Following the result of the UK referendum on EU membership, two of our senior portfolio managers, Simon Down and Holger Mertens update their previous pieces published in March and June:
Brexit: In or Out? The Final Run In. - 15 June, 2016
Scones or Croissants? Brexit: The Route to Exit and Key Risks - 24 March, 2016
David Cameron announced his resignation on the morning of the 24th, but stated that he would remain Prime Minister until the Conservative Party chose a new leader, with the aim of having this accomplished before the October party conference. Critically, he stated that he will not enact Article 50 of the Lisbon Treaty, but would allow the new Prime Minster to handle negotiations with the EU and the decisions on how to proceed.
An important point that needs to be stressed at this stage is that the process of Exit will develop over a period of years rather than months and will be a potential stress point for a lengthy period. During this period, market sentiment will likely have moments of complacency and bouts of overreaction, depending on various unfolding events and the rhetoric of the various parties.
Cameron's resignation will delay the initial stages, as the Conservative party leadership contest will last until September. The realisation that this is a medium term event rather than one with immediate consequences is likely behind the relief rally in markets in recent days. Looking forward, it is critical to be aware of potential flash points and take this into account when making medium-term investment decisions. If there is no early general election, then the Conservatives will not want the EU to be an issue at the 2020 election, so the party will want everything clearly in place before that date.
Source: Nikko Asset Management
The first stage will be the leadership campaign for the Conservative party in September. Once the leader is chosen, there will be more clarity on how the country will move forward. An early General Election is somewhat possible after this if the new leader decides that they want to obtain a public mandate for their leadership. It is important to understand, though, that the Conservatives would only do this if they were very confident that they would win. The UK's fixed term parliament system means that in order to call an election before 2020, they would need to obtain a two thirds majority in parliament to agree to an early election. Although they should have no problems obtaining this, it would further drag out events as it will take time to put this to parliament.
The Leadership Contest
Source: Nikko Asset Management
Although there are multiple candidates for the leadership, with Boris Johnson pulling out of the race, the favourites are now Michael Gove and Theresa May. Assuming no election, the new Prime Minister will have to make the decision on when and if they trigger Article 50 of the Lisbon Treaty. The EU will be putting pressure for this to be triggered quickly after the leadership race is complete, but the UK will likely push for more time. The window for this to be triggered is, thus, likely between the final months of 2016 and Q1 2017. Although Theresa May was on the Remain side, she was always seen as a Eurosceptic and is committed to Brexit. As such, it is unlikely that either candidate would take a particularly different approach to negotiations.
The Pathway to Negotiations
Global financial markets are feeling the aftershock of the outcome of the British EU referendum, but Europe's leaders are moving on, accepting the result and preparing for the exit negotiations with the UK.
At the centre stage of the European crisis management is Germany's pragmatic Chancellor Angela Merkel. On Monday the 27th, she hosted a meeting with Italy's Prime Minister Matteo Renzi, European Council President Donald Tusk and French President Francois Hollande to define the strategy for this week's EU summit, in which the British Prime Minister explained the results of the EU referendum outcome to the EU's heads of states. The leaders of France, Germany and Italy promised to define new priorities for the EU by September in order to discourage eurosceptic views and keep the union together. The focus for the new initiatives will be on economic growth and security.
With the regards the UK, Merkel said that she wouldn't pursue a punitive line in exit talks. She understands that the UK wants to consider things for a while, but stresses that the union cannot wait a long time before the UK invokes Article 50, which sets out a two-year timetable for an exit. Moreover, it became clear over recent days that the EU refuses to hold any talks with the UK before Article 50 is triggered. In addition, Merkel highlighted that no cherry picking will be possible with regards to rights and obligation of an EU membership. She said that the deal for a country outside the EU family cannot be better than inside.
