Brexit is a regular theme in the European financial press. It’s one of the most consequential geopolitical events so far this century. For day traders, the uncertainty can create related Brexit trading opportunities in UK assets (for the basic fact that their prices are more volatile). But for owners of UK financial assets, you probably have little to fear in the long-run.
1. The UK doesn’t need EU membership for the free or mostly free trade of anything – goods, services, labor, or capital. Supply chains can remain intact. They need customs controls. “Mutual recognition agreements” (MRAs) are perfectly fine for goods trade.
The UK can negotiate that separately without having to plug themselves into a flawed economic, geostrategic, and political alliance. Ensuring prosperity for the future of the UK doesn’t need to entail being part of a bloc with conflict and cohesiveness issues and major governance challenges.
The mainstream media often doesn’t help because they have a tendency to sensationalize the process because they sell headlines by turning basic uncertainty and a negotiation process into a form of manufactured chaos.
2. The UK is the second-largest economy in the EU, accounting for 21% of its economic output of the 28-state bloc.
The UK in many respects has more to offer to the EU than the rest of the EU has to offer to UK. The UK is a major security, counter-terrorism, economic, and military power. Its economic power is equal to 19 EU member states.
The UK has a lot to gain from the EU and other economies, but it doesn’t have to be under a flawed structural construct. The notion that it has to be under a bloated multilateral coalition to optimally perform economically and politically is untrue.
3. It can leave the customs union while still operating normal trade and immigration policy. The country has technology and infrastructure advantages over other parts of Europe.
4. Any qualms over regulatory divergences can be remedied with a dispute settlement process. The UK and EU can declare each other’s rules as legally equivalent. Any concerns over data are immaterial, as it is already recognized as legally equivalent.
5. The EU’s procurement rules are already excessively onerous. The UK needs and deserves a more flexible arrangement.
6. The UK already has a detached relationship to the EU, and has for decades. It has never been a part of the euro or Schengen area.
7. The UK is the only member of the EU that has broad experience with financial stability activities when it comes to the transition of individual companies’ risk activities. Transitioning trillions of dollars of notional derivatives activity from London to the EU is not some trivial process that the EU can leverage in negotiations.
8. The EU is full of “financial anchors”.
EU banks have low-quality asset books as a whole in relation to their liabilities. Even Deutsche Bank, the largest bank in the largest economy in the EU, is struggling to maintain an investment grade credit rating. The UK would be disproportionately on the hook for unfunded pension liabilities in the EU going forward. If the UK is part of that it has to fund it.
The UK still has to pay into the EU’s budget for the lower-performing parts of the bloc. Italy has numerous economic and financial problems. Its non-performing loans remain high. Italy is not a small problem either. It’s 15%-16% of the EU economy. It is 19%-20% of the EU economy without the UK.
And it’s not just Italy. Other lower-performing member states like Spain and Portugal have their own simmering problems. Greece is overleveraged, but the durations of its debt obligations have been spread out (average debt obligation is 26 years) to make them manageable, unlike in Italy, which passed on the opportunity. When the EU economy turns down, these economies will see their credit spreads blow out more than any other member states.
These countries, as a whole, benefit greatly from being part of the EU because all their financial problems and fiscal management effectively get socialized among the EU-28.
Of course, the high-performing economies – Germany, UK – inevitably get stuck with their bills and the resulting austerity measures that they don’t want or need when there’s a downturn.
9. The EU has major challenges that don’t structurally apply to other economies.
They don’t have a common fiscal policy. Italy and Spain try to flout the EU rules entirely. Many of them have to share a uniform monetary policy because of the euro. The euro’s value is too high for most of the EU, creating excessively tight financial conditions. They don’t have unity within countries or between countries; and there are major governance and sovereignty challenges.
The EU has structural issues that will come more to light when the economy turns down. Of all the major economies, Europe will be the most strained.
10. Yet in terms of monetary policy, the EU’s rates are still at zero or in negative territory – negative-40 basis points on the deposit facility and zero-flat on the refinancing rate. All the bad debt and structurally unprofitable enterprises will come forward when the ECB isn’t as accommodative moving ahead and investment hurdle rates are restored (if they can get there).
11. The market consensus is that the EU will appreciate against other developed market economies over the next five years. We can view this by looking at the forward futures curve.
However, I think this consensus is incorrect.
Financial and trade flows are a big part of what make currencies move. The current account is a big part of that, capturing trade (exports and imports), investment flows, and foreign transfer payments. When a country has a current account surplus, that suggests that the currency is overvalued. When a country has a current account deficit, that suggests that the currency is undervalued because funding needs to be supplied to finance it.
Many see the euro zone as a current account surplus bloc at roughly 3.5% of its GDP. However, that surplus is a reflection of large output gaps in the weaker member states – e.g., Italy, Spain, and Portugal. Once you adjust for those gaps and factor in recent euro strength, the current account is actually negative.
The euro also lags in terms of its value as a reserve currency. The main reason for this is because there isn’t more supply of the euro zone’s predominant reserve asset – the German bund. Eighty percent of all bunds are held by the European Central Bank and “foreign official” (i.e., foreign central banks) and the supply is diminishing.
The UK leaving the EU will create some short-term headaches, but over the long-run, it will likely not matter. It’s similar to a heart transplant. In the near-term, it will weaken the country to a degree due to uncertainty creating a reluctance to invest and tamping down on consumer and business confidence. Over the long-term, the economy, its equity market, and the pound will very likely be perfectly fine.