On the spot: A perspective on Brexit

ON THE SPOT: A PERSPECTIVE ON BREXIT

A snapshot at where we are from a macro-political perspective right now and
some consequences on the investment policy.

The end of 2015 gave us the impression that 2016 would be quite predictable, with Mrs Clinton elected in the US, the Fed regaining flexibility, with the perspective of rising rates; The will of all developed countries to find a solution on Syria; Europe starting to feel the value of being a stronger and a more united block; Asia on its way to the soft landing everyone had talked about; Low oil prices stimulating demand in developed economies; Emerging markets struggling, but forced to adjust their spending while imbalances are still manageable; Lastly, the memory of 2008 was starting to fade with private lending back in scope. As a consequence financial advisors were talking about investing in financial institutions, seeing the opportunity for some sector rotation / catch up in a globally steady economy, perhaps slightly overpriced from a market perspective.

Basically, the way to think was consistent with how people saw the world during previous years: a global and more integrated economy, which was in a gradual / self mending process.

In our view, 2016 is highlighting a rather different picture and has taken many observers and investors by surprise. Let us articulate some key insightful statements:

  1. In Asia, politics and military strength starts to dominate over economic activity. Japan is a good example for this, with the Abe government reinforced after the recent elections, despite the failure of its economic reform plan and its abyssal level of debt. The innovation there is the prospect of a more active military policy, to protect the economic interests of the country. China, on its side has not been advancing much in the economic domain, with the Remimbi as a global currency lost in the sand, banks Non Performing Loans are at an all time high and growth boosted by leverage, leading as usual to misallocation of capital.
  2. In the Middle-East, Syria was the focal point of the tension between the Sunni and Shia communities. Now the big 2016 surprise is to see Europe as the place the most impacted by this crisis, and Turkey, as the sick man, like it was 100 years ago. Its main weakness being around its structural inability to cope with the existence of different people within its territory and zone of influence at large, as was the case during the Ottoman period, and the will to see itself as a strong / extremely homogeneous Sunni country emerging economically and politically thanks to its strategic position at the crossroads of Europe and Asia.
  3. In Europe, there was an ongoing and unresolved discussion: is it an open market place or is it a politically united territory heading towards a federal union? The debate promised to be hot as the European power seemed to have lost touch with some of the European citizens. The big surprise, though came from the fact that this did not constitute a break up point in the UK as expected. It was rather the mundane topic related to the presence of Polish plumbers and personal assistants that triggered the announced disbanding of Europe at large. We now find ourselves in a tricky situation, where the UK will not be in the strong negotiating position it expected, saying loud and clear that it does not want political integration, but in a rather weak one, where it will try to disentangle the four elements of freedom of movement related to goods / services / people / capital in a way that would have rather embarrassed Adam Smith. This being said, it is important to once again go back to the 19th century and earlier, and remember that the ties between the UK and Northern Europe, via the Hanseatic League have been as important as the Napoleonic Blockade. In this respect it has been very interesting to see the reaction of each country after the Brexit referendum: it was almost back to a light version of the Blockade in France and a more open perspective in Germany. The reality though is that the Europe of the 21st century looks very different from that of the 19th century, in the sense that France has become incredibly weak of late, with low growth, high debt, high unemployment, unlike Germany. All Southern Europe is in a real state of disarray, with Spain becoming ungovernable. We are not yet at the stage of the “Sovietic Republic of Cataluña”, like it was the case in the early 30s, but there is some reminiscence of this at present. Greece has lost all autonomy. Italy would be bankrupt on its own, with the level of Non Performing Loans surpassing by far the level of capital on the balance sheet of Italian Banks. The reality is that Southern Europe is now more or less “Sub Investment Grade” without the support of Germany: an other word for it is “Junk”. France is the question mark. After the 2017 elections, will it fall into the “junk camp” or will it find the strength to redress itself. Having this in mind, Paradoxically, we can see that the UK is about to engage itself in a somewhat absurd negotiation on a selective freedom of movement approach, at a time when it should be able to get a generous bargain and benefit from a weak Europe that cannot inflict on itself more pain by being too harsh with the UK. By way of comparison, the most recent attempt to engage on a blockade with Russia was not a success from an economic perspective. Germany cannot afford blockades surrounding it!
  4. The US, has been the role model for the world during the 20th century. It has been dominant because it was successful having understood better than everybody else what progress, innovation meant and how it can be spread quickly. Nowadays we can observe a large country in a state of doubt, deeply believing in free markets, but deeply affected by the inability of this economic system to spread wealth efficiently, almost back to the pre- Fordism period. Is this because of foreign dumping, is this because of large oligopolies, is this because of identity questions, is this because of systemic moral selfishness? The country does not seem to be able to provide any coherent answer. The Fed has been upsetting market price transparency for a while now, very powerful monopolies such as Google, Amazon lead the game. Previously inflation-abating vectors such as Walmart seem to lose steam both due to an ageing distribution model and to the lesser relevance of tapping Asia as the source of price reduction/ deflation. Like in the UK, the freedom of movement of people constitutes a political challenge, to the point where the traditional ethical subjects that dominated the country (abortion, social security, etc…) are not at the center of discussions anymore.The purpose of this paper is not to shed pessimism all over the place, but to highlight that the way we should read the evolution of the world is probably changing, right in front of us. The stability inherited from the Second World War stability pact is now well behind us and the order of the World towards which we converge is more unclear than ever.If we are not careful, we could end up going into a full risk-off perspective for long, until things settle down in an unknown future. But even the traditional instruments related to risk-off: cash, government bonds are becoming the risky ones, to the point where investors going for these instruments now agree to lose money on a 10-year horizon in the most stable economies such as Germany and Switzerland. Value stocks that used to be the other safe heaven, in the spirit of Warren Buffet, have not done that well recently in a world in transition.What to do?
    • Geography is becoming important again. OK for global, but not all regions are equal, and choosing well the regions where one wants to be present is critical.
    • Choosing in a relative manner. We see some activities really doing well, reinventing themselves and some others struggling to adapt. In this respect, services are likely to be impacted by the same rationalization that impacted the industry in the 19th century during the industrial revolution. This explains why targeting new efficient service models and long / short plays on winners versus losers constitute an important effort to preserve or create wealth. In this respect, an important element to follow is to identify where investments go physically. Structurally under-invested regions will not be able to cope successfully with the new “service revolution”, and the divide will not be here as simple as it used to be between developed and developing economies.
    • Cautious about naked beta. Just riding the markets isn’t going to be as simple as it was during periods of plain growth. The mood of investors becomes a strong driver of market performance, with drop-offs so far successfully managed by central banks, but for how long? Going ahead blending different asset classes together might not be sufficient to smooth the “maniac-depressive” mindset of the investor community. Of course Risk management is of help, but selectivity and a clear vision on structural losers and winners is required to make a difference and generate performance.