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ARP Observations

Brexit at 23:58

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With the vote in Parliament coming up and the exit date now less than four months away, the stakes are getting higher and higher. See here why a hard Brexit - i.e. no agreement - is the worst of all possible outcomes.

With a crucial vote in Parliament on Theresa May’s Brexit plan no more than a week away, and with less than four months to go before the British leave the EU, the stakes are higher than ever.  We are effectively two minutes away from all lights being switched off.  As Michael Gove, a senior member of Theresa May’s cabinet and an ardent Brexit supporter, said only a day or two ago: “Mrs. May’s deal is not perfect but, if MPs do not vote it through on 11 December, there is a risk of no Brexit at all” (Source: BBC).

Before going any further, allow me to make my position on this saga crystal clear.  I am a Remainer, but I am also a staunch believer in the principles of democracy; hence you should not have another referendum until you get the result you want.  Maybe when the next generation is in power but not now.  Yes, many Brexiteers lied through their teeth, but aren’t politicians always guilty of that, and why didn’t Cameron and his allies expose those lies?  

As far as membership of the EU is concerned, although I think the structure is far from perfect, I can only conclude that a life outside is more than likely to be worse than the one inside, which we have enjoyed for the past 45 or so years.  How much worse depends on the nature of the agreement that is ultimately approved by Westminster.  Should we end up with no agreement whatsoever (a so-called hard Brexit), it will get pretty ugly for reasons I will explain below.

Can Theresa May secure sufficient support for her plan when MPs vote on 11 December?  As it looks at the moment, probably not, but stranger things have happened.  The sheer implications, should her plan fail, may turn quite a few Brexiteers around at the last minute, as Michael Gove alluded to.

What will happen if the plan is voted down?  Pretty much anything is possible.  A second vote in Parliament on a slightly improved agreement is probably the best one can hope for, but Theresa May could also decide to pass the baton to one of the hardcore Brexiteers, which would be about the worst possible outcome.  Another general election (which is what Labour is hoping for) could also be the outcome, and that would definitely lower the odds on a second referendum.

A few words about Theresa May’s plan.  Is it perfect?  No!  Can it be improved in a meaningful way?  Almost certainly not.  When you leave a club, you don’t dictate the exit terms.  The club does.  Those who believe otherwise are deluded.  The argument I have come across is that they (the rest of the EU or, in the following, rEU) need us more than we need them, so of course we can - to a significant degree – dictate the terms.  Those who argue along those lines should seriously consider requesting a refund of their school fees.

The EU country enjoying the biggest trade surplus vis-à-vis the UK is Germany, and the argument the Brexit camp has put forward is that the German car industry (which accounts for a significant share of the German trade surplus with the UK) will suffer badly if no trade agreement can be reached.  With only 7-8% of rEU exports going to the UK, whereas almost 50% of UK exports go to rEU, only one export sector will suffer badly if no agreement is reached, and that is the UK export sector.  When you measure the risk as a percentage of export jobs that could be lost (which is the correct way to do it if you want to project economic stability), any loss of rEU exports to the UK is no more than a blip on the curve.

The second reason why no trade agreement between the UK and rEU will be devastating for economic stability in the UK has to do with the just-in-time inventory management practice which is so widespread these days, and upon which so many UK manufacturing companies depend.  Few manufacturers keep inventory of any significance any longer.  If you assemble a car in the UK but depend on components from, say, France to do so, you simply order those components which are then shipped overnight.  With no agreement in place, those lorries that are supposed to deliver somewhere in Britain the next morning will suddenly be stuck in Dover for days (or weeks).  Guess what that will do to delivery times and to pricing.  Obviously, UK manufacturing companies can reduce the impact by stocking those components themselves but, at the very least, that will affect pricing.

The third reason is something I call proximity.  All those who think we can just buy everything somewhere else should think again.  Certain goods, e.g. certain types of pharmaceuticals, need to show up in a matter of hours rather than days or weeks, unless we are prepared to accept fatal consequences.  Another example would be all the Spanish fruits and vegetables we eat here in Britain every day.  With no trade agreement in place, either we need to accept older produce or more expensive produce – or both.

The three reasons just mentioned all relate specifically to the trade agreement.  On top of that, there are many other agreements that are at serious risk of being undermined if the British decide to walk away, not least the long-standing pan-European cooperation on crime and terrorism, but let’s not go there.  The only one I will mention in this context is the divorce bill – supposedly about £39bn.  Some hardcore Brexiteers are of the opinion that we should just renege on that.  Do these people realise what that would do to Britain’s credibility in the international community?

Mark Carney was criticized a few days ago, when he painted a very negative picture, should we end up with no agreement, but his critics missed an important point. Mark Carney’s ‘projection’ was never meant to be his base-case forecast (and he said so all along, but the Brexit brigade didn’t listen) but a worst-case projection, to which he assigned a very low probability.

I think it is quite irrelevant (and I suspect Mark Carney thinks so too) whether property prices drop 25%, 30% or 35%.  The point he wanted to make is that the drop will be significant in a worst-case scenario and will do considerable damage to the UK economy.  And all those who still think he was a bit of a drama queen last week should stop and think about what has already happened to property prices since the referendum.  In parts of the country, they are already down 10-15% - and more so in central London.  Furthermore, since the referendum, the UK economy has gone from being the fastest growing EU economy to the slowest.  Perhaps there is a link between the two!

By far the most important reason why a hard Brexit is a terrible outcome is not economic in nature, though.  It is political.  Think back to Word War II, and what happened in the first few years after the war ended.  Visionary European leaders, who wanted to ensure that we Europeans would never go to war against each other again, saw a higher level of economic integration as the formula to ensure that, and it has worked brilliantly.  Whether you like the EU or not, it is hard to argue otherwise.

With the British decision to leave a community that has underwritten peace in Europe for the past 75 years, a can of worms has been opened which could end very badly.  Again, I am sure some of my readers will push back on me now, saying something along the lines of “don’t be ridiculous - of course this is not going to end in war!”.  For the record, neither do I think that a war will be the ultimate outcome.

Having said that, something will happen.  A very unpleasant level of extreme nationalism is on the rise, and with nationalism follows populism.  The sharply rising gap in recent years between rich and poor has added further fuel to the rise in populism, and there are very uncomfortable similarities between the 1930s and now.  2007-09 were similar in nature to 1929-32, and the phase we are going through now is similar to 1935-39 (Exhibit 1).

Populism index  % of votes across key countries Population weighted (LHS) and DM financial crises (RHS)
Exhibit 1: Populism index
% of votes across key countries
Population weighted (LHS) and DM financial crises (RHS)
Source: Deutsche Bank Research

Extreme levels of populism can, at worst, lead to monsters like Adolf Hitler or, at best, to demagogues like Nigel Farage who, almost single-handedly, managed to turn the British against the EU on a swarm of lies. (Note: If you disagree with me (and I am sure some do), I suggest you read this link). One can only hope the British wake up one day.

In conclusion, I find it rather absurd that it was effectively the older generations that took us out of the EU – in many cases people who lost close family members or dear friends in the battle against Hitler.  How on earth those people could suddenly vote to leave a club that had brought peace and prosperity to the European continent is beyond me.  As they say, peace is priceless.  For everything else, there is Mastercard.

About the Author

Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.