Markets Rejoice But Brexit Fallout Is Yet To Materialize

by: Shareholders Unite

Summary

The markets have taken Brexit in their stride, but we haven't really seen the fallout yet.

This is likely to arrive over time, with considerably weaker economic figures for the UK.

The crux is whether that weakness spills over to the eurozone.

The markets seem to have taken Brexit in their stride. On different side of the debate, people are rejoicing, but the hard part is yet to come.

First, Brexit was based on false promises, amongst which:

  • The UK would be able to control its borders whilst it was never part of Schengen.
  • The UK would be able to control its borders and keep immigrants from Eastern Europe out whilst at the same time remain in the single market
  • The UK would be able to save the full net contribution to the EU and spend it on the NHS whilst remaining to have access to the single market.
  • Brexiters argued they would get rid of all the bureaucracy and regulations, but failed to specify which EU regulation is superfluous and evidence shows that the UK isn't overregulated.
  • The UK would be able to become a free market paradise but it will keep all of its subsidies.

There is a really good article on on this, absolutely required reading.

Negative impact

It's not hard to see why Brexit proposes a shock to the UK economy as lots of stuff is insecure affecting major investment and locational decisions.

Will the UK still have access to the single market on the same conditions, or will these conditions have to be renegotiated? This matters a great deal, here is The Economist:

With 72% of investors citing access to the European single market as important to the UK's attractiveness, the referendum has the potential to change perceptions of the UK dramatically, posing a major risk to FDI. Our survey indicates that 31% of investors will either freeze or reduce investment until the outcome is known.

Will financial institutions still have passport rights to offer services anywhere in the EU?

These questions cannot be answered today or tomorrow, or even next month or next year. Until then, numerous investment decisions will be on hold. For instance, here is The Telegraph:

UK should seek to strike a deal with the EU based on a "liberalised" existing trade arrangement with Canada to eliminate all customs duties and not allow uncontrolled immigration into the UK Britain should seek new free trade agreements with "the biggest prospective markets as fast as possible

This immediately makes clear this is a matter of years and could even approach a decade. Trade deals are not negotiated on a Sunday afternoon, especially if one is very short on trade specialists (the UK hasn't had to negotiate a trade deal in decades) and has to negotiate multiple deals concurrently.

EU-UK trade relations are big (New Yorker):

In 2015, forty-four per cent of the U.K.'s exports went to E.U. countries, and fifty-three per cent of its imports came from them. Although London is famous as a global financial center, it enjoys that status largely because it's a gateway to the Continent.

The fallout is already beginning to materialize:

Several big open ended property funds had to suspend trading because redemptions would have forced these to sell properties in large quantities.

South east Asia's third largest bank Singapore-based United Overseas Bank suspended loan applications for London properties.

Property deals are collapsing as is real estate investment (FT):

More than £650m of commercial property deals in the City of London have collapsed following the UK's vote to leave the EU, including the proposed acquisition of a landmark office block by Germany's Union Investment... Investment into UK real estate almost halved in the first six months of 2016 from a year earlier, according to Cushman & Wakefield, the property agents, as the referendum loomed. Investors spent £7.5bn in the period, down from £13.3bn a year earlier, with institutional funds in particular drawing back.

If the UK cannot secure a Norway like deal as part of the EEA, its passporting rights for financial services, which are a big part of the attractiveness of London as a financial hub, are up for grabs and it will almost certainly lose its euro clearing business.

The impact on bond and derivatives markets are likely to be substantial, according to the study. Some banks have already begun to move some operations. Here is Ben Marlow from The Telegraph:

It's not even a week since the referendum vote and already we've had a flurry of warnings from big companies that they are considering shifting their bases to other European countries.

These include FTSE 100 giants Vodafone and easyJet, who have indicated they could move their headquarters overseas, together with American finance titan Visa, which is reportedly reviewing the future of its UK operations.

Meanwhile, investment banks JP Morgan and Goldman Sachs have signalled likely UK job losses, and German engineer Siemens has said it is putting new wind investment plans on hold.

