Thoughts on BREXIT, breaking up with Europe

Sacré bleu! Hearts are breaking across Europe, as the European establishment has been jolted by the surprise result that Britain has voted to leave. As one might expect the initial reaction has been an emotional one, the innate fight-or-flight response of market participants has been activated, with a sense of panic pervading markets this morning.

In a speech on June 17^th in Vienna, entitled “Unity in Diversity: The Case for Europe”, IMF Director Christine Lagarde said “It has been said that ‘it takes great courage to see the world in all its tainted glory, and still to love it’. So I wish bon courage to our fellow Europeans from the United Kingdom!”.  I remember reading the speech thinking that, if anything, it would strengthen support for the leave campaign. It is the type of patronising rhetoric from the establishment that the average individual has had enough of. Not quite ‘let them eat cake’ but I am sure those Britons who have seen little improvement in their personal circumstances over the last seven years don’t care to be reminded about how Europe has transformed Britain for the better.

Personally, I thought Britain would stay, based on the fear of the unknown dominating voters’ minds. “What Britons have under the current system will outweigh the uncertainty and inability to quantify the economic and social consequences that comes with a free and independent Britain.” The fact that over half of the 33 million people who cast their vote choose to embrace the unknown speaks volumes of how they view the current system. Leave voters will be castigated for their ‘stupidity’ by their fellow citizens on the ‘remain’ side, but there is a bravery in voting for change. Either that or they feel they have nothing to lose.

 While we have seen markets react sharply this morning, how the relationship ends will determine the impact of BREXIT longer term. Breakups are never easy and there are all sorts of theories on how long it takes to get over a breakup. Where love is involved, one theory is that it can take half the number of years you were in the relationship to recover from the breakup. We are talking about countries when we consider BREXIT, but still the interdependence between Britain and the European Union has been fostered over decades so this split will not be easy on either party. A long drawn out breakup can be expected to unfold.  

The irony is that in most breakups the advice is typically to cut all contact. However, Britain and Europe now need to work closer than ever to avoid a wider collapse of the European Union. Britain may have voted to leave, but they have a vested interest in ensuring Europe does not fall apart. Likewise, while the Europeans may feel a bitterness towards Britain, it is only by working with them to deliver a smooth exit, can they ensure that the wider Union does not disintegrate. Common sense will need to prevail on both sides if they are to avoid a bitter end to this relationship.

As for the markets, the headlines this morning have surely scared people, as they are designed to do. A few observations below:

• “Surging” to “Plunging”, hyperbole sells: The German DAX index is down -6.88% as I write this, fodder for the media reporting on “plunging markets”, on the hour news headlines reminding people about how many billions have been wiped off major stock markets. There is no debating the fact that today is a bad day for equity markets but wouldn’t it appear a lot less scary if the media reminded people that the index is only down -0.83% from the closing value last Friday as the early week gains have merely being eroded. But those kinds of headlines don’t sell.

• Stuck in a world of declining yields: The latest drop in bond yields is going to put further pressure on underfunded DB schemes, but this phenomenon of declining yields is about something more fundamental and has been in play since the 2008 financial crisis. Declining UK government bond yields is somewhat counterintuitive since it is now cheaper for the UK government to borrow money.

• Currency markets have always been volatile: Currently trading around the £0.80 level against the Euro, Sterling has been cited as the central issue of concern for the Irish economy, with Irish exporters warning they may need help from the Irish government if Sterling weakness persists. Again, this situation is not new. Sterling has been significantly weaker against the Euro in other periods.

In 2008 Sterling was nearing parity against the Euro. In 2011 it was around the £0.90 level when the Bank of England’s (BOE) policies were more aggressive than the European Central Bank (ECB). Then Mario Draghi and the European Central Bank upped their monetary policy game and weakened the Euro (currency wars). The single currency hit £0.70 in 2015 as market participants expected the Bank of England to begin raising rates while the ECB were becoming more aggressive (so-called monetary divergence theme).  However, the Bank of England shifted gear and warned that rates hikes would not be happening anytime soon, which set the stage for weaker sterling. (See charts below)

BREXIT has no doubt weighed on Sterling in recent months, but relative policy being pursued by central banks has been the dominant factor in currency markets since the 2008 financial crisis.

• Long term investors are the minority: financial markets in the short term are driven largely by speculation. The BREXIT move has added to uncertainty for companies, but that is the nature of business. Take Ryanair, for example, the stock is currently down -14.44%. Are people really going to stop flying? Is Michael O’Leary going to stop getting up in the morning with the sole goal of cutting costs and making money? The answer is a simple one, no! Buying an equity of a company like Ryanair is about taking a stake in the long term future of a business, the earning potential of that company. The best companies adjust to their market environment, a long term investor should be asking where Ryanair will be ten years from now.

• “Your pension has taken a hit!”: ‘If you are driving to work and you think this doesn’t affect you, it has. Your pension has taken a big hit.’ was what I heard from one presenter on Newstalk this morning.  This is a broad sweeping statement. While equities have fallen, core government bonds have maintained their safe haven status, delivering positive returns. Diversified funds will have fallen a lot less than equities.

• Focus on your own situation: I have continued to emphasise: “The most important thing for members of a pension scheme is to align oneself to the most appropriate fund given one’s willingness and ability to take risk, time to retirement and overall retirement goal.” See my blog from last July: Retirement Planning Considerations Amidst the Market Noise

If I make it to retirement, I’ll be looking at 2050 when I take my retirement savings pot from my pension scheme. For me, the current market sell-off is just short term noise. The key point is that I have 34 years to maximise my contributions. But also I get to invest my contributions at lower prices, which for me is a good thing. For instance I would rather buy Ryanair at €11.50 per share than €13.50 per share.

Having said that, someone nearer retirement cannot stomach this type of volatility or a sustained drawdown, hence why this type of member should have a lower allocation to equities.

Conclusion:

It is the uncertainty around the terms of the breakup which is the biggest risk, so there is a huge amount of responsibility on the elected officials to act decisively to allay fears. As well, the elections in Ireland and other countries should be a wake up call for governments around the world that large groups of people feel left behind by the current system, which has seen wealth and power become more and more concentrated.

For individuals planning for retirement, what is most important is maximising your contributions to meet your retirement goals, and aligning to the most appropriate fund. Don’t be swayed by the fear gripping headlines.

End

Vincent McCarthy, CFA