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Brexit commentary from our Private Wealth Advisors

Thursday, July 21, 2016

by Jamie D. Wright, CFA

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way – in short, the period was so far like the present period, that some of its noisiest authorities insisted on being received, for good or evil, in the superlative degree of comparison only.” A Tale of Two Cities; Charles J.H. Dickens

Sad that the writings of classic authors are now rarely taught in public high schools or universities. In them lies an inescapable, sometimes bitter truth; that all of the reader’s life still-to-come has been written, several times over. In Dickens we can learn of humanity and their everyday struggle for existence. In Shakespeare of comedy, love, betrayal, and tragedy. Machiavelli and Sun-Tzu wrote of politics and power, Dante Alighieri of journeys through faith, punishment, and human resurrection. All of us exist within the folds of history. “To know where you are going, you must know from whence you came” is something our children heard, likely ad nauseum and typically as I handed them a book from my library. That at least a part of their life was contained within was to me a potential roadmap they could use to their advantage; for them, a certain cure for sleeplessness or better, a prop for the window. But they’re still young and there’s still time. And there are now grandchildren…

Democracy was exercised in full plumage in Great Britain and the over-polled and underprepared woke up to their version of Tocqueville’s “tyranny of the majority.” Great Britain, after years of membership in the European Union, voted to opt out and go their own way. The hue and cry, as Dickens predicted, ranges from “we had everything before us…” to “we had nothing before us…” The reality is that their before-and-after is all a human invention and, saner heads prevailing, will be reconciled in game-theory fashion such that everyone walks away with something positive they didn’t have before. Only children will win if Europe decides to punish Great Britain as a warning to Spain, Portugal, Ireland, Italy, and Greece, who just might recognize that disparate economies and their financings saddled by a common currency is the acme of foolishness, and vote to leave themselves. If there is a genuine feeling of being suddenly naked and vulnerable in the EU it assuredly is within the governments of Germany and France.

The currency issue is deeply important, and goes to the root of a very shaky global financial system. A currency provides a country two things: A daily report card graded on the basis of their current account balance, trade balance, finances, debt level etc. It’s also a flotation device; a self-righting mechanism that can appreciate, making their goods and services relatively more expensive internationally, or weaken and make those same goods and services cheaper. We’ve written previously that if Greece still employed the drachma, Greek vacations would be cheaper than they’ve been in ages. Planes and ocean liners would fill, as would restaurants, hotels, and tourist attractions; the unemployment rate would very likely fall, putting dollars in pockets and government coffers, an event that hasn’t happened there in years. In reality, they owe billions of Euros over the course of this summer they don’t possibly possess, a fate sealed by a currency inflexible to their particular needs. In London, as we speak, the goods at venerable British establishments like Burberry’s and Harrods, and expensive, hand-crafted Range Rovers are on sale, the result of a rapidly depreciating British Pound.

The Maastricht Treaty was signed in February of 1992 to create a common economic and monetary union in Europe. Its underlying purpose, actually begun with the Marshall Plan post-WWII, was to help prevent the massive destruction that two wars within three decades produced; if one is joined at the hip economically to another it would hopefully deter one from turning on the other in aggression. Trade aggression could be settled in a court of law, not in Flanders Fields. It worked. The EU has grown to be the world’s second largest economy, barely trailing the U.S. But something else crept into the batter over the years. A virulent socialism and central planning scheme that increasingly relied on a sclerotic, un-elected bureaucracy based in Brussels which wanted to create a rule-based society that applied to all. I guess I would argue that as an over-arching currency is folly for disparate economies, so is an over-reaching societal blueprint for disparate peoples. No one flies the Flag of Europe at a football match between France and Spain. Though, by now, my biases have been exposed, I will bet any reader a lunch that if the EU had stopped at a common market scheme, the subject of this writing wouldn’t exist. Nor would the extremely strong and growing nationalistic efforts in France, Spain, Hungary, and Germany.

