The Brexit Ball Is Now Rolling

by: Owen Williams, CFA

Summary

Markets caught wrong-footed.

Beggar thy neighbour populism is a long-term negative for world growth.

Our post-Brexit outlook.

We can trace Brexit and the ground swell of nationalistic opinion in Europe and in the U.S. back to the Financial Crisis of 2007-2009. Yes, the effects of the Financial Crisis are still very present today. At the heart of the Eurosceptic's message is "keep Britain for the British." Indeed, an anti-immigration, xenophobe sentiment drove Eurosceptics to the polls Thursday.

Much as we saw in Austria a few weeks ago, when Norbert Hofer and the Freedom Party of Austria missed winning the presidential election, taking 49.65% of the vote. Much as we see in France, with Marine Le Pen and the Front National becoming the first political party in the country. Much as we see in the U.S. with Donald Trump's populist message of keeping illegal immigrants out of the U.S. and renegotiating fair trade deals for the U.S. Much as we are seeing in the Netherlands, Finland, Sweden, Denmark…

Free trade is a hot button issue. Why, after so many years of moving towards an open-border, free-trade global economy with integrated financial markets, has public opinion swung back to the "go it alone" independence of the 19th/early-20th century? Don't all economic students know that everyone is made better off with free trade?

David Ricardo demonstrated back in the early 1800s that if each nation specializes and produces goods in which they have a comparative advantage in producing (in terms of skills, natural resources, etc.), that we can increase world production. The excess goods produced can then be traded/shared amongst all. With protectionism and trade barriers, world production falls and we are collectively worse off.

What is the link between the Financial Crisis, the recent protectionist public sentiment, and populist movements across the globe? When growth slows, production falls, times are tough, and "belt tightening" takes place, those who have less today than before the Financial Crisis start thinking about "Me First." People have become less generous, as there is less wealth to go around, and don't want to share their "reduced portion" of global wealth with the "bloody immigrants."

In sum, the global economy has not bounced back from the Financial Crisis, the pie is smaller. The working class as a result wants to cut the pie differently. There is not enough to offer a piece to immigrants. It is not those who are financially well off voting for Hofer, Le Pen, Brexit, and Trump. It is those who "feel" the shrinking of the pie since the Financial Crisis. This is the world we live in today.

In the same manner, populist opinion has turned towards protectionism. Again, due to misguided reasoning by the impoverished working class. Whether it be Donald Trump lambasting China for "stealing American jobs" or Marine Le Pen inciting French workers to "save the French economy" by stopping factories from moving to Eastern Europe (where labour costs are much cheaper), the message is universal: politicians are expressing the "beggar thy neighbour" sentiment of their constituents.

Maybe we should distribute copies of Ricardo's treatise, "On the Principles of Political Economy and Taxation" to the working class today. Slower growth of the world economy (again getting back to the root cause, the Financial Crisis) means fewer jobs. If there are fewer jobs to go around, we can't allow immigrants to take a job from a good American (French, British…) citizen.

The Invisible Hand of Adam Smith is being handcuffed by populism. Jobs should flow to China, where salaries are more competitive. Factories should relocate to Eastern Europe when labour laws are less stringent. And this is the main point we want to drive home. This wave of populist protectionism is impeding the efficient allocation of the world's capital and resources. If the U.S. wants to slap tariffs on Chinese goods, an imported shirt made in a Chinese factory with labour paid at a rate of $0.50/hour will now be made in a California factory with labour paid at a rate of $17.50/hour. Tell us again how this will increase production of shirts and allow all of us to purchase more goods.

In sum, the current wave of nationalistic, populist anti-immigration and protectionism can only be bad in the long run for the global economy and equity prices. While it is unclear how far the pendulum will swing in the next months/years, we can only hope that central banks and government step back and allow global growth to pick up.

Free markets are the only solution. The Invisible Hand must not be impeded in allocating resources to the most efficient uses. Central bankers are doing us no favours. Protectionist governments are doing us no favours. Only when capital flows freely will economic growth quench the populist fire now burning.

In the rest of this week's Commentary, posted on our website, we share our two cents on the likely fallout of the Brexit referendum both for the European project and financial assets.

Conclusion

In a period of negative seasonality, we began de-risking our portfolios in May. The Brexit risk, along with key U.S. equity indexes bumping against major trading range resistance, caused us to de-risk even more than our models called for. We do not recommend that investors try to be heroes and jump on the Friday sell-off.

The dynamic has materially changed and uncertainty will only increase both in Europe, the U.K. (Scottish referendum on staying in the EU), and in the U.S. (presidential election, Fed policy). Uncertainty rarely rhymes with equity gains.

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.