The lack of deals is having reverberating effects in the wider economy, for instance, high-end restaurants have seen a marked decline in business (Bloomberg):

Across London, restaurateurs worry that worse may be to come as diners adapt to a post-Brexit world in which bean-counters keep closer tabs on expense accounts, a weak pound raises prices of imported food and eateries struggle to hire workers from the EU.

We learn that HSBC has been inundated with foreign-currency account applications as British customers rush to protect their savings.

What will happen to regulatory frameworks isn't quite clear either, and the following quote only covers one sector (Bloomberg):

Britain voted on Thursday to leave the European Union, fracturing what was slowly becoming a single digital market into potentially two-or possibly more-jurisdictions for technology issues ranging from data privacy, competition, tax and recruiting.

A considerable amount of British start-up and technology funding comes from the EU, for instance through the European Investment Fund.

The car market might also see problems, here is Bloomberg:

The U.K. is Europe's second-biggest car market and -- as Gadfly warned before the referendum -- it's a profitable place to sell motor vehicles. Thanks to the popularity of leasing, British buyers drive cars they might otherwise struggle to afford. Premium models with lots of add-ons earn higher margins.With a question over London's finance sector jobs, it's difficult to imagine British punters thinking now's the time to splash out on a prestige motor. Carmakers who export lots of vehicles into the U.K., such as Peugeot, face a double hit to revenue because of the weak pound.

What will happen to British agriculture? EU subsidies amount to $3 billion and make up 54%(!) of British farmers income and the EU takes 62% of British agricultural exports, according to The Economist.

Food prices will likely go up and a labor crunch is expected in the sector, which relies quite heavily on workers from other EU countries.

All of this is having a considerable effect on that most intangible of economic assets, confidence (Bloomberg):

U.K. consumer confidence plunged the most in 21 years, the latest sign that Britons' vote to leave the European Union is harming the nation's outlook.

And from the BBC:

UK business confidence has fallen sharply in the aftermath of the vote to leave the EU, research suggests. The share of businesses that reported feeling pessimistic about the UK economy doubled in the week after the Brexit vote. The figure jumped from 25% the week before the referendum to 49%, according to YouGov and the Centre for Economics and Business Research.

There are some compensating forces.

  • The pound has fallen making UK exports more competitive. However, one should also realize there are risks to this. The UK has a very large current account deficit and is dependent on capital inflows for financing. A falling currency might act as a deterrent to at least some of these inflows (on top of the uncertainty created by Brexit itself), so the depreciation could be a rather mixed blessing.
  • Expansionary fiscal and monetary policy are in the pipeline. The first would mark a considerable break with the austerity of the previous government.
  • Mutual assured destruction. There are those that are counting on the EU yielding to compromise, giving the UK access to the single market but allowing it to limit freedom of movement for people. On the other hand, The EU just denied Switzerland a similar deal, so they will have to take some convincing.

But apparently not enough for the Bank of England to be convinced everything is ok (The Guardian):

The outlook for the economy is so bleak, the governor of the Bank of England talks of "economic post-traumatic stress disorder." The Economist Intelligence Unit projects a 6% contraction by 2020, an 8% decline in investment, rising unemployment, falling tax revenues and public debt to reach 100% of our national output.

Conclusion

Brexit has opened a Pandora's box, one of extraordinary complexity. The UK government is in a bind. Economically, it's crucial for the UK to remain in the single market (through the Norway/EEA route), or at least have access on the same terms.

Anything else would only magnify the uncertainty that can already be felt in many sectors in the UK. Remaining in the single market will force the UK to renege on most of the Brexit promises.

The likely scenario is that they're going to buy time. But the uncertainty this creates is affecting the economy, and will continue to do so until a solution becomes in sight.

We think the whole Brexit relief rally, based on expected stimulus from the UK, the Japanese, and possibly also followed later by the ECB will falter once real economic figures start to come in.

It could be most of the damage remains limited to the UK, perhaps they could blitz some of it away with a combination of fiscal and monetary stimulus and further depreciation of the pound (which seems a given, in our view). Actually we think they'll have no choice.

Far worse can happen if the rot spills over to the eurozone, already grappling with debt-deflationary dynamics in many countries, with an Italian banking crisis to boot.

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.