tallying up the cost of Brexit

How good is the UK, the part of the EU most American investors know best, as a way to participate in potential economic strength in Europe over the coming 12 months?

Probably not good at all.  Here’s why:

–since the Brexit vote last June, sterling has depreciated by 13+% against the US dollar and 8+% against the euro.  While the loss of national wealth in Japan through depreciation dwarfs what has happened in the UK, the blow to holders of sterling-based assets is still immense.

Depreciation lowers the UK standard of living and reduces the purchasing power of residents by raising the cost of imported goods.  While one might argue that the fall in sterling is in the past–and while the consumer will be in trouble benefits to export-oriented firms through lower costs are still to come–this may not be the case here.  More in point #3.

–there’s some evidence that UK residents, realizing last June that prices would soon begin to rise, did a lot of extra consuming before/while firms were marking up their wares.  If so, the UK economy could be in for a significant slowdown over the coming months, both because consumers are now poorer and because they’ve already used up a chunk of their budgets through anticipatory buying.

–much of the appeal of the UK as a destination for export-oriented manufacturing comes from its position as the large foreigner-friendly country in the EU, from which multinationals could reach into the rest of the union.  That’s no longer the case.  An article from yesterday’s Financial Times is titled ” Brussels starts to freeze Britain out of EU contracts.”  Its basis is an EU government memo, which, as the FT reads it, advises staff to:

–avoid considering the UK for any new business dealings where contracts may extend beyond the two year deadline for Brexit

–cancel existing contracts with UK parties that extend beyond the Brexit deadline

–urge UK-based companies to relocate to continental Europe, presumably if they want favorable consideration for new business.

It seems to me that the EU leaked this memo to the FT to get the widest possible dissemination of its new not-so-friendly-to-the-UK policies.  It implies that the post-Brexit business slowdown in the UK will start immediately, not in two years.

One set of potential winners:  UK-based multinationals that do little or no business with the EU.  These, like ARM Holdings, are also potential takeover targets–although it’s questionable if the UK will permit further acquisitions by foreigners.

 

a French sovereign debt default?!?

First there was the surprise Brexit vote in the UK, after which sterling plunged.

Then there was the improbable victory of Donald Trump in the US presidential election, which sent the dollar soaring.

Now there’s France, where the odds of a far-right presidential victory by the Front National have improved.  A competing right-of-center candidate, former frontrunner François Fillion, has been hurt by allegations that his wife and children did little/no work in government jobs he arranged for them (with aggregate pay totaling about €1 million).

If Marine Le Pen, the FN leader and standard bearer, were to win election in May (oddsmakers now give this about a 1 in 12 chance), her victory might conceivably snowball into a similar sea change in the National Assmebly election in June.  Were the FN to win control of the legislature too, the party says it will leave the euro and re-institute the franc as the national currency.  In addition, it intends to, in effect, default on €1.7 trillion in French government bonds by repaying the debt in new francs, at an exchange rate of 1 Ffr = 1 €.

Improved prospects for Ms. Le Pen–plus, I think, President Trump demonstrating he means to do his best to keep all his campaign promises–have induced a mini-panic in the market for French-issued eurobonds.  Trading at a 40 basis point premium to similar bonds issued by Germany as 2017 opened and +50 bp in late January, they spiked to close to an 80 bp premium last week.

my take

At this point, the conditions that would trigger a French exit from the euro and its refusal to honor its euro debt instruments seem high unlikely.  Still, the possibility is worth thinking through, since the financial markets consequences of Frexit would likely be much more severe than those of Brexit.

More tomorrow.

 

 

 

 

 

 

 

Brexit vs. the Trump election

Trump and Brexit

Right before election day, Donald Trump predicted his victory by saying that it would be just like Brexit, only more so.

That turned out to be correct, in the sense that in both cases the pre-election polls were incorrect and that the result turned on the votes of older, disaffected, less-educated citizens who came out in large numbers in response to a call to roll back the clock to days of former glory.

post-Brexit

The immediate UK stock market response to the Brexit vote was to drop through the floor, with the multinational-laden large-cap FTSE 100 index faring far better than generally domestic-focused small caps.  The FTSE has rallied since, with the index now sitting about 6% higher than its level when the election results were announced.

That does not mean, however, that the Brexit vote turned out to be a plus for UK stock market participants.  By far the largest amount of damage to their wealth was done in the 15% drop vs. the dollar that the UK currency has experienced since June.

post-Election Day

Despite the voting similarity between UK and US, the currency and stock market outcomes have been very different.  In the week+ since the US presidential election,

–the dollar has risen by about 3% against both the euro and the yen since the election result became known

–the S&P 500 is up by a bit less than 2%, with small caps significantly better than that.  Potential beneficiaries of Trump policies–oil and gas, construction, banks, pharma, prisons–have all done much better than that.

Why the difference?

Brexit

Brexit was a simple, binding in-or-out vote on an economic issue (recent legal action seems to show it’s not so clear-cut as that, however).  Leaving, which is the action voters selected, has immediate, easily predictable, severely negative economic consequences.  Hence, the continuing slide in the currency.

