The Weekly Update

It is virtually impossible not to comment on the UK’s decision to leave the EU, but before we do that, here is an interesting fact; even in our global portfolios we no longer have any exposure to countries within the EU, once the UK is excluded. This is due to the fact that many of the remaining 27 EU members are heavily indebted, and therefore automatically excluded. In the case of the wealthier countries, yields are trading at such a low level or indeed on negative yields, that they offer no value. Even without the current uncertainty, owning dollar bonds hedged into euros or sterling offers a greater return than holding local bonds although it is questionable whether one would want to own sterling even at these lower levels.

So, the British public have voted and Boris Johnson and Nigel Farage have now got their “independence day” but the UK is left divided as the vote was close with 52% voting to leave against 48% voting to remain. Within the UK, Brexit now raises the likelihood of Scotland calling another referendum as Scotland voted overwhelmingly to remain in Europe. The city of London, with a population of 8.7 million voters, also overwhelmingly voted to remain and social media campaigns are now calling for London to form its own city state and stay in the EU! David Cameron has announced his decision to step down in October and allow a new Prime Minister to negotiate Great Britain’s exit from the EU.

Financial markets have been wrong-footed by the result and the reaction has been negative: sterling has traded off heavily against the US dollar and traded at its weakest level since 1985, breaking the 1.32 level earlier today. With equity markets under pressure, unsurprisingly, safe haven assets have rallied with 10-year US Treasuries below 1.50 and the yen on the strong side of 102 as we type.

The UK Treasury had forecast in the event of an ‘Out’ vote that by 2030 GDP would be negatively impacted by 3.5-9.5 percent depending on the type of trading relationship the UK ends up with the EU. For the rating agencies Brexit is credit negative: S&P has warned that the UK risks losing its AAA credit rating and for Moody’s (which rates the UK Aa1) this will “weigh on the UK’s economic and financial performance”.

Just ahead of the referendum the European Commission President Jean-Claude Juncker made the EU’s position on renegotiation clear stating “We have concluded a deal with the Prime Minister. He got the maximum he could receive, and we gave the maximum we could give. So there will be no kind of renegotiation.” Thus, the UK Parliament will need to pass the decision to leave into law before it can be enacted upon but interestingly the majority of parliamentary members declared in the “remain” camp. When this gets passed, and dependent on any decision to hold an early election, then the UK would have to invoke Article 50 of the Lisbon Treaty to formally start the process to leave the EU.

Clearly, there is a debate starting about whether the UK should call an early election once a new Prime Minister is in place so that all parties can map out their vision in the post Brexit era. Under the current law the parliament runs for five year fixed terms but with two possible exceptions. First, if a no-confidence vote in government is passed by a majority of the Parliament and a new government cannot be formed within fourteen days. Second, is if two-thirds of the House of Commons back a motion for an early general election.

Brexit has wider implications for the rest of Europe where the anti-establishment and anti-austerity movements are gaining popularity. Aside from the more obvious examples of Greece and Portugal, in Italy the anti-establishment Five Star movement has been gaining ground (winning 19 out of 20 mayoral elections last weekend) and the party leader Beppe Grillo has called for a referendum on the EU. Polls in the Netherlands also show the majority of voters want a referendum on EU membership; today Geert Wilders called for a referendum on the issue after the Brexit result if he is elected Prime Minister in the March election. In France Marine Le Pen is calling for France to have its own referendum and in Germany the Far Right parties have been gaining ground.

Although a negative in the short run, the decline in sterling may be a blessing in the longer term. The UK has a current account deficit of ~7% of GDP (Q4’15) and based on calculations we made earlier this year, our current projections suggested that the UK would become a 2-star rated country by 2020, along with the United States. However, this was based on a much higher exchange rate and so the decline in sterling will certainly push that date out into the future. In the meantime though, it is hard to see the UK situation doing anything other than drag down global growth from an already weak position. As a consequence, long dated high grade bonds, outside of the EU at least, look to offer the best value in such an uncertain world.