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Global Brexplosion!

Monday, July 11, 2016
Global Brexplosion!
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Authored by Saeculu Research 

In June 2016’s Brexit vote was equal parts unprecedented, omi­nous, and stunning. SI interviewed Saeculum Research Founder and President Neil Howe to get an overview of all the economic, political, and market sequelae that are likely to issue from Brexit.

SI: What are your first impressions of what happened across the pond last month?

NH: Where to start? The Brexit vote was high drama. In a game of sacrifice bunts, this was a grand slam. In a political universe full of evasion, compromise, and incremental process, we were able to witness a great democracy make a critical and—appar­ently—irrevocable choice having far-reaching global consequences.

Brexiteers were jubilant. The Remain Camp was sullen. Yet whatever their mood, it grad­ually dawned on every Briton that their nation was entering a new and challenging era. Labor pundit Alistair Campbell was none too pleased with Brexit, and lampooned all the guys running around with their Union Jacks who hadn’t thought about the inevitable consequences.

SI: What sorts of consequences do you think Campbell was referring to?

NH: Well, let’s think about them. Turning first to the U.K., I see four distinct consequences of Brexit—a “quadruple whammy” bearing down on the region’s economy.

Whammy number one is trade shrinkage. An island nation with an entrepot economy, the U.K. thrives off trade. Its goods and service exports amount to 28 percent of its GDP—of which roughly half (14 percent) goes to EU members. That’s slightly more than total U.S. exports as a share of U.S. GDP. A large share of this 14 percent is thrown into question by Brexit.

Of course, no one knows how large a share. No one has any idea yet what sort of post-Brexit trading relationship the U.K. will be able to negotiate with the EU.

One model, the Norwegian-style European Area Agreement, would minimize trade losses—but almost certainly won’t fly because it would require the U.K. to slavishly abide by all the EU standards and regulations the Brits dislike, only now with no voice to object. The U.K. is more likely to try to negotiate a totally new free-trade agreement with the EU. Or, if this fails, the U.K. will try to forge Swiss-style multilateral accords on individual sectors. And if all talks fail, the U.K. could still trade with the EU—and pay their tariffs—as just another WTO nation.

SI: Which of these trade scenarios do you see playing out?

NH: Tough to tell. The outcome is utterly unclear.

I will say this: Even in a worst-case scenario, there will continue to be substantial trade between the U.K. and the EU. But even in a best-case scenario, many U.K. exporters will face hardships. Some will find themselves totally barred from the EU because they can no longer subject themselves to the EU’s regulatory process.

Others may be forced to incur higher costs to demonstrate compliance with EU regulations or to advertise, market, sell, or enforce contracts in a now-foreign economy. These costs may in turn cause global corporations to pull the U.K. out of their supply chains. For cen­turies, London (the City) has developed a reputation as a frictionless, low-cost insider and networker—able to provide top-notch financial and business services to clients all over the globe. That reputation will suffer if the U.K.’s financial “passport” into the EU is revoked.

Only time will reveal the bottom line. The Centre for European Reform did a careful, multivariate analysis in 2014 of the growth in U.K. global trade over the past 25 years. The conclusion: Roughly one-third of the U.K.’s trade with other EU members can only be explained by the U.K.’s political integration within the EU. One-third of 14 percent is just this side of 5 percent of GDP.

Sure, that has to be regarded as an upper estimate of what the U.K. might lose. But it’s also a really big number. Much of the recent fall in the pound on the foreign exchange (FX) is the market’s estimate of how much the U.K. will eventually need to cut its export prices and/or raise its import prices to balance its current account once it’s out of the EU.

SI: Okay. What’s the next whammy, dare I ask?

NH: Two words: capital flight.

The City of London—along with Edin­burgh, Leeds, and Glasgow—constitutes the undis­puted financial capital of the EU. A quarter of all EU banking assets are managed by U.K.-based banks. London banks dominate the wholesale trading of euro securities. Within the EU, they account for 85 percent of hedge fund assets and 70 percent of OTC derivatives trading. In FX trading and certain insurance lines, London is not just an EU leader, but a global leader.

It was once thought back in the 1990s that the U.K.’s refusal to adopt the euro would impair London’s financial supremacy. Didn’t happen. But Brexit? That’s another story. In no sector are EU leaders as adamant about strict regulatory and legal compliance as in financial services.

From the perspective of Brussels, the trading wiles of “les Anglo-Saxons” must be closely surveilled. Even before Brexit, for example, the EU was pushing hard on London to clear more euro-denominated trading in the Eurozone. No way will the Eurocrats allow the City to do banking business on the continent under their own maverick rules.

