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ARP Observations

The Empire Strikes Back(wards) – Now what?

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See all articlesThe Absolute Return Letter

So, what could or is likely to happen next? The following five points are certainly not a given, but neither are they just plain speculation. Each and every one of them have a reasonably good chance of materialising.

1. Brexit may never happen.

This rather controversial prediction is based on modern day constitutional law and how democratic regimes all over the Western World work. Whether you look at the UK or any other modern day democracy, it is obvious that there are significant checks and balances in place to ensure that any action undertaken by the government is not based purely on majoritarian views, but on the views of the representatives of those people, and what those representatives consider the best outcome for the nation. (Thank you to Ecstrat for pointing this out.)

Modern day democracies were set up this way to protect minorities – to avoid a ‘bullying’ majority forcing through legislation deemed inappropriate for the nation. The British parliament is heavily skewed towards Remain, with 479 MPs polling for Remain versus 158 for Leave. That leaves the government in a bit of a pickle but, at the same time, with enough ballast to look for a way out.

Given the political turmoil in recent days – Boris Johnson dropping out of the race to become the next Prime Minister after sustaining some pretty serious back-stabbing conducted by a Machiavellian Michael Gove – it is probably fair to say that anything can now happen; however, as things stand at this moment, Theresa May is emerging as the favourite to become the next Prime Minister of the UK.

This is relevant as far is Brexit is concerned, as she is a Remainer. Should she win, the government under her leadership will probably bend over backwards in their frantic search for a solution to the Brexit crisis. What that solution is remains to be seen but the more ‘uncooperative’ financial markets turn out to be in the weeks and months to come, the more likely other European leaders are to swallow some pride and work out a compromise solution.

  • Probability of Brexit never happening with Theresa May at the helm: 30-40%.
  • Probability of Brexit never happening with a Leaver at the helm: 10-20%.

2. Assuming we proceed with Brexit, a second independence referendum in Scotland goes ahead – and possibly one in Northern Ireland as well.

Scotland voted overwhelmingly in favour of staying in the EU – 62% to 38%. Not even in the pro-EU capital of the country was there a bigger majority. There is little doubt in my mind that, should the UK actually exit the EU, a second Scottish independence referendum is an inevitability, and the result of the 2014 referendum, which was a relatively slim 55% majority in favour of remaining part of the United Kingdom, could very well be overturned. The fact that Scotland will have to go through the entire application process again is not likely to act as a deterrent, such is the appetite for EU membership north of the border.

Northern Ireland is in a slightly different position. The demand for independence in that part of the country is almost non-existent, but a growing number of people want the two Irelands to be re-united, and an EU exit would most likely have the effect of pushing more people in that direction.

The reality facing the political establishment in the UK is therefore a total meltdown of the United Kingdom, or, to give it its full name, the United Kingdom of Great Britain and Northern Ireland, to give its full name, should Brexit happen. This will only encourage our political leaders to be even more creative in their search for a compromise solution.

  • Probability of a second Scottish referendum: 80-90%.
  • Probability of Scotland leaving the Union: > 50%.
  • Probability of a referendum on Irish re-unification: 20-30%.
  • Probability of Northern Ireland leaving the Union: 10-20%.

3. Brexit leads to an avalanche of referenda in other European countries.

Should Brexit actually happen, Leavers all over Europe (and there a many of them) will demand a referendum in their country as well. Coming from Denmark, I follow the political debate in that country particularly closely, and there is no doubt in my mind that a British exit will be akin to pouring petrol on the fire of a very emotional Danish debate.

Geert Wilders, the leader of the far-right Dutch Freedom Party, has promised to put a possible Dutch referendum on the agenda in the general elections next March, should he win. One shouldn’t take such a promise lightly, as the Freedom Party holds a substantial lead in the opinion polls at present. In other words, the Netherlands could possibly be next to exit.

In France, hailing the Brexit vote as the beginning of a “movement that can’t be stopped”, Marine Le Pen, leader of the Front National, has suggested that France could follow suit. She has said that, if she wins the French presidential election next April, she will hold an in/out referendum on the country’s membership of the EU within six months. Having said that, opinion polls don’t fancy her chances of becoming the next French president. I do not agree with Le Pen on many issues, but I would have to agree that Britain has started an avalanche that may be difficult to stop.

  • Probability of another EU country holding a referendum within two years: 70-80%
  • Probability of another EU country deciding to leave within two years: 20-30% 

4. Whether Brexit actually materialises or not, the outcome of the UK referendum leads to a significant slowdown in economic activity all over Europe; consequently, policy rates stay put for the time being.

Leavers in the UK live in a dream world; such is the conviction that Brexit will lead to an acceleration of economic growth. Little do these people (appear to) understand that the UK is already very competitive when compared to most other countries around the world.

Consequently, longer term, Brexit is likely to have little or no (positive) effect on GDP growth. As far as the rest of Europe is concerned, longer term, the effect of Brexit will also be relatively modest. The truth is that the UK economy simply isn’t big enough to really matter.

In the short term, all of Europe (the UK included), is likely to be negatively impacted by Brexit. I have spoken to a handful of company owners around Europe after the UK referendum, and they all told me the same story. Until we have more clarity, all new investments have been frozen. If that view is representative, it doesn’t take an Einstein to figure out what could happen to GDP in the second half of 2016.

The risk to GDP growth short-term has pretty much eliminated any risk of rate hikes anywhere in Europe, at least for the remainder of this year. It was already very low in the Eurozone but growing steadily in the UK.  Meanwhile, in the U.S., a slowdown in Europe is likely to have at least some effect on the Fed’s actions.

  • Probability of a UK recession in the second half of 2016: 60-70%
  • Probability of a Eurozone recession in the second half of 2016: 40-50%
  • Probability of the Bank of England staying put in the second half of 2016: > 90%
  • Probability of the ECB staying put in the second half of 2016  > 95%
  • Probability of the Federal Reserve Bank staying put in the second half of 2016: 30-40%

5. Social and political instability in the UK to rise, as people get more and more disappointed that Brexit doesn’t deliver ‘better times’ as promised by the Leave campaign.

Not only is Brexit unlikely to lead to any increase in economic growth but, in the years to come, and for reasons entirely unrelated to Brexit, economic growth in the UK is likely to remain quite subdued, at least when compared to the growth we have enjoyed in the last 30-35 years. 

In other words, whether Brexit actually happens or not, because slow economic growth is pretty much set in stone for many years to come, one side is more than likely to blame the other. If we leave the EU, and hospitals in the UK are constrained from recruiting abroad, NHS services will almost certainly deteriorate, which is likely to create social unrest.

Alternatively, if we stay in the EU, the NHS will continue to recruit abroad, as the British labour market cannot deliver sufficient hospital staff with adequate training and knowledge.  As GDP growth doesn’t pick up, as the Leave-supporters were told it would, the government will come under fire, the NHS will be heavily criticized for its recruitment policy by an ignorant public, and social conditions will become more unsettled.

Corporate profits under pressure

As we all know, when corporate profits come under pressure, jobs are lost. Global earnings growth is now the lowest it has been since the great bull market took off in the early 1980s (chart below). The obvious implication is that unemployment will rise. As more people lose their job, social unrest can only increase and, in the UK, one side of the Brexit campaign will blame the other.

Global earnings growth (10-year rolling)
Global earnings growth (10-year rolling)
Source: Goldman Sachs Global Investment Research, Datastream, June 2016‍
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.