Brexit – “Breaking up is hard to do”

Global insight

By Ron Bewley*. Brought to you by Infocus

History and the vote
When Neil Sedaka had his 1962 hit “Breaking up is hard to do” it was only four years after the signing of the Treaty of Rome – from where the European Union (EU) was born. France strongly objected to Britain joining for many years, which was the catalyst for many boys in secondary schools across England to question why they had to learn French.

So with Brexit winning the referendum on Thursday, did Britain get what it wanted or needs? We thought the bookies would have got it right with a ‘Remain’ win. Even Boris Johnson (Tory MP and former Lord Mayor of London) and Nigel Farage (MP and Leader of the UKIP party) – the two most prominent “Brexiteers” – didn’t think they would make it on the morning of the referendum – but they did. With the vote at about 48% : 52% and a total casting vote of about 70% (voting is not compulsory in Britain), the people who didn’t vote came in a very close third in the race: 33.6% = 70% x 48% for ‘Remain’; 36.4 = 70% x 52% for ‘Brexit’; and 30% = 100% – 70% didn’t vote)!!

This was not a resounding victory, but it was enough to start the exiting process.

Many of us were glued to the telly all day on that Friday, June 24th. Our reaction changed markedly as the results flowed in. Our first reaction was unrest, because the consequences of leaving hadn’t really been discussed in the media. But we felt calmer as the day progressed. The shock subsided.

So why did Europe want Britain to stay as much as they implored? They must be getting a better deal than Britain! If they trade with Britain now, why wouldn’t they want British goods when they are ‘sans Europe’?

Changes ahead
Of course Britain may stop making Airbus wings in North Wales which then have to navigate canals, the River Dee, the Irish Sea and the English Channel, and more canals to be delivered to Toulouse, and stuck on the bodies of planes. But Britain won’t have to subsidise all of those small farmers any longer in France, Greece and elsewhere. Britain won’t have to pay for our euro MPs to live on the gravy train in Brussels. It is a nontrivial problem to solve and the answer is not known by anyone – yet!

The Bank of England and the European Central Bank have stated they will pour oil on any troubled financial waters. This is certainly not a Lehman Brothers or GFC type event. It is also clear that it will take up to two years for Britain just to exit Europe – it doesn’t change straight away. Indeed, the full transition to renegotiate trade deals could take up to a decade.

So what are the pros and cons? On the downside, the biggest risk is what will happen to London as a financial centre. That could be a big down-side and it could also affect Australian banks in their funding (yes – we borrow from the world, and not the RBA for home loans, so that’s why mortgage rates shouldn’t simply shadow the RBA rate).

But Britain will no longer be told how to regulate its economy by Europe. A Cornish pasty can once again be ‘crimped’ on the top, and not just the side to be properly classified as a “Cornish” pasty. And they can again grow any variety of apples they want! They can even take control of the style of sausages they make and sell!

Continental Europeans freely working in Britain may have to go home. Economic refugees in Britain would not as easily get government benefits. Britain can regain control of its borders. People will have to show their passports to travel and get visas to work – just as young Australians do who work in Britain now, and vice versa.

Australia has recently made important bilateral trade deals with the likes of China. It can now make some with Britain without having to convince the other 27 counties that the same rules should apply to them. For example, one deal with Europe was recently scuppered because the Italians didn’t like our proposed anti-dumping laws for their tinned tomatoes.

Domino effect
But who will be the next cab off the rank? Britain joined the then European Economic Community (EEC) when there were just a handful of countries “in Europe” – then some peripheral countries joined – then the far eastern, poorer European countries such as Bulgaria and Romania joined in 2007.

We don’t think Britain would ever have joined if there was a common currency and 27 other countries. The current EU is so different from its forerunners, and is largely led by Germany – and to some extent France – and Brussels.

The EU has a common currency, the euro, across 19 of the 28 countries, but no common fiscal policy. That is, unlike in Australia where Canberra controls much of taxing and spending across the separate states, 28 governments in the EU have no strict common goals. Hence, we got problems with Greece and its debt problems. Greece couldn’t devalue, as it used to without leaving the euro and the EU subsidies it gets.

Scotland is now talking about having a second bite at being a separate nation after Brexit. Scotland largely voted to ‘Remain’ in Europe – as did the south east of England – but the more working class north of England, swamped the ‘Remain’ votes in the single aggregated British vote.

And there has been talk of a referendum to decide where, if anywhere, should be the border between the Republic of Ireland and Northern Ireland (in the UK).

