Brexit – It’s Not Whether We’re In Or Out...
Skerritts View - March 2016
We’d love a Pound (or a Euro for that matter) every time we heard or read the word “Brexit” in the next four months. Its’ coverage will be wider than Demis Roussos’s kaftan in the run-up to June 23rd and we don’t doubt that most people will be growing mighty weary of the in-out debate well before then. But we can’t ignore the impact that it may have on the equity, bond and currency markets connected to the UK as we move through Spring to Summer.
Probably the biggest cause of uncertainty will not be whether we stay in or leave, but rather the changing perception of the outcome as the date draws nearer. We’ve already had a clue as to what will happen to Sterling, as it fell sharply upon the announcement by Boris Johnson that he was joining the “out” camp. Of more interest to us however is the discrepancy that exists at the moment between what the polls say will be the outcome and what the bookies say.
Most people think that the bookies always get it right. That wasn’t necessarily the case in our General Election of last year as a Tory majority could be backed at 7-1 even on the day. Today, bookmakers have it as a near certainty that the UK will remain in the EU after June 23rd but if you look at the polls you see a much closer vote occurring. The polls didn’t cover themselves in glory leading up to the General Election, it’s fair to say, but over Brexit they are suggesting close to a 50/50 chance of coming out, which is a massive discrepancy. It doesn’t really matter at this stage who is right. It does matter from a short term investment perspective though that one of them is clearly wrong. Deciding which one will have a fundamental effect on UK portfolios as, if the bookies are right, the drop in Sterling is almost certainly overdone and certain stocks and sectors will benefit once the result comes through. If the polls are right though, this means that expectations of leaving will increase as polling day approaches, probably leading to further downward pressure on the Pound and seeing share prices in the companies and sectors that will be major beneficiaries of staying in, fall.
Either way, June 24th will bring clarity and we suspect that markets may respond positively whichever way the UK votes as most of the price volatility will have happened prior to the date itself. We may, of course, be wrong, but we’ll not be increasing our UK exposure in the run up to the referendum. We will however be ready to act quite quickly after the vote, whichever way it goes.
Our comment last month that the last time the world was shaping up as it is today was “just before World War 2, and before that just before World War 1” was greeted with some scepticism. Since then, China has unveiled some missiles on an island in the South China Sea claimed by Vietnam and Taiwan and Donald Trump has taken a huge step towards making it a straight fight for the White House with Hilary Clinton. Just saying….
With the Bank of Japan crossing into negative interest rate territory and speculation mounting that the ECB and other Central Banks may follow suit in the event of a worsening global economy, we have read something that we found interesting regarding possible outcomes from a move that we, and nearly everyone else, will be facing for the first time. We will continue to make our point that we are in, or entering, a deflationary era that is unfamiliar to policymakers, politicians, bankers and fund managers alike and as such there will be numerous errors made in expectations and assumptions as old models are found to be wanting in the new environment. Negative interest rates may be one such area.
Intuitively, negative interest rates suggest cheaper borrowing and a positive stimulus to the economy. This may not be the case. Strangely, negative interest rates could actually lead to the cost of borrowing increasing. How? Well, according to BCA Research, a bank has to respond to a negative interest rate policy in one of three ways.
One of these is to increase their margins by raising the cost to borrowers. This, then, would have the effect of tightening credit when the intention from the central bank was exactly the opposite.
If the negative rate was to be passed on to depositors, this would encourage capital flight and thus put the bank’s solvency in jeopardy. If it took the hit on both lending and saving rates this would again adversely affect its own profitability and, ultimately, solvency. We saw in February a sell off in bank stocks as this state of affairs raised its head for the first time.
It is pretty clear that any one of these three outcomes is negative for the wider economy and adds fuel to our argument that this time around, if there is a crisis, the Central Banks’ armoury is empty.
Linked to the idea that we are in a different era today in which yesterday’s rules don’t work, we tip our hat to Dhaval Joshi (Managing Editor at BCA Research) for this superb analogy as to why it is a mistake for policymakers such as our own Bank of England to put a numerical target on the inflation rate that they are trying to hit. Their stated inflation target is 2%. Unsurprisingly, they are way off hitting it on a constant basis. Why? Well, according to Joshi, it’s akin to trying to arrive at Heathrow Airport at precisely 8 a.m. in a weekday from North London.
Leave home at any time up to 7 a.m. and the journey to the airport is a smooth, constant forty minutes. Leave after 7 a.m. and the journey time doubles, due to bus lanes coming into force and the general rush hour surge. “This non-linearity creates a perverse effect. It is mathematically impossible to arrive at Heathrow at precisely 8 a.m.”
If you leave before 7 a.m. you will arrive early. If you leave after 7 a.m. you will be late. There is no time that you can leave so as to arrive bang on 8 a.m. But this doesn’t stop people trying with the resulting increase in dangerous driving, rising stress levels and increased physical risk.
So it is with a 2% inflation target in a deflationary world. Central Banks are pursuing an unobtainable quest and, as we see through the introduction of negative interest rates, the unintended consequences of their linear approach could turn out to be quite damaging. Better that they target a range, if they need to target at all.
As we’ve seen in countless situations since the Financial Crisis though, if we are waiting for policymakers to act in anticipation of an event then we may have to wait a long time. Their normal course of action is to wait for a crisis, and then respond. We’re not sure exactly what the next crisis will be, but a next crisis will surely happen as the world crawls out of the mess that it got itself in nearly a decade ago.
These are our views, as always, and don’t constitute advice in any way.
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