Brexit Is Far From Dead: Good Or Bad For Equities?

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Includes: ADRU, DBEU, DBEZ, DBUK, DEZU, EEA, EPV, EURL, EWU, EZU, FEP, FEU, FEUZ, FEZ, FIEE, FKU, FLGB, GSEU, HEDJ, HEWU, HEZU, HFXE, IEUR, IEV, PTEU, QGBR, RFEU, UPV, VGK
by: Max Greve
Summary

Much of British equities' profits come from overseas and benefit from a weaker pound sterling.

Prime Minister Theresa May is now in office, but not in power, after a historically unprecedented defeat. Chaos seems likely.

A no-deal Brexit, wrecking sterling and possibly the entire British economy, might thus produce a bounce in equities after a short dip.

Because a no-deal Brexit is the default option, political chaos makes it harder, not easier, to stop Brexit from happening.

Recently, Contributor Peter Cooper has further opined on the impact of a canceled Brexit on Britain (EWU) and its stock market. In general, I agree with much of Mr. Cooper's analysis. But because I disagree with one particular facet of it, my final conclusion is almost exactly contrary to his. This one facet is enough to turn the entire argument on its head. The purpose of this article is to explain this point and offer an alternative take on the near future for British equities investments.

The Bar Was Set Pretty Low...

This is an economics publication, not a political one, so I will not belabor political news here. But there are times when the course of an investment will almost inevitably be defined by political factors rather than by economic ones, and this is such a time. As such, with regrets, it is simply impossible to analyze British equities accurately without first bringing the reader up to speed on certain realities in Westminster right now.

First, it needs to be understood that the British government didn't just lose a vote in Parliament. In Britain's parliamentary system, that in and of itself would be quite rare and potentially transformative. But the sheer size of the defeat flies in the face of history, and has almost as many implications as the defeat itself.

Before the vote, pundits and MPs themselves were wondering about the margin. Many were saying that 100 would be a major blow to the government, the worst since the 166-vote margin Labour suffered all the way back in 1924. That, they felt, would almost certainly be fatal to Prime Minister Theresa May's hopes to carry on and try again. The hope was that she could get that margin down quite a bit, to preserve some semblance of her authority.

...And She Crashed And Burned

As it turned out, May lost by 230 votes. That may well have been - records are not always preserved or comparable - the all-time record in the 800-year history of the House of Commons. And certainly in modern times. The House of Lords voted the deal down 321 to 152 the night before, an even larger percentage margin - though the Lords' role in modern Britain is almost exclusively advisory, except for rare constitutional matters.

This all follows the vote by Parliament a few weeks prior to make May's government the first government in the 1,000-year history of the British Crown to be held in contempt by Parliament for refusing to publish legal advice received from Parliament's own attorney general.

In short, while Prime Minister May remains in office, she is no longer in power, in any meaningful sense. The ship is dangerously close to adrift without a captain or a pilot.

Does This Mean No-Brexit Is Next?

This brings me to the one part of Mr. Cooper's analysis I don't entirely hold with. As he puts it, Brexit is now far more likely to simply not happen, because MPs have rejected leaving with a deal, and as he puts it:

There is also no way that Members of Parliament would vote for 'no deal' as that is generally agreed to be a recipe for recession and chaos, and lawmakers do have to get re-elected.

If Mr. Cooper is right, Britain is not leaving with a deal, and it is not leaving without one. In other words, it's not leaving at all.

Always Check The Autopilot

The problem with this is, strictly speaking, the House doesn't have to vote to leave the EU without a deal. It already voted to do that. Back in March 2017, the House of Commons held a vote authorizing the government to trigger Article 50, which was overwhelmingly approved, with even most of the Labour Party backing it. This was not a resolution of approval or a sense of the House motion - it was the enactment of an actual law.

This means that Parliament doesn't have to vote to leave - it has to vote to stay. And while a majority of the House did vote in favor of motions during the recent debate opposing leaving with no-deal, none of those motions actually enacted changes to the law, or even proposed to endorse such changes - since even many opposed to no-deal can't bring themselves to say they favor disregarding the referendum result entirely.