SI: Is it just the finance sector that will be under the watchful eye of EU regulators?

NH: Hardly. Let’s make the plausible assumption that the U.K.’s post-Brexit trade regime—whatever that looks like—will disproportionately injure the operations of U.K.-based multinationals that are partly or wholly foreign-owned. Again, these are mainly London-based firms that sell, or may want to sell, a full range of goods and services to EU custom­ers. Consider that nearly 50 percent of foreign direct investment in the U.K. comes from other EU members. Consider as well that, under the EU’s Parent-Subsidiary Directive, these companies will no longer enjoy favorable tax treatment.

Or reflect on another fact: Fully half of all European HQs of non-EU firms (many of them U.S. firms, like Caterpillar, eBay, and Ford) are located in the U.K. Typically, they choose London as a gateway for their EU operations. Post-Brexit, how many of them will want to stay? In countless surveys, U.K. business managers overwhelmingly agree that Brexit will severely impact incoming foreign direct investment and foreign office location.

So let’s cut to the chase. That giant sucking sound you hear is the withdrawal of investment from the U.K. In fact, the London branches of five major U.S. banks are already planning to move 10,000 jobs elsewhere. According to PwC, eventual U.K. job losses in financial services alone will hit 100,000 by 2020.

Across the board, firms are moving funds, reconsidering advisors, putting plant and office expansion plans on hold, and reconsidering their location options. There are exceptions of course. Many smaller, labor-intensive firms that export mainly outside the EU will see the fallen pound as a huge profit opportunity. They may thrive. Indeed, their success over time will put an FX floor under the pound. But for the big integrated multinationals—and certainly for financial firms—the overwhelming theme will be capital flight.

SI: What about other big markets, like real estate? How will they be impacted by Brexit?

NH: That actually brings me to my third whammy: an impending real-estate crash. 

London is not just another big city. It dominates the national economy. With 12 percent of the U.K.’s population, it accounts for 22 percent of the nation’s GDP. The U.K.’s global reputation in fashion, media, advertising, technology, law, and (as noted) business and finance is all centered in London. More to the point, nearly one-third of the U.K.’s three million foreign-born residents live in the London area. Many of these are highly paid professionals. Many others are wealthy emigres from all over the world who choose London as their residence of convenience.

Post-Brexit, as jobs are cut and investment is pulled, these immigrants are likely to lead the “Brexodus” out of London. They tend to be the most mobile and least attached to the U.K. by family or childhood. They also are the most likely to value London’s multicultural vibe, which means many will be put off by the new anti-immigrant mood of the Brexit-voting countryside. Just after the vote, London’s mayor Sadiq Khan, himself the son of Pakistani immigrants, tried to reassure London’s foreign born that “You are welcome here.” That may satisfy some. It won’t satisfy all.

SI: Wait a minute. Hasn’t London’s real-estate market been doing pretty well of late?

NH: More than pretty well, I’d say. Over the last eight years or so, we’ve seen a veritable boom that has buoyed London home and office prices. The market is down a bit over the last year, but not by much. Home prices in most of the rest of the U.K. are today only back to about where they were in 2007. In London, they are 51 percent higher than what they were in 2007.

But London real-estate brokers report that demand started fading just as the odds of Brexit started rising. And post-Brexit they say that the bottom has dropped out of the market. Most FTSE 350 companies that specialize in anything related to home construction or real estate were down 20 percent to 30 percent on the Friday after Brexit.

At long last, the London-centric U.K. real-estate market is blowing up in glorious fashion. This may be good news to any American looking to buy a townhouse in Chelsea. It may even bring grim satisfaction to many hinterland Brexit voters who probably agree with the Brussels regulators on this one point only: The City’s financiers are overpaid decadent scum. But it’s bad news for the U.K. economy, because it’s happening at just the wrong time.

SI: It sure sounds like it. So what’s the fourth whammy?

NH: The sheer, paralyzing uncertainty brought on by Brexit. Markets detest chaos. Just let me know how all of this is going to play out, traders will say, and I’ll take a position. But with everything in limbo, I’m out.

Unfortunately, indefinite limbo just this side of hell is precisely what Brexit promises to deliver.

In principle, the leadership on both sides of the English Channel understands that political delay is economically destructive. At an emergency meeting on the Saturday after Brexit, the ministers of the EU’s six founding members, led by Chancellor Merkel, urged the fastest possible resolution of the U.K.’s departure. But according to the EU’s Constitution, the U.K. must first initiate the process by invoking Article 50 of the Lisbon Treaty. And the U.K., well, the U.K. just can’t get around to it quite yet.

