Theresa May’s 157 Brexits – and beyond

Mon 28 Jan 2019

The Economist magazine has characterised Brexit “The mother of all messes”. To exit a trade agreement so comprehensive that over the past half century has come to encompass virtually all aspects of the British economy is, by and large, unprecedented. To do so in less than three years, in the midst of political turmoil, is nearly impossible. After last week’s rejection of the PM’s plan for Brexit, a large number of paths have opened for the next few months. Visibility is next to zero, maybe even within Whitehall, but as investors we need a framework to make decisions going forward, so we have mapped the basic routes for the next few months for Britain. By our – relatively conservative – count, there are no less than 157 scenarios which could conceivably play out over the next two to eight months. To limit the number of scenarios, we made some key assumptions:

a.            The EU has probably put its best offer on the table, and only tweaks to the Irish Backstop will be discussed.

b.            There’s currently a parliamentary majority for a soft or no Brexit, which will drive decision making. The enemy of that outcome is time limits.

c.            There’s currently Brexit-fatigue within citizens resulting in only a slightly higher than 50% probability that a second referendum would yield a “Remain”.

d.            A hung parliament may occur in the event of one general election, but a second general election will provide a working majority for one party or other.

What does Europe want?

Ostensibly, European leaders hold the principle of free movement sacred and will side with Ireland’s demand not to compromise the island’s integrity. However, looking at recent history, the EU commission is not always adamant on principles. A year ago, it allowed Italy to flaunt budget rules to bail out its own banks. Possibly it will be allowed some leeway again. Is it a stalwart of smaller states? While all countries have agreed to the need of stemming illegal migration, Greece and Italy have been largely left without significant help these past few years, with countries such as Austria and Hungary even unilaterally closing down borders. Greece is also the only country exempt from QE and subject to a harsh restructuring regime. This means EU rules are flexible and subject to perceived utility. So it’s not necessarily principles that are at stake, but rather a “win”, against a neighbour with which it has a £60 Billion trade surplus. By redefining the relationship with Britain, impediments to further Euro integration were removed.

What EU leaders probably don’t want to remove is the British contribution to the EU budget, which would mean a blanket curtailing of expenses of about 10%. As much economic pain the UK feels from Brexit, the EU also has a lot to lose. Which is why things have come to a point where the UK either capitulates or risks economic disaster (a no-deal Brexit could see the economy contract 10% and unemployment double according to the Bank of England). Given that the current Parliamentary majority is predisposed towards a softer Brexit and Brussels holds most of the negotiating cards, rescinding Article 50, becomes more enticing by the minute.

What does our model say will happen?

Based on the current parliamentary balance of power, as well as prevailing sentiment, we now believe that there’s:

– a 38% probability of a general election

– a 27% probability of a new referendum

– a 53% probability of a softer or even a no-Brexit.

However, there’s still a considerable probability for a hard or crash Brexit (28%), enough to give pause to international investors and delay important spending decisions, both on a household and a corporate level.

What does all this mean for investors? A market rebound is something that investors can make an intelligible bet on when following monetary policy communiques closely. Politics on the other hand, the product of sentiment and compromise, is driven by each country’s unique social contract, and so very unpredictable. No evidence exists rendering political ideology a good long term investment principle. Instead investors need to look at what the negotiation has become: a non-cooperative zero-sum game with the EU betting that it has less to lose than the UK.

Where economic and market performance is too reliant on politics, investors should wait for some clarity rather than bet on largely uncertain outcomes.  In an era of identity politics we fear that the outcome remains uncertain, which is why we avoid making investment assumptions on the outcome.

Beyond the next 6-8 months

Notwithstanding the outcome, what we need to do, as long term investors, is to take a few steps back and look beyond the short term noise.

An independent observer would find that for the past 25 years Britain and the EU had already been following different paths. One  path is moving towards an ever closer union, maybe eventually even a federation, underpinned by the demands a common currency places upon countries. The other istowards a confederation, which was the original EU concept. Germany, France and 17 other countries, even those which, like Greece, could not afford an expensive currency such as the Euro, have opted for the strategic benefits of the union. Britain and certain eastern European countries have conversely preferred independence, the endgame of which would be a trade and customs union with a solid Euro-Block.

Brexit is not a process which began in 2016. The referendum was a milestone on the second route, that of a confederation, on which Margaret Thatcher placed Britain in 1992 by removing it from the monetary exchange mechanism. 25 years of divergent paths are enough to turn a rift into a chasm. Even if Brexit were to stop tomorrow, core European countries and Britain would be in very different places.

Britain has come face to face with an intractable problem. Continue as a member of a union in which it has very little say, dominated by its 19-country-block partner, and suffer some economic pain, or leave and,  according to the Bank of England, suffer considerably more pain.

From here on, there are 4 different paths for the UK:

One: It leaves Europe, under good or bad terms in a short period and fights to re-establish itself as a major world trading power.

Two: It maintains the status quo, remaining in Europe in some way, shape or form, trying to find an edge within the boundaries of the single market, and establish a trade surplus.

Three: It remains in Europe and enters the Euro. That would mean forgoing monetary independence in exchange for possible strategic leverage.

Four: It leaves Europe, on its own terms, when it’s good and ready to do so. This would require extensive planning and a period of execution of no less than a decade.

All paths have their perils. All include antagonising Europe by creating a trade surplus with the Euro-Block, i.e. exporting more than the UK imports. Currently that means that it needs to close a £60bn gap (3% of GDP) and create a big surplus, on top of attaining average GDP growth of 1.5% to 2.5% per annum. The task, given current trends, is nearly impossible, no matter how much Sterling is devalued (competitive devaluation is a game that can be played by two, and hurt both equally).

Whatever one’s vision for the UK, it has to be forward looking. With the possible exception of the Persian Sassanid Empire in 240 AD, no empire in history has ever staged a comeback. From Rome, to France, to Spain and Germany, to Egypt and Japan, once imperial standards were lowered, they never returned.

Instead, like post WWII Germany and Japan, success lies in reinventing one’s future. Legislation to foster true technological innovation, an environment that helps the service sector to maintain a competitive edge, besides a tax race to the bottom, and ideas on how to create a modern-skilled workforce are what attract foreign and domestic investment. Monetary policy, or currency competition, is a short-term fix and would likewise attract short term money.

What is the path to Brexit that would lead investors to strategically overweight UK risk assets (not just the international FTSE 100 conglomerates)? A carefully planned long term exit, which plays on current strengths (rule of law, strategic position, diplomacy, English as the global language of business) making Brexit irrelevant to major investment decisions.