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Investment e.Perspective

Current Issue | May 15, 2019

What’s Happening Across the Pond This Month?

By: David Lewis, CFA, CAIA, Managing Director & Oxford Investment Fellow


As background, the European Union (“EU”) was formed shortly after WWII to create economic and political cohesion across the continent. The United Kingdom (“UK”) joined this organization in the 1970s. To advance its goals of reducing trade friction, integrating financial markets and creating a stronger presence for the EU in the global economy, the Euro was launched in 1999 as a shared currency. There were initially 11 countries which agreed to use the Euro. By doing so, they effectively relinquished their monetary policy (the ability to raise or lower interest rates) to the European Central Bank. The UK was concerned about giving up this level of control so it elected to retain its currency (Pound Sterling) but remain in the EU.

While there are a number of benefits to its membership in the EU (trade agreements, free-flow of labor from EU countries and being seen as the financial gateway to Europe) the UK gives up a degree of sovereignty. There had always been some concern amongst the UK population with this arrangement, but the 2011 to 2015 period saw growing frustration, particularly around the issue of migration from other parts of Europe and worries about domestic job losses. In 2015 the Conservative party unexpectedly won the election on a platform of leaving the EU. A public referendum was held in 2016 which narrowly (51.9%), and again unexpectedly, supported leaving the EU or “Brexit” (British exit). This outcome led to an 11% decline in the Pound Sterling and brought it to the lowest level in more than 30 years.

In March 2017, the UK invoked Article 50 of the Lisbon Treaty, which began a two-year timeline to negotiate the terms of the split. This period expires on March 29, 2019 – which is supposed to be the end of the story.

Over the past twenty three months, however, negotiations have not gone smoothly. There have been discussions of a “soft Brexit”, which would entail some degrees of continued reliance on EU policy and infrastructure, or a “hard Brexit” which would include a fully independent immigration policy and trade agreements would fall back underneath the WTO.

One significant issue, which has not generated as much media attention, relates to the fate of Northern Ireland. While the Republic of Ireland (the South) will remain in the EU, Northern Ireland remains part of the United Kingdom and is slated to leave. As such, any version of Brexit which requires a change in customs/immigration policy would necessitate a barrier between Ireland and Northern Ireland. While there has been relative peace since the 1998 Good Friday/Belfast Agreement, the decades prior were marked by protests, riots and violence. Fears of renewed tensions have been elevated in recent months, with a car bomb that was detonated outside a Northern Ireland courthouse in January 2019.

This bombing was just four days after UK Prime Minister Theresa May’s proposal to effect an exit was voted down by 230 votes (432 to 202). This was the largest ever defeat in the House of Commons. A subsequent vote on March 12 was also rejected, though by a lesser margin.

The uncertainty since 2017 has created significant stress and frictional costs on financial institutions and consumers. Banks and other institutions have moved thousands of jobs to the European mainland and in some cases developed redundant infrastructure to support a second regulatory regime. Manufacturing plants have begun stockpiling excess inventory amid worries of supply chain disruptions at the UK’s ports of entry, and some consumers have adopted a bunker mentality, purchasing canned goods and “Brexit Boxes” as the UK imports about 50% of its food.

The concern has been reflected in the economic data, as we’ve seen a slowdown in business investment in recent quarters.

GDP growth rates have also fallen on an absolute and relative basis. The UK had one of the highest growth rates in the G7 from 2013-2015, but has reported the lowest growth of this cohort over the past four quarters.

As things stand today (3/21/2019), the British Parliament has voted to seek a delay of Brexit beyond March 29 and Prime Minister May will be meeting with EU leaders to negotiate an extension. Interestingly, there is a straightforward (albeit politically painful) escape hatch given the European Court of Justice’s ruling that the UK could cancel the Brexit process without consent of the other EU members.

As difficult and challenging as globalization was to develop over the past 70 years, it will be equally challenging to unwind. Brexit and other populist/nationalist measures are at the fore, and we anticipate further trade friction and geopolitical disruption in the years ahead. This will create opportunities for our managers and our portfolios, as we closely watch the regime shifts within central banks and government houses. In any event, we can be assured the next 10 days will offer an interesting window into the fractures in Europe’s democratic systems.

The above commentary represents the opinions of the author as of 3.21.19 and are subject to change at any time due to market or economic conditions or other factors.