EU Will be Stronger: The Pyrrhic Victory of the Muggles

EU Will be Stronger: The Pyrrhic Victory of the Muggles

We typically reserve our commentary on individual companies, but there have been some fairly obvious conclusions to draw in the wake of the Brexit vote that not too many people, including Mr. Market, are focusing on. Even as rational optimists, we find it hard to see a silver lining for the British economy in the short and medium term, except for the few remaining UK-based manufacturers – assuming of course other nations extend generous terms of trade to the British in the wake of this exit vote. We wouldn’t hold our breath. This isn’t particularly contrarian.

British multinational corporations with a majority of earnings derived outside of the domestic economy have been flat to up in the couple of days following the Brexit vote. On the other hand, Eurozone multinational corporations have been heavily bruised, and while the currency has declined less than the pound, we find this market reaction quite odd. Many people have been asking us what we believe the pockets of opportunity are in the wake of the pronounced volatility – we think the best buy-side opportunities today are on the European continent. While still early into the political vacuum in Britain, if one agrees with us that the economy was already headed for a recession, and will now find itself in a stagflationary environment of worsening employment with high inflation (the misery index), Britain will offer a painful short to medium-term example of the repercussions to other members of quitting the eurozone. The deeper the recession and employment reaction is, the closer it will draw the continental Europeans together.

Most pundits were quick to point out that the fringe anti-EU parties in Spain, France, Italy, Netherlands and Denmark all called for their own referendums, inspired by the Brexit vote. This was unsurprisingly not well thought out. The market reaction to the news sent immediate ripples through pro-EU politics, and manifested itself in Spanish Prime Minister Rajoy doing unexpectedly better in Sunday’s election. Both a worsening UK economy and a potential non-exit of the UK from the EU will strengthen the continental union. First, let’s take a look at why we’re convinced Britain is about to enter into a fairly pronounced recession.

Britain Was Already Heading for a Recession

Prior to the vote even taking place, we believed the risks were skewed to the downside in the economy. The economy was enjoying near record-low unemployment, peaked and declining consumer sentiment, peaked auto sales (the latter two are forward-indicators for most economies by 6-9 months), and inflated housing prices that have already started registering declines. While it’s very early to gauge how these measures deteriorated in the wake of Brexit, real estate agents are reporting, “a wave of buyers” pulling out of deals scheduled to close. While reported data by the national mortgage providers Nationwide and Halifax have yet to report second quarter price statistics, local reports have indicated frenzied activity cooled markedly after the rise of the stamp tax on April 1, 2016 (see here in the Telegraph, here in the Guardian, partially mitigated by offshore buyer interest reported here in the Independent). Surveys have now shown expectations for price declines now that the stamp tax rise has phased in and the pulled-forward demand from the first quarter is absent from the market.

Exhibit 1: UK Residential Market Survey

Source: RICS

This hangover from the stamp tax rise in April couldn’t come at a worst time, as the ratio of house prices to new buyers’ earnings hit a fresh high in March, with transactions being rushed through before the tax increase.

Exhibit 2: London Real Estate Price to New Buyers’ Earnings

Source: Nationwide

The property market is only one of many economic factors that has topped out. Unemployment in April was 5%, or 30 bps shy of the all-time record low rate set in 2005-2006. This suggests very little improvement is likely going forward – Brexit or no Brexit. Given Europe’s most practical leader, Angela Merkel, has already promised a loss of trading status as a result of the vote, financial passport rights with the EU are at risk and many banks and insurance companies have already planned job transfers to continental Europe. Leaving all of this aside, the risks were already to the downside for UK employment.

Exhibit 3: UK Seasonally-Adjusted Unemployment

Source: Factset

Because the UK has run a pronounced trade deficit (in addition to government finance deficit), the pronounced devaluation in the pound sterling will lead to higher domestic inflation, as it did in the wake of the 2008-2009 devaluation.

Exhibit 4: UK Net Exports as % of GDP

Source: Factset

Currency devaluations in other countries running deficits, as with Brazil and Russia most recently, have led to economic weakening, not a strengthening as in the case of Japan (a large net exporter). These factors lead to an environment at risk of a high “misery index,” which has frequently led to incumbent governments being voted out of power. Higher inflation and worsening employment and economic conditions, in additional to lower housing prices, will make the next couple of quarters notably painful for most of the British. Consumer confidence, which often leads the economy by 6-9 months, had already been declining and looks susceptible to further weakness in the wake of the vote.

Exhibit 5: UK Consumer Confidence 

Source: Factset

Even if we set aside the decline in the currency and the Brexit uncertainty risk, the preconditions in the UK economy were ripe for an incremental weakening, as the consumer confidence surveys were already suggesting. On top of these preconditions, adding an unprecedented currency decline and the most likely prospect of trade restrictions, particularly on its services sectors, and the near-term risks to the downside in the economy are very heightened now. We’d expect third quarter consumer weakness to lead to a fairly quick onset of recessionary conditions.

Why This Strengthens the EU

Even prior to a full-fledged recession, simply as a result of the stock market and British pound weakness, we believe many voters that voted to leave the EU would change their votes should the referendum be held again (it appears many didn’t even know what they voted on in the first place). Parliament’s petition website has already received 4 million signatures requesting a second referendum. All major acting politicians have said the original vote will stand, yet both parties are leaderless at the moment. So neither party speaks with any voice of conviction or certainty.

