Brexit and the rise of Populist Isolationism

Friends,

The second quarter of 2016 saw some stabilization in global equities after a very volatile Q1. But this calm was short-lived as the surprise results of the Brexit vote roiled markets in the last weeks of the quarter.

We do not believe the Brexit referendum in itself will have a significant impact on the global investment climate or opportunities for investors. Whether the UK remains within the EU, or exits and reaches an alternate trade agreement with the EU, is of marginal significance to investors, especially those outside of Europe. The initial impact is almost certainly restricted to the UK itself, which may see a political disintegration if Scotland dissolves the union with England and Wales. Peripheral EU countries with significant deficits/debt (Greece, Spain, Portugal, Italy) would see a further erosion in confidence as a large, economically vibrant member leaves the EU. The financial industry in the UK is bound to see some contraction if Britain exits. The large London-based banks employ tens of thousands of workers, many carrying European passports. If the pool of available recruits narrows, banks are likely to expand offices in other cities. Dublin, Frankfurt and Paris are obvious alternatives, Switzerland is another continental (though non-EU) option. An exit will also mean personal data that pertains to EU nationals can no longer be stored or retained in the UK. This will impact technology companies and data-centers, where, as a result, the UK will find its market in those industries contracting as well.

An exit would permit the UK to enter into trade agreements with third (non-EU) countries, including former colonies such as India, with far more freedom than it would enjoy within the EU. After a period of adjustment, we would expect the UK economy to resume whatever long-term trajectory it would otherwise have had given demographic trends. The costs of adjustment if Britain does exit will be extensive. Regulations will need to be re-written, border procedures modified, passports re-issued, and undoubtedly the political costs will be enormous. Bickering over the result is bound to continue for years and indeed decades. But these costs will not continue into perpetuity.

This is not to say Brexit is insignificant. From a political perspective, it is extremely significant. It is yet another important signal that the enormous economic, demographic, environmental and political changes of the past few decades have left large segments of many populations with a sense of discontent and loss. Since the collapse of the Soviet Union, we have seen enormous changes in rapid succession. Technology has disrupted many industries, expanded markets and brought new competitors to formerly isolated corners of the world. Online marketplaces allow distributors to reach virtually every person in an increasingly connected world with ubiquitous network access. It has also led to an increasing concentration of wealth in many parts of the world. Environmental and political upheavals have created a historically high number of refugees fleeing war or lack of opportunity. Urbanization is on the rise virtually everywhere with populations moving to cities in record numbers. Large cities across the world, and their surrounding areas, have become ever more diverse and globally inter-connected. Asia, with its enormous population, has historically been the center of global trade and economic activity. After almost two centuries of relative decline, Asian economies are seeing rapid, sustained growth.

Brexit reminds us that these changes are unwelcome to many. Rural areas across the world, industrial areas in the western world, those with nationalist sentiments, and older populations everywhere see an erosion of all that is familiar and comforting. Every crisis is seen as an indictment of an global elite forcing such changes on a reluctant population. In many ways these political forces are not new. They have always been with us and have simply gathered force as the impact of changes has risen. Every era of change and migration has encountered some degree of resistance; this includes prior periods of urbanization and industrialization across the world. Yet, even in the recent UK referendum, 48% of voters, and large majorities of younger voters, opted for remain.

The broader question for us as investors is whether or not political systems will be able to manage these changes peacefully and with as little disruption to daily activity as possible. Quite clearly, this is not the case in many parts of the world. Our view is that democracies have a better chance of managing such change peacefully. Yet, even in the US, the remarkable strength of an openly nativist and populist candidate such as Trump should serve as a warning. Enormous changes such as those we have seen over the past three decades have to be managed with care lest they alienate large portions of the population. That alienation, if allowed to fester, can create a window of opportunity for disruptive forces to attain power. This would pose a real risk to continued stability and the prosperity and well-being that accrue from it.

Quite apart from the significant political risks ahead, equities markets are at cyclically-high valuations. Bond prices too are at high valuations with interest rates at low levels. In our view, as value oriented investors, we see limited rewards for taking excess risk. Accordingly, we continue to advise clients to maintain a relatively conservative portfolio allocation, keeping in mind their long-term objectives and recommended allocation.

 

Regards,

 

Subir Grewal, CFA                                    Louis Berger