Brexit and What Comes After?

Brexit is grinding closer, and no political solution enjoys enough support to find its way to implementation. For what it’s worth, the consensus of analysts is that UK’s Prime Minister Teresa May will eke out agreement on a deal, one that possibly includes pushing out more difficult negotiations to the future. We should bear in mind, however, how badly wrong consensus got the Brexit vote itself. At the very least, the risk of an unexpected outcome — such as a “hard” or “no-deal” Brexit — has risen as a deal has begun to seem more elusive and as the UK’s political class has splintered into factions within and across parties.

The “Remainers” in the UK, that is, those in both the Conservative and Labour Parties who want the UK to remain in or closely bound to the EU, are pressing their case by highlighting worst-case disruptions that they claim could attend a “no-deal” Brexit. The government itself has been publishing rather alarming “contingency plans” for several weeks. These include stockpiling medicines, for example, and recalling generators from overseas military operations to float in the North Sea off of Northern Ireland — in case power transmission from the Republic of Ireland is interrupted.

“Brexiteers” contend that these “contingency plans” are alarmist. Iain Duncan Smith (known colloquially in the British press as “IDS”), a Conservative member of parliament and former leader of the Conservative Party, has pointed out that there is no such thing as a “no deal” Brexit. In the event of failed negotiations prior to the deadline in March, 2019, the UK’s relationship with the EU will simply be governed by the rules set by the World Trade Organization (WTO). (He also points out that the UK’s standing in the WTO will increase dramatically after Brexit, since it will become a full, independent member.) In short, shipping disruptions at ports, inability of airplanes to land, power failures, and shortages of medicines are extremely unlikely. IDS believes that the publicity surrounding such doomsday scenarios is part of a concerted push on the part of anti-Brexit politicians of both parties to alarm the public and increase support for a deal that they would otherwise reject — one that fails to deliver the real exit that the British people voted for in 2016. He calls this “Project Fear,” and he is probably correct.

Since 2016, we’ve been of the opinion that Brexit would ultimately work to the UK’s economic benefit, and we still believe this. After the dust has settled, we believe that a UK outside the European Union will enjoy a much more growth-friendly political and regulatory environment, and we are bullish on the UK’s economic prospects post-Brexit.

 Negotiations, Volatility, and Fear

Still, the political landscape within the UK has become, if possible, even more polarized than it was when the Brexit vote occurred. One change is that the new leader of the Labour Party, Jeremy Corbyn, seems like a throwback to 1970s British politics — a time that most who can actually remember it would refer to as “the bad old days.” His espousal of retro Labour policies such as nationalization of big industries makes Conservatives very wary of doing anything to trigger an election that Labour might win. (This is one reason why Teresa May’s position as Conservative leader is more secure than it might appear.)

Therefore, in the coming months, we anticipate increasingly acrobatic attempts at cobbling a deal together that will satisfy all sides — similar to the acrobatics that have attended Teresa May’s fruitless efforts so far. That is likely to create more volatility for British stocks, and more weakness in the British pound. If the UK does end up leaving “on WTO terms” and without a special deal covering trade with the EU, that volatility and weakness are likely to overshoot on the downside.  In such an eventuality, we would be buyers of UK stocks and perhaps of the pound, depending on the landscape of global interest-rate policies at the time.

     The Wider European Picture

In the bigger picture, what is happening in the Brexit process is not unrelated to wider events in the EU.  Greece has recently closed the chapter of its long and painful bailout — at least for now. With this closure, many are holding out the hope that Europe is finally moving out of the shadow of its financial crisis.

Events elsewhere in Europe belie this hope. Some had believed that improving economic fundamentals in Europe would damp the rise of Eurosceptic sentiment; some suggested that Emmanuel Macron’s victory over the National Front’s Marine le Pen in France signaled that “peak populism” had passed. But not so fast: Macron’s popularity has sagged, Italy has elected an explicitly Eurosceptic government, and even Angela Merkel has faced the near disintegration of Germany’s most durable post-war coalition due to the rise of anti-immigrant sentiment in Germany.

Europe’s most troublesome fault lines are currently political and cultural, and a return to better economic growth will not necessarily help to overcome them. In both Germany and Italy, the opposition is driven fundamentally by anti-immigration sentiment. That in turn is rooted in a deep unease with Europe’s favored tacit solution to the long-term demographic woes faced by its welfare states: the encouragement of mass immigration. Lo and behold, a significant number of Germans and Italians (as well as many others) are anxious at the prospect that German and Italian culture and identity will be overwhelmed by immigration — solely so that immigrants’ wages can support German and Italian pensioners.

Whether or not this fear is rational, it is real, and it is driving many current political developments. The fact that these political and cultural concerns can be linked to economic ones — when Italians blame the euro for their stagnant economy, for example — will only give them more clout.

In short, Europe’s populist tide has probably not peaked. When Brexit occurs next March (and there is very little likelihood of a referendum “re-do” that would prevent it) it may offer fodder to others, including Italy, who have a host of reasons to break away from Brussels themselves.

Investment implications: More volatility is probably ahead as Brexit draws near — both in UK stocks and in the British pound. The failure of negotiations and a “no deal” Brexit would probably heighten both market volatility and the pound’s decline. We view the UK’s prospects outside the EU favorably and we would be buyers of that weakness. The Brexit saga may encourage Eurosceptics elsewhere in the EU, particularly in Italy; we would not be buyers of “Italexit.”