“The difference between a democracy and a dictatorship is that in a democracy you vote first and take orders later; in a dictatorship, you don’t have to waste your time voting” Charles Bukowski
Democracy is a strange beast. Winston Churchill is often quoted as saying that “democracy is the worst form of government, except for all the others.” The post-Brexit vote has shown the good and the bad side of democracy. The vote saw a huge turnout by British standards and a close but definitive result that has split the country. The bad side, a petition to re-hold the referendum has attracted millions of supporters but is unlikely to lead to any fundamental change in the decision. Those signing the petition appear to believe in democracy only on condition that it gives the “right” answer, whatever that may be, for them. That option sounds like dictatorship by the noisy. CheckRisk considers it highly unlikely that a new referendum will be held. It is, however, far more likely that the Scottish Nationalist Party, SNP, will try to block the referendum decision. Again a somewhat undemocratic approach which begs the question are governments elected to serve the people or is it legitimate for government to ignore the popular will? Whatever one’s view CheckRisk believes that there has been a substantial change in the risk environment that will be enduring, and have global consequences.
While we are not focused on the effect on Britain in this issue clearly there is a longer term risk to the Union and we will be adding a small piece on this subject to our blog shortly. However, our best guess at present is that it would be very difficult for Scotland to make arrangements to enter the EU as an independent country prior to actually leaving the UK. As such, the SNP would have to be sure of winning an independence referendum, which they are far from certain of achieving. Having left, the Scots could apply for EU membership but that would entail a consensus among all members and a prioritising of Scotland over other incumbents including Turkey. All of these issues are not insurmountable, however, they represent a very big challenge and danger to the Scots and we do not believe a breakup of the UK is imminent. The Scottish cannot really impact the legislative decision to Leave the EU, what they can do is impact the manner in which it is done with regard to policy.
While markets are concerned over the risk to the UK, CheckRisk believes that the real risk, the unknown risk, has been transferred to Europe. To be clear, the decision to leave the EU is a big one and will have consequences for the UK, but they will not all be negative. After all the UK is just reasserting its sovereignty and independence. More countries in the world are not part of an EU-style grouping than are, and so it is ridiculous to assume that the UK cannot thrive in an independent role. The UK has before and will again. The UK will also continue to be a major trade partner with Europe and others. It will take some time to resolve the divorce, but it can be done.
The most pertinent statement that can be made as to why Great Britain left the EU is as follows: the EU was created by France and Germany first and foremost as a political union. The UK joined the EU assuming it was an economic union where the British would be able to opt in and out of the more Federalist tendencies of EU technocrats. Thus a marriage of sorts was formed, but it was one that could never last with such a fundamental difference of strategic view. It was evident from the outset that a convergence towards a Federal Europe would eventually lead to a divorce.
The post-Brexit risks for the UK are definable. There is transition risk, currency risk, short-term economic risk, and geopolitical risk. The EU can decide to take punitive measures against the UK but can only do so while taking a risk themselves. Punishing Britain involves a degree of self-harm for the EU. Interestingly the EU does not appear to be averse to self-harm as Russian sanctions aptly show. The penalties are, from an economic perspective, costing the EU more than they are Russia, and thus are questionable as an effective punishment. We point to the pressure building in the Italian banking system.
It is important to note too that as far as the UK is concerned a weak GBP is a huge net benefit to the economy. The UK has entered into a real currency war with the perfect excuse. It simply is not possible for Europe or other countries to compete with the sort of devaluation the GBP has experienced. Is one of the biggest risks to Europe the fact that having left the EU Britain then prospers economically? CheckRisk believes this is the core of the risk to Europe. The risk in the UK is known, and both the BOE and the government will do what it takes to stabilise markets. The risk in the UK, despite the current volatility in UK equity and bond markets, is much smaller than elsewhere. There will be a backstop that is reliable; this cannot be said for Europe. This is not simply a contrarian view. Firstly, equity prices have begun the process of risk discounting. Falls in equity values have been broad based and indiscriminate. The indiscriminate nature of the correction is a risk opportunity. Second, as stated before the risks are broadly known. Thirdly, while both the UK’s Labour Party is tearing itself apart and the Conservatives are entering a leadership election, we do not believe there will be a vacuum in government. The UK’s system of government means that the various departments will function just fine. The perception may be a rudderless ship in the short term, but that again is an opportunity.
All of the above, however, does not mean that CheckRisk’s overall view of risk has changed; it has not. The period 2017-2020 is likely to see a peak risk period, with a likely recession commencing in the USA in 2018-2019. The turmoil that Brexit is creating will make it doubly hard for the USA to raise interest rates until later this year and that has significant unintended consequences for the USA’s ability to handle anything but a very mild recession in the future.
