As portfolio managers trying to make money in a world of economic uncertainty, we are constantly scanning the horizon for the biggest issues that can sway or shock global markets. When the Brexit referendum passed in 2016, it certainly shocked the market, sending haven assets such as US Treasurys into rally mode.
Brexit, a portmanteau of the words “Britain” and “exit,” is the name given to the United Kingdom's decision to remove itself from the European Union (EU) trade bloc. When the British voted to leave the EU in June 2016, the shock of the result sent financial markets around the world into a panic. Within a week of the vote, the 10-year US Treasury's yield hit its all-time low of 1.35%. Such shocks to the system tend to drive risk-off sentiment.
Britain sends the majority of its exports to the EU, which also provide the biggest source of foreign investment. Britain's membership in the EU has helped solidify its standing as a global financial center. The British government itself forecasts the country's economy will be 4 percent to 9 percent smaller 15 years after the split.
The problem with the referendum was that it asked the British if they wanted to leave, but never presented a feasible plan on how to accomplish it. In addition, the EU is required to sign off on the plan.
Which brings us to the present, after a series fits and starts, the British government is no closer to leaving the EU than it was three years ago. The original departure date was in March, but that had been postponed numerous times to October 31. Prime Minister Boris Johnson offered a plan in October, but it didn't receive approval from either Parliament or the EU. As the government has no deal with the EU, talk of a no-deal Brexit was pushed by Johnson. Many economists and corporate leaders fear this will cause irreparable damage to the British economy. When Johnson couldn't push the exit through in October, the EU extended the deadline to Jan. 31, 2020. Seeking to consolidate power in Parliament and rally the same pro-Brexit forces that passed the referendum, Johnson called for a new election on Dec. 12 to get the deal he offered last month approved.
There are three possibilities from the upcoming British election. Johnson's Conservative Party wins a majority of seats in Parliament, which would support following through on the Brexit plan he floated last month. The opposition Labor Party wins a majority and they put Brexit up for a second public referendum with a goal to scrap the whole idea. Or neither party wins a majority and we get more of the same situation that we've seen for the last three years.
At Aware Asset Management, with respect to the election and Brexit in general, we don't expect to see a repeat of the same degree of panic that occurred after the 2016 vote or a massive shift to safe havens. We think that the upheaval of Brexit is baked into the market, so we think it's a mistake to load up on Treasurys. The markets have unwound the reaction to the initial shock and had time to adjust to living in an ambiguous world. In our view, it's more of a risk-on environment now. Thus, we are positioning ourselves with the assumption that Brexit will have less impact on corporate credit than domestic factors such as earnings performance, trade, and interest rates.
Brexit is a mess, and as Moody’s observed, “Heightened domestic and geopolitical friction undermines policy predictability and effectiveness and, with it, institutional strength – particularly as growth slows.”1 Still, even with the Brexit mess and inevitable damage to the UK economy, the UK remains one of the best regulated, best governed, least corrupt, and law-abiding nations.2
Currently, Aware owns bonds from several UK-based global banks and these bonds have performed well throughout 2019, at least in part due to their global footprints and the strong regulatory environment in which they operate. In our view, the trade war, interest rates, and the extent these US-centric factors harm corporations’ ability to grow their businesses, remain profitable, and allocate capital. We are not managing towards recession, but instead investing by paying close attention to continuing slow growth; a good, but not great, economy in the US; and a weaker Europe.
Protests and riots in Hong Kong and Santiago, Chile, make us wonder how and where else populist anger of the type that drove the Brexit vote may crop up next. It would be naïve to think a combination of geopolitical events couldn’t shock markets the way Brexit did in 2016. Because of that, we are carefully watching what is happening in Chile and Hong Kong. And that's when active management, portfolio liquidity and diversification will prove indispensable.
1 Source: Sovereigns - 2020 outlook is negative as unpredictable, disruptive political environment exacerbates credit challenges
2 Source: https://info.worldbank.org/governance/wgi/. - My analysis of data set puts UK in the top tier, 15%, of countries on the metrics used by the world bank to rank country’s governance