Great Britain must now invoke Article 50 of the Lisbon Treaty to begin negotiations for leaving the EU. By law that process can take two years. First, however, those negotiations must be undertaken by a legitimate government on behalf of Great Britain, which at the moment exists in a skeletal sense only. Feelings of spite, anger, and perhaps fear have caused much of Great Britain’s electorate, BREXITEERS or not, to leave their current leadership positions or decline to run for Prime Minister. We find out today that two women, Theresa May and Andrea Leadsom, will now square off to see who will be the next British Prime Minister, and lead the country’s effort to disentangle itself from the EU (should we point out that the last time Great Britain enjoyed a female Prime Minister it was perhaps the best of their times?). Since it appears the entire process will be (rightly) painstakingly slow and deliberate, we do not believe this is either a Bear Stearns or Lehman Brothers moment for global financial markets. But nor does it dispel longer-held trepidations, and in some cases has fanned the flames.

Global currency markets remain greatly roiled. The U.S. dollar (USD) and Japanese yen (JPY) rose in relative value as the BREXIT caused a flight-to-safety. Japan simply can’t afford a rising yen; indeed the Japanese Central Bank is doing its utmost to weaken it. A stronger yen is making it indescribably tough for Japanese companies to compete profitably on a global scale. Two, the Chinese Yuan (CNY) is pegged to the USD. But while the USD was rising, China was allowing more air to come out of the CNY in their daily peggings, thus cheapening the CNY versus the JPY. The devaluation competition between the two remains an unhealthy race-to-the-bottom. As a reminder, U.S. equity markets trade about $250-$300 billion per day; U.S. bond markets about $800 billion per day. Currency markets trade about $5.3 trillion per day, or almost as much in an hour as do equity markets all day. When you get the massive amounts of money in currency markets sloshing from one side of the boat to the other it can easily overwhelm the liquidity available in the stock market in any given time period.

Second, the European banking system remains in very poor shape. Deutsche Bank, the 12th largest global bank with $2 trillion in assets is badly in need of fresh capital, as is Credit Suisse (28; $932 billion) and most of the Italian banking system. Annual profit is the largest contributor of capital to any bank, and because of negative interest rates in Europe, earning a profit is increasingly difficult bordering on impossible. Credit Default Swaps (as tracked by the Markit iTraxx Europe Senior and Subordinated Financial Indices), basically an insurance policy one can purchase on the debt of an issuer or cluster of issuers, continue to get much more expensive. While lower than a recent peak, price graphs reflect an ever-upward march since December 2015 as risk increases. As well, interbank dollar lending rates between banks in Europe (LIBOR-OIS spread) have elevated to 2012 levels, when Greece first began causing global financial disruptions. While our stock markets today are very close to making new highs, the global financial plumbing has been making very odd noises for several months, much like 2007.

Domestic bond markets and the Fed Funds futures market indicate there is almost no chance the Fed will have the leeway, based on their stated and implied criteria, to raise interest rates this year and next. This pleases our stock markets, which Friday came within a few buy-side dollars of making all-time highs. The underpinnings, however, are almost-exceptionally weak. The S&P 500 has experienced declining revenue for five quarters now, and declining earnings for four. The upcoming earnings season is not expected to be much better. While the energy sector is responsible for a good deal of those declines, the causes of the rest remain in play; a stronger dollar making it more difficult for U.S. businesses selling their wares overseas, and a weak global economy that is almost certain to get weaker while Europe decides whether to take the high or low road in its dealings with Great Britain. While faith and hope are solid traits of a sound character, they can result in an asymmetrically risky investment portfolio. And the charity of the world’s central bankers by way of money printing is palliative only; it makes the patient feel better while doing nothing to cure the causation of illness.

In short, all of what is taking place in Europe has happened before, perhaps just not in our lifetime. Trade agreements are written to be abandoned some time later, simply because circumstances change. The citizenry becomes disenchanted because they feel their government representatives aren’t listening. And if a people fly a flag under which they are expected to gather and rally, perhaps it’s important that the ties that bind them in a commonality aren’t allowed to fade, especially at the insistence of an elite minority. Earthshaking? Possibly not, though certainly headline-grabbing. A Lehman Brothers moment? No. Piling on an already-shaky financial outlook? Assuredly, but in slow motion. As Margaret Thatcher told George H.W. Bush after Iraq’s invasion of Kuwait, “George, this is no time to go wobbly.” What we will find out is if the adults prevail or the children take their ball and go home.

Our team at First Merchants Private Wealth Advisors continues to monitor the situation; we hope to have dispelled concerns that this event may be a flash point.


Jamie D. Wright, CFA, is a Portfolio Manager and Research Director at First Merchants Private Wealth Advisors.

Mr. Wright’s views are his own, and do not necessarily represent those of the organization.