Ev­ery­thing just changed

Financial Mirror (Cyprus) - - FRONT PAGE -

Whether the pound or other as­sets will en­joy some kind of tech­ni­cal re­bound or plunge fur­ther, and the longer term im­pact on fi­nan­cial mar­kets and the world econ­omy, will de­pend on a host of po­lit­i­cal de­vel­op­ments in Bri­tain, the rest of Europe and other coun­tries. By def­i­ni­tion, these po­lit­i­cal events will be as un­pre­dictable as the ref­er­en­dum it­self. Rather than try­ing to base a strate­gic re­sponse to this earth­quake on purely spec­u­la­tive as­sump­tions about Bri­tish or Euro­pean pol­i­tics, trade ne­go­ti­a­tions or mon­e­tary pol­icy, this is a time to be­have tac­ti­cally. As in the im­me­di­ate af­ter­math of the Lehman bust, the pri­or­ity must be to pro­tect po­si­tions, raise cash and re­tain op­tion­al­ity to re­spond to what­ever op­por­tu­ni­ties or dis­as­ters may emerge in the com­ing weeks and months.

After main­tain­ing ever since 2009 that eco­nomic fun­da­men­tals around the world were grad­u­ally im­prov­ing and there­fore that more risk-on po­si­tion­ing was jus­ti­fied, I have been ar­gu­ing for the past two months that 2016 was turn­ing into a year when pol­i­tics, rather than eco­nomic data or cor­po­rate re­sults, would set the course for fi­nan­cial mar­kets. This be­came ob­vi­ous in the past few weeks as mar­kets around the world started to fol­low the gy­ra­tions of Bri­tish opin­ion polls. What never se­ri­ously oc­curred to me was that the pop­ulist re­volt was in re­al­ity even big­ger than the opin­ion polls sug­gested and would ac­quire enough mo­men­tum to over­throw the en­tire po­lit­i­cal struc­ture of the world’s most sta­ble and gen­er­ally mod­er­ate democ­racy. For bet­ter or worse, that is what hap­pened last week — and as a re­sult all the as­sump­tions be­hind the risk-on the­sis must, at the very least, be tem­po­rar­ily sus­pended, and pos­si­bly turned up­side down.

What this means in prac­tice is that Charles Gave’s long­stand­ing ex­pec­ta­tion of an Ur­sus Mag­nus bear mar­ket must now be con­sid­ered the most likely sce­nario, at least for the months ahead. There are four rea­sons to jump straight to this dis­mal con­clu­sion, even if many of my pre­vi­ously bullish eco­nomic and fi­nan­cial ar­gu­ments were valid be­fore Thurs­day night’s Brexit vote.

First, the UK is a sig­nif­i­cant part of the global econ­omy and the prospects for trade, in­vest­ment, as­set prices and bank­ing sta­bil­ity in Bri­tain will be gravely dam­aged — at least for the next few months — by the un­prece­dented pol­icy un­cer­tainty that be­gins this morn­ing. While Bri­tain’s share of global GDP may only be 2.5% to 4% (de­pend­ing on mar­ket or pur­chas­ing power par­ity ex­change rates) its weight in global fi­nance is much greater. More im­por­tantly, as we learned from the sub-prime cri­sis, and again from Greece and Ire­land, se­ri­ous dis­rup­tions in a small part of the global econ­omy can be mag­ni­fied many times over by global in­ter­con­nec­tions — and this am­pli­fi­ca­tion process is much more pow­er­ful and much faster when it works through fi­nan­cial mar­kets and in­vestor ex­pec­ta­tions, and not just through the in­ter­con­nec­tions in trade and man­u­fac­tur­ing that dom­i­nate con­ven­tional eco­nomic mod­els. Given Bri­tain’s very large cur­rent ac­count deficit and the ex­po­sure of the Bri­tish bank­ing sys­tem to prop­erty val­ues, the po­ten­tial for a fi­nan­cial cri­sis and then con­ta­gion to the rest of the Europe is a clear and present dan­ger.