SI: What’s keeping the U.K. from putting Article 50 at the top of its to-do list?

NH: For starters, the leadership of both of the U.K.’s major two parties is in major dis­array—even more so now that Boris Johnson has taken himself out of the running to replace David Cameron. The process for finding a new Tory PM will take months in itself, so Article 50 will have to wait at least until the fall. Meanwhile, Jeremy Corbyn’s leadership of the Labor Party is also up in the air.

Depending on how all these top-dog issues are resolved, the House of Commons may feel they need to call a whole new election. That may delay pushing the Article 50 start button until well into next year.

Oh, and did I mention that the Scottish Independence Party has announced that they will refuse to take part in any Brexit proceedings until they are assured that Scotland will get another referendum on independence? Most Scots don’t want to leave the EU. And what about Northern Ireland? They don’t want to leave the EU either. London, Scotland, and Northern Ireland voted for Stay; every other region in England and Wales voted for Brexit.

So the new PM may have to tell Brussels, s’il vous plait, we may need to resolve this minor matter of the total dismemberment of our nation before thinking really hard about Brexit. No timetable possible here.

But let’s be optimistic and assume that all the secession questions can be bypassed. Even then, another knotty timing issue arises—a sort of prisoner’s dilemma problem. Each side (U.K. and EU) knows that both sides would benefit from a quick resolution. But each side gains for itself by holding out until the other side makes concessions. Because the U.K. is the smaller party, it has most to gain by delaying.

SI: What exactly is it that the U.K. wants to gain?

NH: Quite simply, a generous new FTA agreement that would grant it close to the same trading rights it has now—but without the need to comply with all those EU decrees it doesn’t like.

Some EU commissioners, in fact, are worried that the U.K. may never actually invoke Article 50, and keep trading as before, but meanwhile have Parliament start striking down all the objectionable EU laws. The EU would then have to find some way to penalize the U.K. for its flagrant treaty violations. It could get really ugly.

But again, let’s be optimistic. Let’s assume that the two parties complete their negotiations within the two-year window envisioned by Article 50. So we’re looking at, say, January 2019 for all the final signatures. Would that be the end of it? Almost certainly not. Most scholars agree that a negotiated agreement would only settle the basic framework. Further negotiations lasting perhaps through most of the 2020s would be needed to disentangle Brussels and Westminster in every area of trade, finance, law, and security. Who knows? These negotiations may outlast the EU itself.

One last point. We’ve looked at these four areas—trade, investment, real estate, and uncer­tainty—in their basic order of causation. It’s the certain prospect of huge changes in the U.K.-EU trading relationship that gives rise to all the rest.

But their timing in markets is just the reverse. Uncertainty is what initially motivated traders to sink the pound and move drastically risk-off since the vote. We’ll see the U.K. real-estate downdraft and personal capital flight play out over the next few weeks. Still later we’ll see changes in business investment. Fundamental shifts in trading patterns will show up last.

Economics moves from policy changes forward. Markets move from expectations backward.

SI: Let’s change our perspective a bit, if you don’t mind. How about jumping into Brexit’s impact on the EU?

NH: Certainly. On the day after the Brexit vote, many were surprised that the biggest stock market declines weren’t in the U.K., with the FTSE 100 down 3 percent. They were in all the other non-exiting EU member states, most of them down well over 6 percent—making this truly a negative-sum divestiture! To be sure, much of this difference is explained by the plummeting pound, which drained value from U.K. firms through FX markets rather than through the bourse.

It’s also true that we saw some rebound in the European markets during the week after Brexit. But of course, that was only with the help of the European Central Bank (ECB) expanding its QE program and central banks across the world flooding markets with liquidity. It’s hard to say whether what happened was a real rebound or just steroids.

SI: That brings up a basic question: Why are the EU markets so traumatized by the departure of a member that constitutes only 17 percent of EU GDP?

NH: There are several reasons. One is that the U.K. runs a large trade deficit with the continent—meaning that it buys a lot more from the other EU members than it sells to them. Germany alone runs a $30 billion surplus with the U.K. Seven EU members, many of them in central Europe, run a surplus over 1 percent of GDP. Hungary may specialize in scientific equipment. But only the U.K. can transform that export into a product and sell it through global supply chains. Now let’s see how well all this works with the pound down 10 percent. Ouch!

Another reason is that EU banks, and EU financial institutions in general, are doing poorly—weighed down by nonperforming loans and squeezed by Mario Draghi’s negative interest rate vice. EU finance ministers in Brussels may not trust the London financiers— but can EU corporations really keep functioning without them? Unclear.

