Markets Are Way Too Relaxed About Brexit

| About: CurrencyShares Euro (FXE)

Summary

Despite an earnings recession, markets are almost at record highs.

Two weeks from the Brexit vote, this seems too relaxed to us.

We'll describe the risks and ways of protection.

The markets are a whisker from record highs on the prospects of a continued goldilocks in which the economy is neither too hot to warrant considerable monetary tightening and a rising dollar, nor too cold to risk a recession.

This is a narrow path, hence the volatility earlier in the year. A rise in interest rates, especially when seen as a first step of many, is likely to have repercussions in the wider world. More especially, it could stop another linchpin of the current rally in stocks in its tracks by sniffing out the rally in oil.

More importantly perhaps are the possible repercussions of the double whammy of higher interest rates and a higher dollar on emerging market debt, much of it in dollars.

However, the markets seem to ignore the risk of Brexit, UK citizens voting in a referendum on whether to stay or exit the European Union (NYSEARCA:EU). The campaign is particularly hard and is splitting the governing conservative party in two.

That alone could have significant repercussions, no matter what the outcome of the vote will be. But the risk of the leave campaign winning could be serious.

The first thing to note here is that there have been wildly divergent reports on the effects of Brexit for the British economy, encompassing the whole spectrum from a catastrophe to a big boon.

We're not going to bother the reader here with a full discussion of all the arguments from both sides (any serious British newspaper like the FT, the Guardian or the Telegraph does a good job explaining these).

But what is instantly clear from that is the uncertainty. Nobody really knows for sure. But there are a few noteworthy elements that stick out and deserve a wider audience.

Capital flight

The Bank of England has shown that capital is leaving at the fastest rate since the financial crisis (65 billion pounds in March and April alone). But it could be worse. Here is Moritz Kraemer from Standard & Poors:

Britain is the world's most vulnerable state on a key measure of short-term debt and credit markets might suddenly seize up if voters opt for Brexit, Standard & Poor's has warned. The US credit rating agency is crystal clear that Britain will be stripped of its coveted AAA status immediately and may face a double-barrelled downgrade if the country takes a leap in dark, jeopardizing its trading and financial ties to its biggest market... the British financial system is extremely dependent on external financing

Debt coming due the next year amounts to a whopping 755% of the UK's external receipts, there is no other country that comes even close.

Now, much of this is international flows and can be netted out (for every liability, there are assets, etc.) but mismatches (in currencies, time to maturity, etc.) could or other skeletons could emerge, or creditors could rebalance portfolios. Nobody really knows.

Economic shock

Even when Britain votes in favor of an exit from the UK, the sun will rise the 24th of June. However, what the economic repercussions will be remains highly uncertain, but there have been many reports (from the Treasury and the Bank of England, for instance) pointing out possible large negatives.

To give you an idea, the Treasury report's bleakest scenario speaks of a decline of the British GDP of 3.6%-6% and a loss of 800K jobs, although the report is quite heavily criticized, for instance for ignoring the European Economic Area (NYSE:EEA) option.

The EEA is a sort of EU light. In the EEA option, the UK would become like Norway, having to accept much of the acquis communautaire but not being able to influence it. It would also have to accept the free movement of people, negating a big element for the no voters.

The most disruptive effects on trade could be avoided by the UK being 'relegated' to the EEA. But still, some disruption is likely, and the point is, the absorption capacity for economic disruption is particularly small.

The eurozone has finally achieved some kind of up cycle, after a slump that lasted longer than even the one in the 1930s plagued much of the eurozone.

But the uptick isn't particularly vigorous, to put it mildly. Many countries, most importantly France and Italy, haven't experienced any cyclical decline in unemployment or debt/GDP levels.

If the uptick is snuffed out as a result of the uncertainty in the wake of Brexit, even if actual dislocation isn't particularly severe but simply because defenses are particularly weak, this is really bad news. This would open up two further risks.

The euro

We think sooner or later the euro will have to be broken up anyway. It is simply dysfunctional, although the cracks are papered over by the current upturn in the economy.

But take away that upturn, and the full scale of the horror will once again be in full view. Much of the South still marred in a sheer endless debt-deflationary cycle without much recourse to remedy.

Countries like France, Italy, Portugal, Spain, Greece, will enter the next down cycle with virtually all macro-economic indicator in worse shape than before the financial crisis.

While things like labor market reform would benefit countries like France in the longer-term, witness the reaction when mild reforms are proposed (without the parliament actually voting on it). Italy has introduced mild reforms, but this hasn't yet delivered any tangible results.

This isn't a surprise. Supply side reforms, whilst useful and often necessary, don't deliver instant results (in fact, short-term many would add to deflationary forces) and are panacea to the demand problems generated by the euro (the 20-30% competitiveness loss many countries experienced in the first decade of the euro and now have to claw back through 'internal' devaluation).

There are already large minorities (or even majorities) emerging in many Southern countries (Spain, Italy, Portugal, even France) that want to leave the euro, and something of a chain reaction is possible.

Even when properly managed, a breakup of the eurozone would be extraordinary costly (even if these costs are one-time), but if this happens in a disorderly manner this will be particularly painful.

The EU

Another risk is the breakup of the EU itself. No less a figure than George Soros, who came out of semi-retirement to place bearish bets for his hedge fund, has argued this (from Forbes):

If Britain leaves, it could unleash a general exodus, and the disintegration of the European Union will become practically unavoidable

We fear he isn't imagining things. The long slump and migration crisis has made the EU increasingly unpopular in many EU countries.

Le Pen in France, Wilders in the Netherlands, Beppe Grillo in Italy are all anti euro and anti EU, and mind you we don't closely follow the politics and opinion polls in all EU member states, there might be quite a few more.

Britain leaving the EU hasn't happened, it will upset the playbook, anti-EU voters and groups will be emboldened by it, demand referenda where these are possible.

Click to enlarge

As you can see, there are no clear majorities yet, but it is striking that Italy already comes close with 48% according to an Ipsos MORI survey. This can turn on a dime.

Investing implications

We feel that the Brits will vote to remain, but nobody can't be certain of this. If it happens, we're in uncharted territory. It could set in motion a chain of events producing dire consequences

It could be tipping up the fine balance that is underpinning the growth and a modicum of stability in the eurozone and the wider EU. These risks are certainly not priced in anywhere, but for now, they remain just that, risks.

But these are tail-end events, the risks are perhaps not that large, but the consequences certainly could be monumental.

Stocks, the euro, the pound will all suffer. Volatility will spike. US shares won't be spared. A relatively cheap way to protect oneself from the possible mayhem is to buy far out of the money put options.

Another way to profit is to buy volatility. The problem with both is that they contain time value, which is why we would prefer a product called a turbo, which doesn't contain time value.

However, we're not aware these trade in US markets (they're rather popular in our native Netherlands), so we're not going to waste space to explain them (which isn't all that straightforward).

The pound sterling has already weakened substantially against the dollar, although Brexit is likely to weaken it more. Against the euro it's less clear cut, the pound has actually been strengthening against the euro since early December. Only the last two months has there been some (mild) weakening.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.