Sec­ondly, the po­lit­i­cal im­pact of Bri­tish with­drawal on other EU coun­tries is po­ten­tially huge, but also to­tally un­pre­dictable. Whether this will mean a tight­en­ing or a loos­en­ing of ties among the other EU coun­tries or even per­haps the to­tal breakup of the EU or the eu­ro­zone, will emerge only grad­u­ally in the months ahead. But what can be said for cer­tain is that the cred­i­bil­ity of the EU and the Euro­pean Cen­tral Bank’s ef­forts to pre­vent an­other out­break of the euro cri­sis and to keep Spain, Greece and Italy within the euro will be se­verely tested and ques­tioned by the mar­kets — and, even more im­por­tantly, by the cit­i­zens of all these coun­tries.

Thirdly, the Brexit vote will surely en­cour­age sim­i­lar po­lit­i­cal up­heavals in other coun­tries. In the rest of Europe, di­rect im­i­ta­tion is highly probable. In the US, the con­nec­tion will be sub­tler, but pow­er­ful, none­the­less. Although US vot­ers will not be in­spired to sup­port Don­ald Trump by the Bri­tish ex­am­ple, fi­nan­cial mar­kets and po­lit­i­cal pun­dits will be forced to take the Trump phe­nom­e­non much more se­ri­ously be­cause ex­pert opin­ion and pre­dic­tion mar­kets turned out to be so mis­guided in the Bri­tish ref­er­en­dum re­sult. That means that Trump will ac­quire greater cred­i­bil­ity and fi­nan­cial sup­port — and it also in­creases the risk that po­lit­i­cal un­cer­tainty ahead of the pres­i­den­tial elec­tion will trig­ger a US fi­nan­cial cri­sis or re­ces­sion, which in turn would give Don­ald Trump a much more plau­si­ble route to the White House than seemed likely a week ago ago.

Fi­nally, and per­haps most dis­turbingly, the Bri­tish ref­er­en­dum has pro­duced an ex­tremely frac­tured and po­larised so­ci­ety — with huge ma­jori­ties for Brexit among el­derly and poor vot­ers and in rel­a­tively un­der-devel­oped ru­ral re­gions ve­he­mently op­posed by al­most equal ma­jori­ties that sup­ported EU mem­ber­ship among young and highly ed­u­cated vot­ers and in the pros­per­ous cities — not only Lon­don, but also Manch­ester, Bris­tol, New­cas­tle and the whole of Scot­land. This ex­treme po­lar­i­sa­tion on a na­tional is­sue of ex­is­ten­tial im­por­tance would raise risks of so­cial and po­lit­i­cal ten­sion even in be­nign eco­nomic con­di­tions. If, as is likely, Bri­tain now suf­fers some kind of fi­nan­cial cri­sis and re­ces­sion, the peo­ple who voted for Brexit will dis­cover that leav­ing the EU has not re­solved any of the eco­nomic prob­lems and so­cial griev­ances that pro­voked their protest against the po­lit­i­cal es­tab­lish­ment. If this hap­pens, pub­lic anger will pre­sum­ably in­ten­sify, rather than calm down. A sim­i­lar dis­il­lu­sion­ment is likely in other coun­tries whose vot­ers de­cide sim­ply to over­throw po­lit­i­cal elites and dis­miss the anal­y­sis of eco­nomic “ex­perts”, with­out hav­ing any se­ri­ous al­ter­na­tives to put in their place.

At some point, these po­lit­i­cal and eco­nomic ten­sions will pre­sum­ably sta­bilise and the pop­u­lar re­volts could ul­ti­mately have pos­i­tive out­comes if new po­lit­i­cal lead­ers and eco­nomic pol­i­cy­mak­ers come for­ward with con­struc­tive ideas for re­form.

That is what hap­pened after the cri­sis of the 1970s with the rise of Rea­gan and Thatcher and in the 1930s in Amer­ica un­der Roo­sevelt. But the 1930s should re­mind us that there could be much less be­nign out­comes. And even in the 1980s, the ben­e­fits for in­vestors only be­came ap­par­ent after sev­eral years of big losses and ex­treme tur­bu­lence. When a so­ci­ety and an eco­nomic sys­tem is turned up­side down, which is what vot­ers have now de­cided to do to Bri­tain and per­haps the whole of Europe, one can never be sure about the longterm out­come. The ra­tio­nal first re­sponse is to raise cash and re­duce risk.

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