Scotland’s First Minister, Nicola Sturgeon, has been very active in the press discussing the implications of the vote, in which Scottish citizens were firm supporters of remaining in the EU. In fact, a poll conducted in the aftermath of the vote already suggests that the Scottish desire to remain a part of the 400-year old union with England has flipped from 45% a couple of years ago to 53.7%. We’d expect any economic hardship to accelerate this nationalist fervor, and calls for Scottish independence to grow.

This puts the Labour party in a very difficult predicament. It has a leader in Jeremy Corbyn who, in addition to having far leftist policies which are out of touch with the median voter, is often blamed for not campaigning for the UK to remain in the EU. He has refused to step down, which is a mere technicality as his fellow ministers will be able to force a vote on new party leadership. But the Scottish question is an existential one for not only the United Kingdom, but for the Labour party. For all the Americans reading this – it would be equivalent to losing California for democrats. Presidential elections in the absence of California would make it very difficult for any democrat to win the needed electoral votes. In the same way, reliably liberal Scotland has been a bastion for the Labour party support. Should Scotland leave the UK, the Labour party would likely never retake parliament.

Which leads us to the conclusion that either a new Labour party leader will make a national campaign to hold a snap election and reverse the “Brexit,” decision, and the British will have a second vote, or Scotland will withdraw from the United Kingdom and create a guaranteed conservatively-led country.

And that’s where the long-term upside comes in for the United Kingdom. If emerging leader (and head of the Brexit campaign) Boris Johnson were to become the next prime minister, and enjoy decades of political power, he just may have the ability to turn England (not the UK any longer) into a libertarian powerhouse. Significantly lower corporate taxes, little to zero regulation, and a pro-business administration could make London’s economy very bright over the long-term. The one problem with becoming a London bull at this moment is the very significant turmoil it will have to endure in the mean time.

Should the economy worsen to a very heightened degree, we don’t believe that even by the fall there will be public support for Johnson, nor the Brexit decision. If snap elections were called, we see it very likely that a Labour minister, running under the demise of a “Bremain,” campaign could easily prevent the UK from ever leaving the EU, and would keep the United Kingdom in tact.

Coming from slightly different and more politically-focused conclusions, one of our favorite columnists in the Financial Times agrees with this conclusion.

Credit Suisse offered a very complicated flow-chart suggesting there were far more scenarios where the United Kingdom remains in the EU than actually exits.

Exhibit 6: Credit-Suisse’s Brexit Flow Chart

Source: Credit Suisse

All of these scenarios remain hypothetical, but they are based on the current reality we find ourselves in. Vulnerable economic preconditions will be hit by the currency depreciation, trade uncertainty, and waning consumer confidence.

Within just 48 hours in the wake of the decision and market reaction, Spanish voters have decided to increase their support for the pro-EU party. Politicians can debate regulatory and geopolitical issues all they want, but in the end, the economy is the only thing that matters. The only way a Brexit impairs the prospects for the European Union remaining in tact is if Boris Johnson is able to take power quickly, negotiate very generous terms of trade with the EU, make London the most business-friendly place to do business in the world, and prevent inflation from setting in – probably via currency appreciation. Unless this scenario comes to pass, the his Brexit dream will take far longer to manifest, which means England will endure significant uncertainty and economic weakness in the mean time. It’s hard to see how that scenario bodes poorly for the rest of the EU.

What This Means for Investors

One of the most surprising reactions of the market in the wake of the Brexit vote has been the response of investors to large multinational British companies. Almost all of the non-banking companies which derive their income from international sources have traded higher in the last few trading days. This is quite rational: these businesses will enjoy higher overseas profits translated back to pounds, and if they manufacture or produce product in the UK, will also enjoy higher profit margins.

This has given us conviction that in the worst-case scenario of an eventual EU breakup, the places where European investors will look to hide is in the large multi-national companies that will benefit from depreciating currencies. Any of you that know us will chuckle, but this means multi-national companies in the peripheral European countries will stand the best chance of fundamental value appreciation. It also just so happens that multinational companies in peripheral countries, like Italy, are significantly cheaper than German counterparts. In the very unlikely event of an EU breakup, the German Mittelstand will once regain retake it’s “Sick man of Europe,” crown and its businesses will be woefully uncompetitive.

Large international corporations in France and Italy have suffered greatly in the wake of the Brexit crisis, and we believe that if the market is indeed pricing-in contagion and an eventual EU breakup, this is perhaps the most incorrect conclusion an investor can jump to. The competitive advantage Fiat-Chrysler would have in world where the Italian Lira is re-introduced would be akin to the competitive advantage that Mexican auto production has against its Detroit neighbors.

It seems like the market has gotten in wrong in one other major way: any suggestion that Brexit will lead to the collapse of the European Union has unsurprisingly rushed to the same conclusions that the anti-EU parties have made. The Spanish voters have already shown these conclusions to be incorrect, and with economic turmoil across the channel, these forces will only grow in favor of continental Europe strengthening their union.  To us, these conclusions are fairly obvious, which is why we’ve been net buyers of continental European stocks in the wake of the fallout.