Before the British referendum, Wolfgang Schäuble, the German finance minister, finished a secret eight-page paper outlining the German position after a Brexit vote. The paper leaked into the press over the last few days and is likely to be a good guide to what the EU position will be in upcoming negotiations. It covers how the UK will leave the European Investment Bank (EIB), how entitlements and liabilities in the EU budget will be settled and what the future trade relationship between the UK and the EU will be. Germany aims for an association agreement. The latter clarifies trading rules and other regulations between the EU and a non-E.U. country, such as import tariffs for certain goods or services. Importantly, the agreement should be structured to deter other countries from leaving the EU.
EU Commission President Jean-Claude Juncker has banned EU commissioners from holding any informal talks with the UK on trade or other matters related to exit until Article 50 has been triggered. Once talks are triggered though, it is likely that both sides will take a pragmatic approach. Free movement of labour is a key issue and was previously a red line for the EU. In the UK, this was one of the defining drivers of the exit vote and the government will have very limited ability to compromise on such without some pathway to limit migration.
French President Francois Hollande has already stated that free movement is a key pillar of the EU and that there should be no change to it, but has been contradicted by French Finance Minister Michel Sapin, who has stated that there will be ‘no red lines'. This sentiment was immediately backed by Finland's Deputy PM. The refugee crisis seems to have weakened resolve on this issue in Europe, so some flexibility could develop.
EU Refugee Crisis: European Weak Points and Outlook - 20 May, 2016
Overall, it seems that the EU is determined to start and finalize the discussion with the UK quickly and would rather focus on the future of the union. Emphasis is currently not on trade relationships with the UK, rather on defining a strategy to keep the union together and not see more countries leaving.
But even as the EU focus might have moved on, stakes in the negotiation remain high, as the UK is an important market for the EU. For instance, 7.5% of all German exports last year went to the UK. On one hand, this might give the UK some strength during the negotiation process, but on the other hand, Germany accepted the fact that exports to Russia plunged due to EU sanctions against the country, so the political agenda might overrule the economic agenda once again.
Financial services is a sector that the EU is likely to hold firm on, and it seems highly likely that London will lose its role as the centre of Euro denominated clearing, which has long been a target for countries such as Germany and France. Other areas, however, could see easier compromises. The auto sector is common ground, with the UK being a major auto manufacturer, supplying engines for European cars and in turn being one of the largest importers of European cars. It is also one of the sectors that incur the highest tariffs, 10% vs. 3-5% for most other goods imported from outside the EU. One question is whether the UK and EU could strike a quick deal in this sector to minimise the economic impact for both sides. Finally, for non-auto trade, it is possible that negotiations could take a considerable time, with some forecasting 8-10 years before a deal is struck.
Source: Nikko Asset Management
The financial industry represents more than 20% of UK GDP and relies on its access to the EU single market. Given recent events, it is unlikely that banks and asset managers will wait until the negotiation between the EU and the UK have been concluded. Indeed, it is easy for this industry to relocate some workers to the EU. JP Morgan's Jamie Dimon, as well as Michael Bloomberg, threatened to cut or relocate part of its UK workforce after a Brexit vote. Furthermore, in the run-up to the referendum, some European cities already started to pitch themselves as alternative financials hubs to London.
In 2014, car imports in the UK from the EU accounted for more than GBP 30bn, while auto exports accounted for more than USD 10bn (see chart below). In particular, the German car industry relies heavily on exports to the UK. Beside China and the US, the UK is the third biggest export market for the German automotive industry, with larger profit margins than in other European markets. Meanwhile, some regions in the UK rely particularly heavily on automotive exports. Nissan's plant in Sunderland employs more than 6.700 people and produces 476,589 cars with 55% exported to the UK, but surprisingly, 61% of voters in Sunderland voted for leaving the EU.
Differing regulations in the EU vs. the UK, as well as trade tariffs, might drive up the costs of cross border business, but a weakening Pound might help British based manufacturers increase their competitiveness. For German manufacturers, the struggling British currency might become a problem, so either they will increase the selling price in the UK or accept lower margins. Moreover, if the UK enters a recession, the affluent customers of German premium cars might delay purchases of new cars. However, lower sales numbers won't arrive overnight and there will be time for the industry to adjust.
