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.

 

 

 

 

 

 

 

thinking about 2016: currencies

There’s no overall theory of how world currencies interact with one another.  Rather, there’s  patchwork of general relationships.  I find two most useful:

general creditworthiness, or would I lend money to these guys (WILMTTG)?.

Another way of asking the same question is whether a country can generate enough foreign exchange to pay for its imports and meet the minimum service requirements on its foreign borrowings.  A “No” answer means trouble.

Natural resources-oriented emerging countries, both in the Middle East and in Latin America, are going to flunk this test, suggesting that for them currency depreciation is in store.

relative interest rates 

Generally speaking, countries where interest rates are rising will have stronger currencies than those where rates are stable or falling.

This rule suggests that the US$ will continue to rise against the euro, yen renminbi and emerging markets currencies–meaning just about everything.

 

As a practical matter, domestic stock markets seem to work best when a currency is stable or depreciating slightly.  A rising currency, because it lowers the domestic currency value of foreign earnings, acts as an earnings headwind.

 

I’ve found that the currency markets–read: traders in the big multinational commercial banks–are always three or four steps ahead of me in figuring out where currencies are going.  For equity investors, there may also be an issue of how the companies whose stocks they hold are acting internally to hedge their foreign currency exposure.

Typically, this second isn’t as big an issue as it might seem at first.  Stock markets most often understand that hedges now protecting profits will soon expire and, in consequence, pretty much ignore the earnings per share generated by hedging.

The question of what’s already baked in the currency trading cake is a more serious one.  It has me questioning whether any interest rate rises that may come in the US next year aren’t already factored into today’s currency rates.

my conclusions

The US$ will be flat to up vs. all other currencies next year.

The yen will be down, on my “No!” answer to the WILMTTG question.

Emerging market currencies will generally be weak.

The renminbi will be flattish, on weak relative rates but “Yes to WILMTTG.

Too soon to act on, but will the euro be stronger in the second half?

stock market implications

All other things being equal, companies with costs in weak currencies and revenues in strong currencies will have the best financial results.

Multinational companies based in the US with exposure to natural resources emerging markets may do poorly.

Those with EU exposure may show slim growth, if any, in their operations there in the first half.  Better news in the second?

As a general rule, when the domestic currency is rising, look for purely domestic companies and for importers.