In Germany, there is some hope that Frankfurt, Hamburg, and Berlin can steal some of London’s banking business. Elsewhere, there’s not a lot of optimism. The EU’s continental members, moreover, are a lot closer to stall speed and possible recession than the U.K. is. The Eurozone may not be able to absorb a body blow, which puts extra risk on the down­side for firms. Japan, where the Nikkei plunged 8 percent on news of Brexit, is also navigating near the macro edge.

SI: So the concern is financially motivated, then?

NH: Not entirely. In fact, the biggest reason why Brexit is setting off so many klaxon horns on the continent is political.

The EU leadership is deathly afraid that the U.K. example will spread like a contagion among other members. Few EU electorates have ever had a clear opportunity to vote on the current EU constitution. And today, with Eurosceptic parties steadily gaining strength (see: “A Rising Generation of Eurosceptics”), the voting public in several countries—includ­ing Greece, France, Spain, Germany, the Netherlands, and Sweden—express roughly the same level of disapproval of the EU as voters in the U.K.

Marine le Pen of France’s National Front, who now dubs herself Madame Frexit, is cele­brating the U.K. referendum and is suggesting that France’s turn will be next. Other Euro­sceptic leaders are similarly congratulatory, including the Italian 5-Star Movement, the Dutch Party of Freedom, the Austrian Freedom Party, the Danish People’s Party, the Swedish Democrats, and the German Alternative für Deutschland.

This poses a dilemma for Chancellor Angela Merkel, President Francois Hollande, and the other heads of the European Council. If they were just thinking about the health of their own economies, they would gladly give the U.K. vast concessions in order to quell the crisis quickly and get the global economy back on track. Merkel in particular has to be worried (as every German leader is) about her economy’s export performance.

Yet if everyone knows that the U.K. can get a good deal, then the floodgates of Frexit, Nexit, Spexit, Auxit, Grexit, and all the rest would surely follow. So the EU figures it must be con­spicuously severe with the U.K. for its decision to leave.

SI: It sounds like the EU is in a difficult position.

NH: More like an impossible one. 

On the one hand, you can make the case that being resolute and unyielding is the best op­tion for the EU. As Voltaire once wrote with his usual touch of irony (after the court martial and execution of a British admiral following his defeat in battle), some must be punished “pour encourager les autres.” In another context, the Austria-Hungarian empire was once said to be a “prison of nations.”

In other words, yes, it’s important that the U.K. suffer—and that it is seen to suffer. There is only one way to deal with prison escapees. You certainly don’t want to be seen negotiating with them. Game theory—to say nothing of honor—argues that the EU should take a very hard line with the U.K.

So that’s one side. But then there’s the other side: history and habit. No matter how many “red lines” EU leaders want to draw surrounding Britain’s exit, the organization has always been naturally inclined to make concessions and compromises. The EU says it won’t nego­tiate until the U.K. invokes Article 50. But what if the U.K. delays? Negotiating and making deals is frankly what the EU calls leadership. What will the EU do if U.K. leaders decide that it’s silly to abide by the rules of an organization it’s fleeing from, and say “to heck with Article 50”?

Remember back in 1992, when Denmark failed to ratify the Maastricht Treaty, the EU’s natural response was to grant concessions so that the treaty could be ratified on the next go-around. EU leaders could very well take a similar tact in this case, crafting a special deal that would allow the U.K. to part as friends.

But there’s no easy option. Who’s to say what the EU will choose to do? It may cave to please nations like Britain that have shown “different levels of ambition”—seriously, that’s how the Inner Six put it—when it comes to integrating further with Europe. Marine Le Pen thinks that this would be the common sense option—but believes that the EU ultimately will take a hard line, thereby exposing “the tyrannical nature of its power.”

SI: What regions are the most likely to follow the U.K.’s lead?

NH: I’ll just say this: It’s revealing that the equity crash showed much steeper losses for Spain and Italy, over 10 percent, than for the rest of the EU.

Nation by nation, the market is clearly tagging political risk. It’s also revealing that the main goal of Italy’s anti-EU 5-Star Movement is not so much to leave the EU as to set up a new, and presumably devalued, currency for southern Europe. Facing the united opposition of Germany and France, however, it won’t be long before Italy too (both left and right) opts for outright exit along with the others.

As for Spain, its recent election showed most of the electorate veering toward the con­servative People’s Party and veering away from a confrontation with the EU. Yet Spain remains deadlocked, with no side able to form a clear majority. Podemos, Spain’s new youth-led populist party, is the first Eurosceptic party since Syriza in Greece to challenge Brussels directly from the left.

We will learn in the next few months how rapidly the anti-EU rebellion grows or fades. If it keeps growing, there is nothing this time that ECB President Draghi can do to quell the threat. One never knows: Being Italian, he may in time join it.