According to Ferdinand Dudenhöffer, from Universität Duisburg-Essen this will not be “the end of the world,” noting that China sells 20m cars per year, while the UK only sells 2m. For most car manufactures, Asian markets are far more important, in terms of revenues as well as profits, than Europe; but, direct investments into the UK by car manufacturers seem unlikely over the coming years, given the uncertainties regarding its trade relationships with the EU.
Imports / Exports UK Auto Sector (£bn)
Source: Office for National Statistics, UK
The main types of EU agreements are outlined below. The Exit campaign in the UK clearly focused on obtaining a deal similar to Canada, which only regards trade. Sweden is the closest to the existing UK position. Eventually the UK is likely to have its own individual ranking on this scale, but the question is how close to the Canada model can the UK achieve without severely damaging growth in both areas.
|Switzerland||Trade Agreement / Free Movement of Labour|
|Sweden||EU member, Independent Currency|
|Denmark||EU member, Pegged Currency|
|Eurozone||Full EU Plus Euro Membership|
European Political Fallout
Denmark: The far right Danish People's Party (DPP) declared that the UK referendum was a ‘stinging slap' to the EU and declared that it wants a referendum in Denmark. It didn't go so far as to call for a referendum on membership, but on a renegotiation of terms. This was immediately dismissed by Prime Minister Lars Rasmussen. With elections not until 2019, pressure should be limited for now.
Sweden: The Swedish Democrats have called for a renegotiation of Sweden's relationship with the EU followed by a referendum on EU membership. The party is currently polling at over 20% but recorded only 12.9% of the vote in the 2014 election, so with new elections not until 2018 and Sweden already significantly tightening its policy on asylum seekers, it is expected to lose support in coming years.
The Netherlands gained much discussion in the UK referendum as the Euro-area country most likely to follow a UK vote. Geert Wilders, the leader of the far right Freedom Party, stated that he will include a referendum in their party manifesto at the elections in March 2017. Although current polling would suggest that the Freedom Party could gain the largest number of seats, it is very unlikely to form a government as other parties will form a coalition to block it. Dutch elections could, thus, be a market focus, but are unlikely to result in an actual referendum.
Italy: Anti-immigration parties are gaining support in Italy and there have been calls from the Northern League for a referendum on EU membership, but support for the Euro remains extremely high, at above 60%, so is unlikely to gain any traction.
France: The Front National has declared that the UK referendum marks the ‘beginning of a movement that can't be stopped' and that France will hold a referendum if they win the Presidential elections in 2017. Although it is highly likely that their leader Marine Le Pen will reach the second round of the Presidential elections, the chances of her winning the Presidency are remote as she will not win the support of 50% of the electorate.
Markets were strangely complacent going into the referendum, lulled into a false sense of security by betting odds that suggested a very low risk of exit. After the vote, there has been a rush to carry out research on the topic, which should have been carried out many months ago, and a panic developed that a crisis was imminent. The reality, though, is likely to be very different, with a long drawn out process that will remain unclear for many months and is unlikely to be finalised for years.
For now, claims that the UK result will spark a series of such events across Europe look overstated. For investors, it is important to recognise that the UK vote is very real and the UK is likely to exit the EU in some form. Stories suggesting that Parliament will not approve Article 50 or that there will be a second referendum that will negate the vote are likely inaccurate, in our view, but not impossible especially if time wears on.
Regardless, it is important to recognise that this will be a story that will now shift in importance over the coming months and years. At times, it will likely become a stress point for markets, as brinksmanship on negotiations creates hard-line rhetoric. At other times, negotiations will likely be quiet and markets will calm. UK growth will almost certainly be negatively impacted and there is a risk of a mild recession in the coming quarters as investment plans are put on hold, but the UK economy is not fragile and has seen significant employment gains in recent years, so it should weather the storm without recessionary implications for the global economy.
In the Eurozone, we expect a loss of consumer and corporate confidence related to Brexit to impact economic growth, but for it to remain in positive territory (albeit marginally) despite these headwinds in the coming quarters.