A day after the British voted to leave the European Union (EU), the BBC conducted random interviews in the streets of London and the answers from two ladies struck me as symptomatic of what had just happened.
One “Leave” voter said that she was feeling some remorse, and if given the opportunity to vote again she would likely support to “Remain”, but her vote had been motivated by fear of what was going on. The other voter, also a Brexiteer, said she had voted to leave because she was angry at politicians, but really didn’t know what the EU was.
Fear and anger cloud people’s judgement, and the surprisingly large advantage of more than one million votes for Leave prove that not even the normally balanced British are immune to such human traits. Fear and anger for and of what?: of terrorism, of immigrants taking their jobs and destroying their culture, of trade agreements triggering a loss of jobs at home, of technology creating massive unemployment and of the effects of globalization.
The political drama in the aftermath of the vote also showed that British politicians are not free from hypocrisy and opportunism. Boris Johnson, the main party spoiler and leader of the Brexit camp, declared after the resignation of Prime Minister David Cameron that he, after all, would not be contending for the leadership of the party and thus the job of next prime minister. And Nigel Farage, the head of the Independence Party and co-leader of the Brexit campaign, which had buses around the country announcing that the 350 million pounds a year saved from not contributing to the EU budget would be dedicated to improving healthcare, went as far as saying in an interview, the day after, that he couldn’t really confirm that the funds would be available for healthcare investment, but that this had never been an important part of his message anyway. He retired from politics shortly afterwards. The Tories then chose Theresa May as Prime Minister, a cabinet member in Cameron’s Government who, confusingly, had supported the Remain camp. She has since danced around the issue and deflected responsibility for the implementation of the Brexit process by appointing Boris Johnson as Foreign Secretary.
The contortions and flip-flopping of politicians worldwide are not uncommon, but there was something unusual in this game of “throw the rocks and hide the hand”. It reflected a genuine fear that they had just led the country into the unknown, and the process of extrication from the EU would be far more complicated and painful than they had promised the people of Britain, and could even lead to the disintegration of the UK.
What will then happen in the short, medium and long term? Are commentators over-reacting when they call Brexit the greatest geopolitical catastrophe since the war, the most careless political gamble by a prime minister in recent memory, a cataclysm of biblical proportions? The easy answer is nobody knows, because it will depend on when and if the new UK Government invokes the so called clause 50 of the treaty of Lisbon that officially starts the exit process, how generous the Europeans are in granting the UK free access to the single market, and how the UK uses its newly found “independence”. The omens are not very encouraging on all three counts. Here is why.
While global financial markets have recovered after the initial shock, the UK is heading for an economic recession that may drag the rest of Europe with it, perhaps cutting as much as 1.5% from GDP in the UK over 18 months and 0.5% from an already battered European economy. The pound has fallen significantly against the dollar and by some estimates may fall by as much as 25%, making imports more expensive and thus raising inflationary pressures, all of which limits the room of maneuver for the central bank to cut interest rates.
The financial markets in the UK have recovered some ground after the initial shock, but will continue to be beaten-up as investors head for the exit, and there are even concerns of a diminished role for the City in London as one of the two most important global financial centers. Banks in England lost half of their market value in the first week after the vote, and have partially recovered since. Most importantly, signs of a loss of consumer confidence in the UK and Europe are already evident and investors in the real economy will at least wait until the protracted process of negotiations concludes before committing new funds.
As for the reaction from European Governments, so far they are treating it as a viral infection that can spread rapidly if not contained, and are urging Britain to start the process immediately and be-done-with-it quickly. Furthermore, they have made it clear the UK cannot aspire to gain access to the single market for goods, services and capital, if it doesn’t agree to the free movement of people as well. This would obviously defeat the whole purpose of leaving the EU, as controlling immigration was the main tenet of the Leave campaign.
However, the process is likely to be anything but quick. Prime Minister May has already hinted that they have no plans to invoke clause 50 this year and perhaps not until they have reached an agreement with the EU, a process can take up to two years after that. This goes a long way to explaining the reluctance of Johnson and others to put their names forward as leaders of the conservative party and prime minister, and the decision by Mrs. May to leave the negotiations in the hands of the main advocates of Brexit.
If a messy and drawn-out process of negotiations is the most likely scenario, what will happen to the UK and European economies in the medium term? How will that affect the rest of the world? How should investors react? The auto industry, one of the most important and dynamic in Europe, is a good barometer, especially because the UK market for cars and trucks has been growing faster than the rest of Europe in the last two years. Current estimates put the decline in vehicle sales in the UK at 10% in the next twelve months, with the European market falling by about 3%. That would take about half a million units off European sales, delaying the recovery of a struggling industry. Rather than cut production, some car manufacturers will try to export the excess to other markets, mainly in North America and Asia. So, expect some additional inventory chasing the same number of customers around the world in the near term. Longer term, the cheaper pound may help the UK industry export its way out of the slump, as companies that are highly localized in terms of components as well as assembly take advantage of lower costs, and others shift component production to the UK.
General Motors, for example, runs two plants in the UK, one at Ellesmere Port that produces the Opel/Vauxhall Astra model for the domestic and export markets, and the other at Luton making Vans. They currently produce about 150,000 units a year, accounting for some 13% of total Opel/Astra sales in Europe. The plants are running at close to capacity, so GM could consider expanding production if the weaker currency makes them more cost competitive. Nissan and other car manufacturers may take a similar approach, and the situation would not be very different for other industries.
However, as indicated this will depend on whether the British continue to have access to the EU free market. By the time all is said-and-done, the train may have left the station and the UK will have missed the next five-year cycle of investments in industries that are capital intensive and have long product cycles, as well as projects requiring heavy upfront costs. Other assets in the UK will look cheap as well and may attract investors, but a bubbly property market in London and other parts of England will put a limit to the investors’ appetite.
For the rest of the world, once again, it all depends on how things unfold from now on, but the risks are high. While the UK economy represents only about 4% of global GDP, there is plenty of opportunity for things to go wrong on a global scale. Just as examples, the financial sector in Italy is in a fragile state and could crack in a new European recession, adding pressure on the currency Euro zone. A further strengthening of the US dollar may be inevitable even if the Fed remains dovish, as investors take a flight to the quality of US assets. And a stronger dollar, combined with a recession in Europe, would trigger renewed concerns about the devaluation of the Chinese Yuan and other emerging market currencies.
My conclusion is that, hyperbole aside, the decision to exit the EU was a tragic and sad event for the UK, the EU and the world, and the next couple of years will be full of uncertainty. The best outcome, short of a “Breversal” (meaning a humiliating change of heart by the British and perhaps a new vote), would be a fast and constructive set of negotiations that keeps the UK inside the single market, Scotland and Northern Ireland as part of the UK, and a cohesive EU with no more exit experiments. But don’t bet on it. Based on what we have seen and heard from politicians in the UK and across the continent and the growing pressures from populist movements everywhere, chances are the process will be long, muddled and full of drama. Capital hates uncertainty and that is exactly what those who make capital allocation decisions are bracing for. Perhaps a good opportunity for those who subscribe to Warren Buffet’s investment philosophy: be fearful when others are aggressive; and be aggressive when others are fearful.