Trump

The Trump vote, on the other hand,  was for a charismatic reality show star with unacceptable social views, very limited economic or policy knowledge/interests and a questionable record of business (other than show business) success.   Not good.

The US vote was for a person, however flawed, not necessarily for policies.  In addition, the  legislative logjam in Washington has potentially been broken, since Republicans will control both houses and the Oval Office.

The general economic tone Trump seems to be setting is for fiscal stimulation through tax reform and deficit spending on infrastructure.  Both would relieve the extraordinary burden that has been placed on the Fed (the only adult in the Washington room).  This will likely mean larger, and faster, interest rate hikes.  Hence the rise in the currency.

knock-on effects

Democrats seem to realize the folly of having a cultural program without an economic one; a substantial restructuring of that party may now be under way.  Bipartisan cooperation in Congress seems to once again be in the air, if for no other reason than to act as a check on Mr. Trump’s more economically questionable impulses.   Trump’s “basket of deplorables” social views may make Americans more vividly aware of the issues at stake, and what progress needs to be made   …and serve as a call to arms for activism, as well.

Another thought:  yesterday’s news showed the Trump brand name being removed from several apartment buildings on the West Side of Manhattan.  Based on feedback from tenants, the owner, who licenses the Trump name, concluded that retaining the buildings’ branding would result in lower rents/higher vacancies.  Given that Trump does not intend to have his business interests run by an independent third party while he is in office, the public would seem to me to have an unusually large ability to influence his presidential actions by its attitude toward Trump-branded products.  I’m not sure whether this is good or bad   …but “good” would be my guess.

All in all, the UK seems to be lost in dreams of the days when it ruled the oceans.  The US is less clear.  We may be in the early days of a renaissance.

 

“hard” Brexit, not “soft”

Ever since the Leavers overwhelmed the Remain faction in the UK’s Brexit vote, observers have been wondering how the UK is going to effect its break with the EU   …and how complete the breach with continental Europe will be.

The two main approaches were dubbed soft, meaning that negotiations would be held at a leisurely pace, the break would come eventually–but not soon–and that the UK would retain as many of the privileges of EU membership will shedding as many obligations as possible.

Article 50 of the Lisbon Treaty lays out the process for a country to withdraw from the EU.  It provides that a state that wishes to leave sets the process in motion by invoking Article 50. That starts a two-year clock running, at the end of which the separation occurs.  Since two years is a relatively short period in diplomatic time, especially to arrange complex future trade agreements, conventional wisdom has been that a country like the UK would begin negotiations first and only trigger Article 50 when the negotiating finish line was in sight. Taking this path would be the more economically sensible.  It would also be a clear sign that soft is the ultimate goal.

The alternative would be “hard,” meaning basically getting out of Dodge as fast as possible.  Why do so when collateral economic damage would result?    …because other political considerations, like halting immigration from the rest of the EU, have a higher priority.

 

Over the past week or so, Prime Minister Theresa May has been signalling that Brexit will not be put on the back burner, and that, in consequence, the UK government is opting for the “hard” road.  She will invoke Article 50 by next March, at the latest.  And she has packed her negotiating committee with the most anti-EU people she can find.

This decision has a number of consequences:

–Scotland, where two-thirds of voters cast their ballots to Remain in the EU, is reviving its own referendum to withdraw from the UK and enter the EU as a sovereign country itself

–putting itself under time pressure by effectively starting a two-and-a-half-year clock running, the UK has revealed its sense of urgency.  That may have lost it negotiating leverage

–half of the UK’s exports go to the rest of the EU.  Time constraints may see it leaving the EU in early 2019 without trading agreements with countries where its major customers reside–meaning export sales may fall off a cliff

–similarly, it becomes less likely that bankers based in London can retain their current unfettered access to clients in other EU countries.  This suggests that banks may begin to shift operations to the Continent

–sterling will continue to slide.  For portfolio investors like you and me, this has perhaps the most important near-term implications.  There’s no need now, nor in the near future, to change from favoring London-traded stocks whose assets and earnings are outside the UK.  Better still if the firms’ borrowings and SG&A expenses are in sterling.

 

 

 

the slow-motion disappearing act of the British pound

Brexit

Just prior to the Brexit vote in June, at a point when sentiment had temporarily swung in favor of Britain remaining in the EU,  the British pound reached a high of about 1£ = $1.48.  Yesterday the post-vote slide reached a 31-year low of 1£ = $1.27, 14% lower.

What makes the $1.27 level significant isn’t just the continuing fall in national wealth induced by the Brexit vote.  It’s also that the UK has now slipped behind France for the title of second-largest economy in the EU.

The cause is the gradual working out of the detailed consequences of something that was, or should have been, well known in general terms before the Brexit vote–that however emotionally satisfying the Brexit vote might have been, there are potentially very large economic costs to the UK from leaving the EU.

They come in two forms:

–London is the financial center of the EU, and as such has tons of banking jobs which may well shift out of the country

–because it is more open to foreign companies than continental Europe, many multinationals have chosen the UK as the home base for their EU operations.  Much of that presence–and the associated jobs–may well be leaving now, as well.