The bigger picture is more important than Brexit. It is very easy to lose sight of that wider vision when the media is feasting on immediate and enticing news items. While the markets are looking in the opposite direction, there will be long-term opportunities for investors in the UK.
Can the same be said for Europe?
One of the greatest ironies of Brexit is that Europe now has a golden opportunity to reform. The question is can the EU grasp the opportunity? If the EU misses it, then we will almost certainly see an existential crisis in the EU for both the EU and the euro.
The essential question EU leaders, and we are not referring to the unelected technocrats at the EU Commission, we are talking about the leaders of EU member states, must ask themselves is; what is the EU? Is is a political partnership with needs to become a Federal unity or is it an economic union with substantial shared interests at a political and cultural level. It is the very question that Great Britain asked and had failed to receive an answer to which then led to the Leave vote. Likewise for Europe, if the EU cannot create an exciting vision for its member states then as a club the EU will die. The European political elite is still talking about convergence and ever closer union, however, the people are not. There is a fundamental disconnect between government and the people that is potentially a massive risk for the cohesion of Europe.
Where has the risk gone post-Brexit?
It has moved to Europe and it is Europe that will remain the epicentre of risk for the world for the foreseeable future. There are up to six countries that could vote to leave the EU following Brexit: France, Italy, the Netherlands, Finland, Austria, and Hungary. The issue again is the choice between ever closer union or an economic union that leaves sovereignty untouched. Our bet? Is that the EU commission is so hooked on the Federalist vision that conflict between the EU Commission, member states, and the people is almost inevitable. The EU only ever seems to move at times of crisis; there is no vision that is anything but grey coming out of Europe. There is no sense of hope in the EU dream. Ask anybody on the street in France, Germany, or Italy to name three senior EU commission members and they struggle. Ask the same people if the EU has delivered on the concept they were sold on, that is to say, better economic prosperity, lower taxes, and security the answer is more often than not “no,” to the first two and “maybe,” to security.
The fear in Europe is not a financial crisis but a political crisis. The fear in the UK is a financial crisis and not a political one, and the difference is quintessential to understanding the opposing nature of risk in the two regions. The risk of a complete disintegration in Europe is on the cards. This may seem an extreme statement, and of course, we do not anticipate such a break-up in the short-term, however, we note that CheckRisk as early as 2009 was saying that both the EU and the Euro would be tested in the coming years, that examination has now commenced. CheckRisk, specifically forecast a northern Euro and a southern Euro, which would then be linked to the northern euro with a wider band for movement. The northern euro might consist of Ireland, France, Germany, the Netherlands, Denmark, Sweden, Belgium and Finland.
How will Europe react to this existential threat?
There are only two realistic routes. Firstly, ever closer union, or secondly, a reform of Europe that recognises that EU bureaucracy has run amok and that national direction of Europe by member states is both the will of the people and probably the only way to go to avoid disintegration. CheckRisk’s view, at present, is that it is going to be very hard for Europe to move away from convergence. The likelihood is a push to a tighter union as a result of the rejection from Britain. Such a reaction will sow the seeds of the eventual breakup of the EU.
What does this all mean for investment risk?
Firstly, the European sovereign debt market is going to experience periods of elevated volatility in the coming months and years. Spreads against German and French bonds will widen. There is a strong possibility that the whole Grexit issue will re-emerge.
In the coming months, a series of votes have the potential to rock Europe. In October, Hungary will vote on immigration levels. This is a referendum that could reject EU directives. In the same month Italy goes to the polls and Renzi, a European centrist, could be dismissed if the recent mayoral election in Rome is any indicator. In March 2017 the Dutch go to the election booth where right winger and anti-European Mr. Wilders is currently leading the polls. In April 2017, France will have its elections with Marine Le Pen for the “Front Nationale” in a commanding position. While Le Pen may not win outright, she will most likely secure a strong position in government that will create a French distancing from the EU.
Again CheckRisk believes, in the short-term, that talk of European disintegration is overhyped. However, the genie is out of the bottle. It is inevitable that governments in Europe, over time, begin to negotiate with each other more directly to work around a visibly dysfunctional Europe. The EU commission will cling to power, of course. However, the tide has turned for Europe and risk is, therefore, more likely to appear here than elsewhere. Not all in one go but as a result of the tensions that the post-Brexit Europe has to deal with.
On a global basis, risk is rising, but not just because of the tensions in Europe. We are reaching the end of the credit cycle with interest rates at close to zero and debt at levels that are above those that created the 2008 credit crisis by some $58 trillion. There will be risk opportunities of course, like those created by the recent severe fall in certain FTSE 100 stocks. However, the broader picture for the moment suggests the avoidance of excess risk and a reduction in overall risk exposure to EU sovereign debt.
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