SI: Let’s zoom out and talk about the rest of the world. Can you discuss the big macro themes playing out in the United States and elsewhere?

NH: Of course.With investors world­wide fleeing risk in favor of safe-haven assets, the prices of precious metals and sovereign debt are rising almost every­where. As the VIX climbs, so do credit spreads. And in the ultimate safe haven of the United States, the dollar is surging against nearly all other currencies while the 10-year Treasury yield has plummeted to under 1.5 percent, a historic all-time low.

True, many of the global stock markets have rebounded back close to where they were before. But that really reflects their response to the new worldwide policy of central bank easing more than any sort of renewed confidence.

If we know anything about Janet Yellen and her data-dependent Fed, we know how it will respond to these developments: by swearing off any thought of hiking interest rates. According to the FedWatch Tool, the market is now writing off almost any chance of a Fed rate hike by the end of the year. In fact, there’s just an 18 percent chance of a hike by February—against a sizeable (5 percent) chance of a cutback to zero. The Bank of England already plans to cut its own rate to 0-0.5 percent; Governor Mark Carney may person­ally ask Yellen to ratify the cut by joining him.

Yet at this point any course of action by the Fed is fraught with danger. If the dollar stays elevated and credit spreads keep rising, Yellen will have two major worries.

One is if the continued health of the U.S. economy. A higher dollar will further hammer exports, causing real pain among U.S. manufacturers which—according to the BLS, ISM, and the five regional Fed surveys—have already been losing employment con­tinuously over the past 12 months. Can services and retail continue to do all the heavy lifting? A higher dollar will also devalue overseas earnings, pouring more red ink into S&P 500 earnings state­ments already on track to show (in Q2) five consecutive quarters of earnings decline. Ever-thinner profit margins will discourage both investment and employment.

The other worry is the health of the commodity-exporting emerging-market economies, especially those laden with dollar-denominated debt. Or forget health: We’re just talking about avoiding crisis—in Turkey, South Africa, Malaysia, Russia, Indonesia, Thailand, and a slew of Latin American economies, none of which were in very good health to begin with. A rising dollar and widening credit spreads will strangle these economies, especially if they are accompanied, as they usually are, by declining dollar prices of their primary exports.

The Fed could, of course, decide to cut rates back down to zero. But this too comes with worries. First of all, what if the Fed cuts and nothing much happens—to the dollar, interest rates, or equity markets? Then the Fed has further sacrificed its credibility (assuming there is much left to sacrifice) for nothing.

Yellen may want to be a bit daring and combine a rate cut with a new round of QE. This sort of shock and awe will surely get the markets’ attention. And it may, at least temporarily, smash down long-term yields, jag equities, and reflate the dollar. But this too comes with a downside. As we become more dollar-competitive, the U.K. and the EU—which may by this time be teetering on the edge of recession—become less.

SI: The Fed seems to have backed itself into a corner.

NH: Exactly. It’s becoming ever more obvious that the Fed cannot rescue the global econ­omy—or even just the U.S. economy—on its own. It needs help from the sort of vigorous fiscal innovation and coordinated global leadership that only Congress and the White House together can supply.

But of course this year the Fed will get no such help. A lame-duck presidency and partisan gridlock have pretty much paralyzed high-level economic policy—much as they did when the global economy was plunging into financial meltdown in the fall of 2008. Remember that? Remember when Barack Obama and John McCain were debating each other while saying almost nothing said about the free-falling Dow, even as George W. Bush was busy moving out of the White House? Ready for a replay with Hillary and Donald?

SI: Any closing thoughts?

NH: I just want to reflect a bit on how we got here.

The world’s leaders have blundered into this impasse through serious errors of judgment. By trying to forestall any market downturn, central bankers have exhausted the stimulus they might have been able to use at a moment like this. By failing to tear down and rebuild such hapless and dysfunctional institutions as the European Union, political leaders have left electorates few options other than total, foot-stomping disruption. And by failing to appreciate that ordinary people prioritize identity, community, and sovereignty ahead of money, financial leaders had no inkling of what was coming. Indeed, they doctored the evidence: It now seems clear that London banks were stacking the Brexit betting odds right up to the final day—hoping that this would either change the outcome or keep FX markets “orderly” to the bitter end.

Imagine that. The world’s elite believing that everyone is motivated only by income and wealth. This may explain why so many ordinary people are no longer listening to them.

Material posted on this website is for informational purposes only and does not constitute a legal opinion or medical advice. Contact your legal representative or medical professional for information specific to your legal or medical needs.

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