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Brexit. In? Out? Shake It All About.

22.02.16

The weekend’s news is not a major surprise, but does trigger some portfolio considerations. We have always known David Cameron would get a pretty weak deal, and that the referendum’s outcome would be hard to predict. I suppose Gove and Boris will be good spokesmen for Brexit and there are equally pugnacious ‘In’ proponents. The ideal solution to Cameron’s negotiation would have been for the other members to recognise existing flaws and agree to review the whole structure in the near future. Instead, reactions were defensive and unproductive. A reformed EU would be by far the best outcome but has been denied us.

If we vote to stay, there will be little change.

Could Brexit be a bad choice? Making our own laws again cannot hurt. The economic impact could even be quite positive for Britain. For example, many of the important rules we have to comply with are not from Brussels but from international trade bodies, to which Brussels also bends the knee. It is obvious we would negotiate the UK’s part in world trade deals better independently than as a minority on an EU team driven at best by Germany and France’s interests, at worst by a conflicted bureaucracy.

In many respects the UK is in a great position. We now have a deal that is better (well, a bit better) than our previous lot, and have the chance of doubling up with a full exit. Far from Brexit being a problem for Britain, it is more likely to be a headache for Europe. Brexit shines a vivid light on the EU’s many weaknesses and failings. In addition, our departure may cause the EU to raise the drawbridge, becoming even more inward-looking. It might just also encourage other members to demand their own changes, leading to more disunity and departures. The one thing that should happen, modernising reform, is extremely unlikely.

Just as it is difficult to predict the outcome of the referendum at all at this stage, it is impossible to predict the shape of things afterwards if we leave. With the right policies independence could be a great benefit. With the wrong ones, disaster.

One thing is definite. Markets dislike uncertainty, and if the odds of Brexit rise investors may shift further into bonds and Gold. There has been some immediate Sterling weakness.

As far as our portfolios go, they are already in quite a defensive position. We moved significantly into cash and bonds across portfolio strategies in December and January thanks to the threat of a US Fed Funds rate rise on heavily leveraged Emerging Market Dollar exposures, and the jury is still out on that point. A deflationary China collapse and EU banking crisis would be painful and have to be taken into account as possibilities but are not our base case. Markets and the ‘real’ economy interlock in a mutual embrace, so a fall or rise in one has an effect on the other, but so far it looks as if growth in the US is bearing up and China is containing instabilities. The worst short term Brexit risk would be a ruction in Europe, but whether we stay or go the EU is doing little to help itself anyway.

Two small moves make sense in these conditions. US Treasuries are a good place to park in times of stress, as are UK Gilts. If Sterling weakens further, and if Brexit is spun as ending an era of cheap labour then inflation prospects could rise. A small shift to US Treasuries and Index Linked bonds is in order within the bond allocation. Small, because this is only a possibility. Our views on the impact of Brexit on Europe’s credibility also suggest a small reduction in European equities, back into a US market that is bearing up well given the extremes of bearish sentiment.

But does Brexit speculation really imply a shift away from risk? As investors we see Brexit itself being immediately less important than Chinese debt, although it reflects larger problems in Europe itself. Eight years after the Crash there is still plenty wrong with the system, but it is worth remembering that investors have been among the few beneficiaries of the authorities’ response. Equity returns tend to be good in times of worry.

Giles Rowe
CEO & CIO