James Bevan: Brexit and states of confusion

Four polls suggest that the result of the 23^rd June referendum will be to “Leave” and in case you hadn’t noticed, The Sun, which has the largest circulation of any domestic newspaper, came out in favour of a Brexit, which is notable given that it has a great track record in general elections and has always backed the winner.

The football will influence the outcome as so much of the voting will be sentiment-driven and it’s been widely reported that a restaurant was set ablaze as drunken English football fans clashed with Russian and French hooligans in France’s southern port city of Marseille.

The simmering dislikes and issues are never far from the surface – and a Brexit would set an unwelcome precedent for countries to leave the EU whenever domestic priorities conflict, and would do so at a time when political risks and potential for sovereign-EU confrontation are already high.

Simultaneously the UK would present continental opponents of immigration with a politically potent example (and threat) of how to deal with one of the thorniest and most emotionally charged trans-national issues confronting European voters: immigration.

In other words, Brexit poses a much bigger risk to the European economy than Grexit because Greece didn’t exit and has a tiny economy (with lots of debt), while Britain might be on the verge of leaving in a way that could be very disruptive to commerce and finance in the region, with lots of adverse global consequences.

Precedent

The precedent of a member state leaving the union would open Pandora’s box: it could be used as a political argument by populist and extreme parties in several countries, both from the right and the left, to push for an EU exit, including for some Euroland countries.

European financial markets are now rapidly moving to discount a Brexit. The pound is the worst-performing G-10 currency this year.

We presently have no FX hedges in place having anticipated this direction of travel and the pound remained under pressure on Tuesday (last week) as data showed annual inflation held at 0.3% in May, falling short of consensus forecasts for a 0.4% increase.

Last month, Bank of England Governor Mark Carney said that the central bank would likely raise interest rates if Britain remains in the EU, while an exit vote wouldn’t necessarily trigger easing because a decline in the pound would boost inflation.

However, last week’s lower-than-expected inflation data will allow the BoE to ease to boost demand in a Brexit scenario, which would send the pound still lower.

Bund

That said underlying inflation came in at 1.2% vs the ten-year gilt yield of 1.18%. But the ten-year gilt yield looks sane compared with the yield on Germany’s 10-year government bund which fell below zero for the first time on record yesterday.

Germany joined Japan and Switzerland in having 10-year bond yields of less than zero – and the German 10-year bund joins the more than 40% of the $6.4tn of Euroland debt that already has yields below zero (source of this extraordinary stat: the Bloomberg Eurozone Sovereign Bond Index).

As for equities, prices have been pummelled yet UK equities haven’t been hit as hard as EMU equities and that may be because the pound has been pounded, which helps exporters.

Meanwhile the bookies suggest that betting money is on Remain winning the day.  Odds on at the beginning of last week (4-7 for stay vs. 7-4 for leave) imply a Brexit probability of 36%.

You can square-off the difference between the polls and the bookies if you anticipate that there will be a swing on the day of the vote toward stay as some voters, who may only marginally favour Brexit, lose faith due to all the uncertainty encompassed by a departure from the EU. Voting for the unknown takes higher conviction than voting for the status quo.

Bookies

If the bookies are right, this could be a great opportunity for contrarians to buy European financial stocks and go long the pound. After all, since 2010, there have been three Grexit crises that were resolved without a Grexit and that set the stage for big relief rallies in Euroland stocks (particularly the banks) and bonds.

European stocks could rally smartly if there is no Brexit. However, the economic fundamentals remain lacklustre in the region. Industrial production jumped 2.0%mom in April, but the trend has been sideways since early 2014, particularly for manufacturing output, and in Euroland, production rose 1.1%mom during April, but remains no higher than it was in early 2011.

If there is a Brexit, both the European Union and Euroland could be in a state of confusion. In a worst-case scenario, powerful political forces could pull apart the economic and monetary unions. While that seems very unlikely, it will seem more likely in the event of a Brexit.

While we would like to be contrarians, we certainly can’t rule out a Brexit. Even if it doesn’t happen, there seem to be more reactionary responses to globalization all around the world.

Over in the US, Donald Trump certainly has tapped into that theme very effectively. While the US won’t be immune if the world turns more nationalistic and protectionist, it will be less adversely affected than most other countries and that’s because the US economy is more resilient, diversified, and self-contained than all other ones. Poor old Britain with its open economy has much to lose and we are underweight relative to comparator neutral weightings.

 

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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