CNN, BBC and other international and relatively impartial news organizations - most British press publications have a pronounced slant - have long since come to agree that no-deal Brexit is now not only possible, but also the single most likely outcome of the process. The British public increasingly feels the same. Much like in America, when there are not enough votes for any changes to policy, policy simply stays on autopilot on whatever course previous law has set. In this case, for Britain, "autopilot course" is no-deal, not no-Brexit.

What It Would Take

So basically the House of Commons has said "we have to leave, and there has to be a deal." All very well and good, but what if the EU won't give you a deal? Is it then no-deal, or no-leave? Under British law, it's still no-deal and leave the EU. And the problem is that in order to change that, a majority would have to be willing to vote for setting aside the referendum result entirely, not just expressing some vague sentiment - not even binding in law - that there "ought to be" a deal.

How likely is that? Well, put it this way. Kenneth Clarke is the Father of the House, the longest-serving member at 49 years. He was the only Conservative to vote against triggering Article 50 at all, calls himself a "hard-core Remainer," and has become something of a champion of the Brexit opposition. Today in Parliament, he told Prime Minister May, "I've had to accept that…this House is committed to leaving the European Union."

He's not the only one. The Official Leader Of the Opposition, Jeremy Corbyn, publicly called after the referendum for Article 50 to be implemented "as soon as possible" and refuses to endorse a second referendum - the preferred way for no-Brexit MPs to get around the result of the first. He says he wants a "soft Brexit." But he's a long-time critic of the EU who has never called for staying in.

I Really Do Agree

Now, let me finally list all the things in Mr. Cooper's analysis that I agree with, and like I said I actually agree with most of it. Obviously, I agree business has reacted very badly to the uncertainties and trepidations that Brexit has unleashed, and which a no-deal Brexit might yet magnify ten-fold. Estimates are as high as an 8% economic contraction, almost Depression-level, in that scenario.

After two-and-a-half years, we actually have some experience with Brexit-induced gyrations in the British market. And I also agree with Peter Cooper when he points out the pattern so far has been for a brief dip followed by larger rebounds. This is because, as he explains, the FTSE is primarily composed of companies that make over half their total profits outside the UK - in other words, a weaker sterling does more to boost their profits than to hurt them.

Mr. Cooper then applied his "no Brexit" assumption to conclude that British equities could be in trouble, because the process we have seen before whenever Brexit became more likely - the initial referendum result, the triggering of Article 50, etc. - would now run in reverse. Instead of a brief dip followed by a bounce, stocks would bounce on the no-Brexit news, then decline as a rising sterling ate into profits.

But It's Upside Down

But if you accept that no-deal Brexit is made more likely, not less likely, by political chaos in Westminster, we aren't due for a reversal. We're due for another leg in the same journey. Dip, then bounce. If Brexit really is on autopilot to happen - in other words, a "no-deal" Brexit - then sterling has quite a bit further to fall yet as markets start to price that probability in, perhaps even to parity with the euro. And this fall should boost British equities back up after an initial dip.

This would all be preparatory to actual departure. Obviously come April when Britain would actually be out equities might behave very differently. But at least for the next two months, I expect anticipation of Brexit to drive the same pattern we have observed previously.

Conclusion

Like Mr. Cooper, I see Brexit as now having a crucial influence on the course of British equities for the foreseeable future. Like him, I see those equities as inversely aligned with sterling, since so much of British corporate profit comes from overseas. Like him, I see potential for much more political chaos in Britain.

The only area I differ with him is what that chaos means for Brexit. It seems to me that such difficulties make Brexit harder, not easier, to stop. As such, that takes all the parts of Mr. Cooper's analysis that I agree with and basically turns them upside down. I am less pessimistic about British equities than he is, precisely because I am more pessimistic about stopping Brexit than he is.

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.