US parallels

Two parallels can be drawn between the UK and the US from Brexit.

The first is that the vote in favor of Brexit–since generally regretted in the UK–was driven by an older, rural constituency that felt left out of EU-generated prosperity.  There is also an anti-immigrant element in the pro-Brexit camp, though not so overtly racist, I think, than among Trump supporters here.

The second is that in stock market terms the Brexit vote has not been as bad as one might have feared.  The currency has since fallen by about 12%.  The large-cap FTSE 100 has risen by 10% or so, however, offsetting most of that decline.  Many multinationals are actually up in US$ terms.

However, although the same forces driving voters in the UK may well be motivating those in the US, I don’t think the idea that the S&P 500 reaction to a Trump presidency in the US would be similar to the post-Brexit FTSE holds water.

That’s because the two stock markets have very different structures.  The UK is a small country with an outsized stock market, dominated (about 3/4 of the market cap) by multinationals headquartered in Britain but doing the vast majority of their business elsewhere.  For most of those, a fall in sterling has lowered administrative costs significantly but has had very little negative effect on revenues.  For multinationals with their debt in sterling, the advantage is magnified.  In additions, because multinationals give access to a stream of hard-currency revenue, they also serve as a modest form of capital flight.

Half the US stock market, in contrast, is made up of purely domestic companies, with another quarter doing business in nations whose currencies are linked to the dollar.  So the safe haven effect would be much smaller.  In addition, all of his other negatives aside, simply given Mr. Trump’s loony notions about foreign trade, the economic damage he might do is considerably greater.

 

 

Brexit, sterling and InterContinental Hotels Group (LN:IHG)

Early indicators after the UK vote to “Leave” the EU are already showing the country is dipping into recession.  Nevertheless, large-cap stocks in the UK have held up surprisingly well.

This can clearly be seen in the results just announced yesterday by IHG.  The fear of markets before Brexit about hotels had been that the post-recession cyclical upsurge in vacationing had just about run its course–and that, as a result, hotel profits were just about to peak/had already peaked.  But the figures from IHG were good and the stock rose by about 3% on the news.

To see how this can be, it’s important to note    that the post-Brexit decline in the fortunes of the UK has been expressed almost entirely in a 10%+ decline in the British currency.  This is an unexpected boon for British-based multinationals.

As Richard Solomons, the CEO of IHG, put it in yesterday’s report to shareholders:

“Note that whilst the UK comprises around 5% of our group revenues,

approximately 50% of our gross central overhead and

40% of Europe regional overhead are in sterling.

At 30 June 2016 exchange rates, approximately 70% of our debt is denominated in sterling.”

All of these figures are now 10% less in purchasing power terms than they were pre-Brexit.  Without any price changes, revenues will be 0.5% lower in dollar terms than they would have been.  But overheads will be down by much more.  In addition, the dollar value of the company’s debt is sliced by about $128 million.

This situation has two positive effects in the minds of UK investors:

–profits will likely be higher than anticipated, making the stock more attractive, and

–to the extent that a company like IHG, which has the lion’s share of revenues outside the UK, is affected by Brexit, the influence is likely to be positive.  This means that it can act as a way for British residents to preserve the purchasing power of their savings.

 

redemption halts in UK-based property funds

Over the past week or so, the boards of a number of UK property mutual funds have exercised the ability their charters give them to suspend shareholder redemptions.

What’s this all about?

The central issue is, of course, the “Leave” result of the Brexit vote.  This has two negative consequences for UK property.  The first is that property is a domestic sector, where holders whose base currency is the US$ or the € have felt the full brunt of the subsequent fall in sterling against those currencies.  The second is that although suddenly 12% cheaper to foreigners, it’s questionable whether offices or other commercial properties will retain their allure once the UK is on the outside of the EU.  Also, the central bank is predicting the vote will cause a mild recession, always a bad thing for property.  So bargain hunters haven’t yet appeared as buyers.

On balance,  a lot of people want to cash their shares in.

The second problem is endemic to property.  It’s not a particularly liquid sector.  Not only would you get a horrible price in a forced quick sale, it’s probably impossible to get the paperwork processed and a check in hand inside, say, a month.  Property funds–in fact, all mutual funds–try to safeguard against being overwhelmed by redemptions by keeping a percentage of assets (maybe 2% or 3%) in cash.  Funds also have credit lines they can draw against if need be.  But for property funds if holders of 10% of the outstanding shares all want to redeem at once that won’t be enough.

Initial redemptions can also create a self-reinforcing cycle.  Shareholders who initially had no intention to redeem may join the queue simply because they fear continuing withdrawal pressure will depress net asset value further.

The result is that the funds in question have been unable to meet the redemptions they’re experiencing.  They’ve been forced to suspend redemptions while they raise cash in a orderly way.

I don’t think the redemption window will be opening any time soon, although I’d imagine enterprising brokers have already set up a market to transact in these suspended shares, at a substantial discount to NAV, no doubt.

 

Lessons for the US?  More tomorrow.