Denmark and others who are not in the common currency but in the EU might be watching closely. If Britain starts to look better off, why wouldn’t they follow suit?

The EU morphed into a grab-bag of unlikely bedfellows. The initial reason for making the union was almost certainly to give Germany and France a voice on the world stage. But they needed to add some chums to make it seem like a real union. Shades of 1989, and the falling of the Berlin Wall are now so close.

Stock markets
Markets usually over-react and they probably have done so this time. It looks like there will be big buying opportunities ahead, but not in our banks until we better know what will happen in that space.

We couldn’t help but notice that the falls on the ASX 200, the London FTSE and the S&P 500 on Friday were all around ?3.5%. But over the week the ASX 200 was only down ?1.0%. We got a bit ahead of ourselves in predicting a ‘Remain’ and then unravelling some positive momentum.

The London FTSE was actually up +2.0% for the week, even after Friday’s big sell-off! The S&P 500 on Wall Street was down only ?1.6% for the week.

The Frankfurt Dax was only down ?0.8% for the week after tumbling over ?6% on Friday night.

With our SPI futures (an indicator of how the ASX 200 is likely to open on Monday as it is traded overnight) up +3 pts for Monday, it is possible order could quickly return to markets.

Football (soccer)

England lives to fight another day in the Euro 2016 football competition. England faces the mighty Iceland at 5am on Tuesday in the last 16. England has only played them once before and England won 6-1. But has Iceland improved or did the other teams just capitulate in the group stage matches? We hadn’t really thought of Iceland as being in Europe. Are they in the EU? No! And Australia entered Eurovision and we are certainly not in Europe.

But if England gets through, it will probably meet France in the quarters – and in the unlikely event England progresses to the semis, it then faces its arch-rival in football, Germany. For England to possibly face France and Germany only days after Brexit, the mettle of these footballers will surely be tested.

What to watch for

Simply watching the finance news on TV might not give you the information you really need. The media has a seeming predisposition to focus on bad news and draw a long bow when connecting some events.

The end of the financial year on June 30th usually brings with it some extra temporary volatility on our stock market as fund managers ‘window dress’ their portfolios to look as good as possible for reporting purposes.

Our general election on July 2nd could cause some volatility in its own right depending on how the voting goes. A hung parliament is the worst result. Our government – of whichever political flavour – needs the power to enact good economic policy.

The Reserve Bank of Australia deliberates on interest rate settings on July 5th. It might cut rates. It might change its interpretation of how the economy is travelling. So more volatility is possible!

On July 14th (Bastille Day!), our June Labour Force data will be released by the Australian Bureau of Statistics. The recent trend in full-time employment has been falling to the extent that changes in f/t employment have been negative for four consecutive months.

No one really seems to be talking about this – except us at Infocus for the last few months – so if we get another fall and it gets picked up? You’ve guessed it – more volatility.

And in August most listed companies on the stock exchange report their final or half-year results. Since companies must give guidance about changes in performance, many companies upgrade their prospects in July – the so-called ‘confession season’.

Conclusions
Even without Brexit, we would expect a few weeks of heightened uncertainty in our markets. The fundamentals are quite strong – but not brilliant. We anticipate looking back on June and July later in the year, as another blip but no more.

The UK Prime Minister has flagged he will leave office in a couple of months and Boris Johnson, the enigmatic former Mayor of London, will probably succeed. He is a very smart, charismatic man who is likely to steer Britain through change as good as anyone could.

We need to watch for any of the big international banks, like Morgan Stanley and Deutsche, to see if they feel a need to relocate some of their offices, etc.

And at home, the only likely downside to the Brexit seems to be an impact of funding for our banks. Perhaps we can strengthen our relationship with Britain. That should not stop us continuing to have good relations with continental Europe.

Of course, dual citizens (Australian and Continental European) might be less able to go and work in Britain. But plenty of Americans holiday in Britain each year without being EU members.

So it’s time to take a deep breath, put the kettle on and have a cuppa to settle the nerves – just as they are probably doing across Britain right now.

*Ron Bewley(PhD,FASSA)– Director, Woodhall Investment Research

Important information

This information is the opinion of Infocus Securities Australia Pty Ltd ABN 47 097 797 049 AFSL and Australian Credit Licence No. 236523 trading as Infocus Wealth Management and may contain general advice that does not take into account the investment objectives, financial situation or needs of any person. Before making an investment decision, readers need to consider whether this information is appropriate to their circumstances.

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