29th June 2016

Arminius’ global macro hedge fund recorded a modest positive return on the Brexit vote, even though we do not make bets on political events. We invest our clients’ money on the basis of quantitative statistics about the market, and our quantitative models told us in mid-May that risk in global markets was too high. Therefore we shifted 95% of our fund to the safe haven of cash, which is where it will remain until at least 01 July. As a result, we have avoided the market falls which followed the Brexit vote, and the Fund made profits on some market neutral short positions in the US equities market.

The Brexit vote has triggered a regional crisis, not a global crisis. But it has undoubtedly increased the already high level of risk in global markets, and its complications mean that there will not be a return to “business as usual” anytime in the near future. The ratings agencies have already downgraded UK government debt, putting it on lower levels than Germany, the Netherlands and Australia, on the grounds that the UK’s economic and constitutional outlook is extremely uncertain and that growth will fall sharply as businesses defer investment and hiring.

For Australian investors, the danger lies in the heightened risk in global markets, because Brexit has very little direct impact on Australia. The UK is no longer one of Australia’s major trading partners. It accounts for only 3.2% of Australia’s exports and 4.6% of Australia’s imports – about the same as Malaysia, except that Malaysia is growing faster than the UK.

We expect that the next six to twelve months will be a period of extreme political and economic uncertainty, not only because of the complexities of constitutional and international law, but also because the UK has no idea of where it is going, other than the general direction of “Out”. In this period of uncertainty, most companies with UK and EU operations will avoid adding to their exposure to the UK and the EU, so they will minimize investment and hiring. There will undoubtedly be a negative effect on the profitability of US and Australian companies with material operations in the UK and EU (…of course, some companies will find Brexit a useful excuse to cover up their own failings). How long this lasts depends on exactly what arrangements the UK ends up with.

The single largest problem with Brexit is that the “Leave” campaign included various incompatible views on what they would do if they won. A period of confusion is inevitable because there is no agreement on the details of a post-Brexit UK, let alone on the mechanics of getting there.

Because Brexit requires several complex legal and political processes to occur at the same time, the UK faces at least six months of confusion. The new Conservative Prime Minister will not take office before September, and it will be up to him or her to push the button which formally starts the exit processes.

The exit itself will take up to two years, because it comprises three parallel streams:

  • The UK Parliament will have to pass legislation to replace all the issues which used to be covered by EU regulations.
  • The government of the day will have to negotiate all the mind-numbing details of new relationships with the EU to cover trade in goods, trade in services, and the movement of people.
  • The government will also have to negotiate the UK’s new relationship with the World Trade Organization (WTO) because the old one operated under the UE umbrella.

These multiple sets of negotiations will not be straightforward, not least because Parliament will have to vote on all the new treaties. Prior to the referendum, most of the Labour MPs and a small majority of Conservative MPs favoured “Remain”. Another general election may be needed.

First of all, the new Conservative government will have to decide what its new relationship with the EU should look like. Norway and Switzerland are models of successful relationships with the EU, but these models do not meet key concerns of the Brexit campaigners, such as restrictions on immigration and freedom from EU regulations. Nor is there any reason why the EU member countries should do the UK any favours in the negotiations: each country has its national interests, its own companies, its own lobby groups, and its own voters.

For example, London’s pre-eminence as a global financial centre relies in part on its “passport rights”, under which London-based banks are allowed to service clients throughout the EU. These rights will almost certainly be removed, so that banks will have to service such clients from banking offices inside the EU. This is why several banks have already started to move staff from London to their offices in Paris or Frankfurt or Dublin.

The sharp division of opinion within the UK ensures that politics will not be back to normal any time soon. Londoners, who voted overwhelmingly for “Remain” are well aware that their jobs may be heading off to Europe. The strong Scottish majority for “Remain” has already been translated into renewed calls for independence. The post-Brexit need for a hard border between Northern Ireland and the Irish Republic endangers the peace settlement there. In particular, the 75% of young people who voted for “Remain” will regard Brexit as yet another disaster caused by the same baby boomers who saddled them with student debt burdens, the GFC, unemployment and unaffordable house prices.

Given these divisions, not to mention the personal enmities which have arisen during the campaign, it is possible that the UK will find itself in a full-blown constitutional crisis. The Conservative Party has a caretaker Prime Minister, a small majority of MPs in favour of “Remain”, and a majority of Party members in favour of “Leave”. The Labour Party has a leader under threat, a clear majority of MPs in favour of “Remain” but a majority of its working class voters in favour of “Leave”. Many MPs on both sides of politics will face hard choices if they want to persuade their constituencies to re-elect them. Under such circumstances, stable government is unlikely.

The longer term impact on the EU is uncertain, and this uncertainty has been reflected in the “flight to safety”: investors have deserted UK and EU equities in favour of the comforts of very low yielding government bonds. The Brexit example will certainly encourage separatists throughout the EU, starting with the Italy’s constitutional referendum in October. But most of the impact on the EU will play out over the next five years, rather than the immediate future. It should be remembered that the EU economy is five times the size of the UK economy, has many other trading partners, and functioned very well before the UK joined in 1973.

In short, Brexit joins “President Trump” as another unwelcome complication to the investment outlook. Arminius will retain its broadly defensive portfolio positioning until our quantitative models indicate that markets are cheap again.

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