Referendum Déjà Vu

26 February 2016

After the sharp recovery bounce, stock markets consolidated somewhat as we had anticipated last week, before a rebounding oil price and falling £-Sterling on Brexit fears provided new fuel for another leg up. The market moving developments were, therefore, the oil price (yet again) on the international level and, from a more UK specific perspective, a rapidly weakening £-Sterling. Before turning to discuss the latest implications of the UK’s looming EU exit referendum, it is worth touching on the topics that were perhaps more important from a Global perspective. One such topic was that leading macro-economic indicators recorded a noticeable deceleration last week as a number of European and US purchasing manager indices (PMI) recorded lower readings. However, stronger European bank lending, US durable goods orders and lower jobless claims all suggested that Western economies have thus far continued on their expansion paths. PMIs are usually watched very closely because of their forward looking character, while most general macro stats provide a view back to what happened in the past (lagging indicators). Sometimes, however, the survey based PMIs can be influenced more strongly by short term fluctuations in general sentiment, and business sentiment would have been markedly influenced by recent negative press from the Jan/Feb stock market correction. It is therefore probably too early to conclude that we are starting to observe a slow down of the real economic that the markets began to anticipate since early January. At this point, it is quite possible that the PMI readings are exaggerated and have themselves become somewhat lagging (the capital market sentiment) rather than leading (business outlook). Interestingly, we also noted, over the past week, a topic taking hold of the market media which we have covered in past editions of Tatton’s Weekly. This is, namely, whether the time has come where fiscal policy (public investment initiatives) has to complement monetary policy (low interest rates and QE) in order to get the Global economic development back to its potential growth rate – rather than the current slow growth due to underinvestment and lack of consumer spending. Further down, we devote a whole article to this broader discussion which looks at the different options available to overcome the current lack of economic dynamism – where too much is saved and not enough invested for future growth, despite cost of capital for large borrowers being near negligible, even for terms of up to 10 years (German yields for 10 year Bunds are once again below 0.2%; UK 1.4%). Public sector austerity is all fine and well to structurally reduce the Government share of the total economy, as it is accepted wisdom that the private sector tends to turn available resources into more and better goods than public services. However, if the private sector is, for whatever reason, unwilling to employ the available resources (E.g. capital), then it maybe indeed advisable for the public sector to take up some of the slack and use the cheap capital to invest into the increased provision of public goods – goods which have the propensity to provide a long term return for the economy as a whole. Infrastructure investments and education and training for the workforce are good examples of this. The almost pedantic focus on debt to GDP levels and fear of debt markets turning against Government borrowing (Ireland, Greece, Portugal) overlooks the fact that debt markets do make a crucial distinction between public debt increasing to fund general handouts and investments which create additional growth potential in the future. Should economic growth not pick up in the next months, then we expect public austerity strategies to be reviewed and it is quite likely that public investment (aka fiscal stimulus) will once again be allowed to complement monetary stimulus to form a more effective two-pronged economic policy. It was interesting to hear the Chinese finance minister and his deputy last week state as much during a conference in Hong Kong. Returning to the UK, the date setting for the EU membership referendum for 23 June was clearly what focused the British public’s interest most last week and even more so private investors. Just as was with the 2014 Scottish referendum, my best advice is ‘Keep calm and carry on’ – hence my Referendum Déjà vu heading this week. We have written a few times already in these pages about the economic angle of the UK’s EU membership and, for the moment, I just suggest everybody do a quick mental comparison between UK economic growth dynamics before and after joining the EU – we believe it is very hard to argue that the UK’s overtaking Germany and France’s rate of growth was entirely because of superior economic stewardship by successive UK governments. Would it really be worth risking to find out, in return for a marginal increase in self-determination? We totally agree that a lot of quite annoying regulatory initiatives these days seemingly comes from Brussels, rather than Westminster. However, in return, UK businesses are now selling goods and services to a 500+ million consumer market rather than just 63 million in the UK. Furthermore UK citizens are free to settle for as long as they wish in Spain or France or anywhere else in the EU (tried non-EU Switzerland?). To my mind, Brexit would merely mean that very similar regulation would come from Westminster instead of Brussels, but still be a near carbon copy of the latest EU regulation – lest we risk having to pay far more for different spec goods and/or not trade our product and services with the EU. We wouldn’t, however, be able to influence their drafting very much anymore (have a look at Norway’s experience). Therefore, we believe it rational and sound to expect that UK businesses will throw a lot of funding at the ‘IN’ campaign to make clear what the risks and potential costs of an ‘OUT’ may be - as they understand the EU benefits and exit risks much better and first hand than the general public. It is then also reasonable to expect that, just like with the Scottish vote, the UK is likely to vote to remain in the EU. This is also what the bookie’s odd once again suggest. However, even if, against all odds, Brexit becomes reality, then the longer term outcome is hardly going to be as dramatic as this week’s cartoon at the top suggests – geographically the UK will remain where it is! Just like with the Scottish referendum, we expect temporarily increased stock market volatility, but then this isn’t particularly different to the last 8 months. Investors should not lose their calm and mothball their investments in cash until we have certainty – markets have the unpleasant habit to move quickly and ahead of actual events.    Consequentially, a temporary flight to cash can quickly result in missing out on sizeable returns as markets quickly bounce back from losses – hence missing out on long term investment return opportunity, which is the whole point of long term investing. Over the shorter term, the increased uncertainty over Britain’s economic future has had an interesting and quite supportive side effect for Britain’s economy: The external value of £-Sterling against the €-Euro and the US$ has fallen by around 10% since last year, which provides both a welcome boost to the UK’s global trade competiveness as well as a hike in import prices, which acts as an effective countermeasure to the low rate of inflation which has recently been an issue everywhere in the Western world. Bank of England Governor Mark Carney is probably not unpleased about this, given the European and Japanese central banks have both had to resort to negative interest rates to achieve much less. We still very much doubt that Mr Carney will treat London’s mayor Boris Johnson (and the ‘OUT’ campaign’s most important new figure head) to dinner over this. Nevertheless, we think it shows how investors should refrain from jumping too quickly to conclusions about the potential short term consequences of political turns for investments.