Home Rule Britannia

• Britons vote to leave the EU.
• What does the future hold for the UK and EU?
• Panic grips the markets, but not Bond Squad.
• It is more important than ever to know what you own and own what you know.

Equity markets are plunging and sovereign bond prices are rallying as the majority of British people decided that sovereignty and political independence are more important than (potential) economic advantage. The British people’s decision brings with it consequences, not only for the UK, but for the EU as well, if not more so.

The United Kingdom will begin a process to extricate itself from the EU. This could, perhaps, take two years. Depending on what post exit trade deals are negotiated, the UK may be subject to import/export tariffs, trade quotas, etc. The UK will probably have to deal with another Scottish independence referendum. More than 60% of the Scottish people voted to remain in the EU. In my opinion, it will take some ingenious politicking to convince the Scots to remain part of the UK. I believe that a Scottish separation provides the biggest risk to the British economy and economic stability. In my opinion, the British decision to exit the EU has more potential dire consequences for the EU than for the UK.

We must remember that the UK never adopted the euro currency. Thus, there is not the same potential for economic disruption from currency exchange and revaluation of assets as if a Eurozone member exited. Yes, the pound  is repricing in currency markets, but there will be no repricing of assets from one currency to another and no currency change among debt repayment, such as would happen if a Eurozone member, such as France, Germany or Italy decided to exit the EU.

Could this cause a slowdown or contraction of the British economy? Yes, but I believe this will prove temporary. As I stated previously, the UK was not part of the European common currency and was probably the most loosely-integrated into Europe of any EU member. Leaving the EU will probably not diminish the UK (London particularly) as a major financial center. The UK has more globally important banks than France and Germany combined. Many bonds are issued with indentures written under British law. It is the reliability and clarity of British law, as well as financial infrastructure which should help Great Britain retain its standing as a financial center.

I believe there will be a period of disruption. This period could take months, if not years. However, the British economy should be sufficiently strong and flexible to endure this voyage into lightly-explored territory (U.S. independence from Great Britain is probably the closest comparison). The biggest risk to the UK economy, in my opinion, is if Scotland decides to separate from the United Kingdom, ending a union which has lasted more than 300 years.

I believe the naysayers (doomsayers) who are casting doubt on Britain’s economic prospects, post-exit, fail to acknowledge the fact that European nations, such as Switzerland and Norway, get along just fine and trade with their EU neighbors with little difficulty while remaining outside the EU and common currency. To think that the UK cannot prosper outside the EU is a naïve concept.

I believe that the prospects for EU survival, as an economic block, are challenged (to say the least). We are already hearing rumblings of a desire for EU exit referendums in The Netherlands and Germany. In France, far-right politician Marine Le Pen is arguing for a French exit referendum. Last night, I tweeted that the European Periphery could bear the brunt of a British exit from the EU. At the time of this writing, equity markets in Italy and Spain were down more than 10%.

The Periphery faces two potential problems:

1. If core EU/EMU members vote to leave, it would leave Periphery members without the economic/monetary support they currently enjoy. It is unlikely that Italy would be able to borrow at about 1.50% and Spain  at about 1.60%, if not linked to a central bank (the ECB) supported by larger economies, such as Germany and France.  An exit by core EMU members would almost certainly lead to a dissolution of the EU.
2. Periphery nations desperately desire a weaker currency to be able to print their way out of economic distress (rather than engaging in structural reforms). This could/should energize radical left-leaning political parties, such as Podemas in Spain, to push for an EU exit so as to return to sovereign currencies which can be devalued to pay obligations and repay debt.

It is possible that the EU offers the UK incentives to stay. However, this would almost certainly result in other member nations lobbying for various concessions. Once there are different rules for different members, the EU would be effectively dead. Thus, the only chance the EU has of surviving is, in my opinion, to play hardball with the UK and allow it to exit.

What does this mean for investors/investment strategy? I believe we have entered a period of heightened volatility. The UK exit from the European Union instills much uncertainty into the capital markets. Markets abhor uncertainty. In periods of uncertainty, the initial reaction of investors and market participants is to fly to quality/safety. The uncertainty surrounding the British pound and the euro should increase demand for the U.S. dollar and the Japanese yen. This should help to hold down bond yields in the U.S. and push Japanese sovereign debt farther into negative territory. A strengthening yen is much to the chagrin of the Bank of Japan.

Markets (investors and market participants) have become complacent in that they believed that existing institutions, such as the EU and EMU, were durable and central banks (and central banks alone) had the power to engineer desired and familiar outcomes. They are learning that this is untrue. The fact that the majority of Britons have chosen sovereignty and self-determination over economic certainty (which is not necessarily synonymous with vibrancy) is confounding market/investment strategists around the industry. Those with a knowledge of history and cultures understood that there are things which often take precedence over short-term economic prospects and the comfort provided by maintaining the status quo.

There was a group of colonies which placed liberty and self-determination over the security of membership in a large empire, more than 200 years ago. Things did not always go swimmingly for these united states, but it has seemed to work out in the end. I would not count out the UK just yet.

I think much of the negativity in the markets, today, is a bit silly. A good portion of the weakness in risk markets (particularly equities) is probably due more to unwinding of Brexit bets rather than to a fundamental view of investment values. However, we could see market participants re-evaluate investments on their own fundamental merits. In my opinion, selling of high quality equities, investment grade corporate bonds and even many high yield bonds, en masse, based on a British exit from the EU and/or a dissolution of the EU itself, is borderline foolish. If you know what you own and have selected specific investments based on suitability and/or the best interest of clients, you will probably be alright, in the end. If you have used a prefabricated strategy with a smattering of asset classes, with little idea to what you are truly exposed, I’m afraid I cannot help you.

As for Fed policy; I find it difficult to imagine a July Fed tightening with so much uncertainty in the global economy and markets, unless we see blow-out U.S. economic data in the coming weeks. In fact, I believe that a September Fed rate hike is unlikely, at the present time. In my opinion, December is the next FOMC meeting which might deliver a Fed rate hike, but even this is questionable.

In spite of the likelihood that interest rates remain low, across the UST yield curve, I would caution readers against reaching very far out on the yield curve in search of yield. I also caution against reaching too far down the credit quality scale to pick up yield. A balanced approach to duration and credit risk is warranted, in my opinion. The best interest of investors/investors suitability must take precedence over all other considerations when selecting investments and investment strategies.

In this period of uncertainty, there is something of which I am fairly certain. Investment strategies based on historical mean reversion will likely leave investors and advisors disappointed. As I stated in the 6/16/16 edition of “Making Sense,” Semper Vigilans should be the motto of investment strategists and financial advisors.

Readers know that I have been very critical of the viability of the Eurozone and European Union. It is very difficult, if not impossible, to have a monetary union without a fiscal/political union. The tide appears to be rolling out on a united Europe. I believe that this is the beginning of a slow and, possibly, messy EU dissolution. I believe that this is a long-term positive to the people of Europe. Ironically, it is the citizens of Periphery nations who could benefit the most from exiting the EU or, at least, the euro currency. This does not mean that a European trade block cannot or will not exist, but rather a trade bloc containing members with sovereign currencies could materialize. I would look for the UK to become a member of a European trade bloc which did not impinge on its sovereignty. However, there is much ground to cover before we get to that point.