservative party members, and the struggle to dispose of the ineffective Labour leader Jeremy Corbyn will be eventually come to an end. The new PM will have the task of negotiating Britain’s withdrawal from the EU, which will take 2 years once Article 50 of the Treat of Lisbon is triggered, which is at a time chosen by the British government.

Brexit is a useful reminder that unexpected events occur in investing, but it was a “known unknown” to use Donald Rumsfeld’s phrase. The referendum had to be held by the end of 2017 once the Conservatives won last year’s election, and the date was set over 4 months before the vote. Investors decided that Remain would win, piled into sterling assets and had to reverse themselves suddenly when a very close vote turned out the other way. With a floating currency to act as shock absorber, the UK will experience slower growth over the next couple of years but also be able to remove some of the burden of EU regulations and be free to negotiate its own trade agreements with emerging and North American economies. Just for interest, it’s worth noting that the UK doesn’t have a trade agreement with its largest single trade partner, the US. Investors should be prepared for sudden shocks by having a well-diversified portfolio, with different asset classes and geographical exposures. Brexit will not be the last unexpected curveball the markets and politics throw at investors.