Today’s Daily Reckoning is brought to you by the word ‘uncertainty’. Because after last week’s momentous decision by Britain to leave the European Union (EU), you can be sure that absolutely no one knows how all this is going to play out.
First things first though. Good on the Brits for ignoring all the fearmongering by the establishment, and the opinions of all the world’s leaders, who urged them to remain in the EU. They now have a chance to shape their own future. Let’s hope they make the most of it.
I don’t know if leaving was the right decision to make. But I do know that, if the leave vote still managed to get up after all the hysterical posturing by the self-interested elites, the Brits had good reason to vote the way they did.
Not that anyone picked it. Markets were taken completely by surprise on Friday. Or I should say nearly everyone. Our man Jim Rickards, editor of Strategic Intelligence, was about the only person I know saying that Brexit was more likely than the polls suggested.
Having got it wrong, the vast majority of opinion then condemned the leave vote as being ignorant, racist, and the result of the older generation wanting to hark back to a bygone era. The gist is that the UK has thrown the EU into turmoil.
That’s rubbish. The EU has thrown itself into turmoil. The decision by the UK to leave is merely a manifestation of that. The core of the EU — those countries using the common currency, the euro — has lurched from crisis to crisis over the past few years.
The management of this crisis, seen through the eyes of the common people, has been abysmal. The machine of European bureaucracy has only grown bigger while the democratic process in many countries — Greece, Spain and Italy — has shrivelled to nothing.
The leave vote is a protest against this. Rightly or wrongly, it’s a desire to get as far away from this dictatorial style of economic and political management as possible.
As I said, whether this was the right way to go about it, I don’t know. But if the EU doesn’t take a long hard look at itself now, the British referendum won’t be the last. The whole project is failing the people, while enriching bankers and bureaucrats. More countries will look to get out.
How the UK fares from hereon in depends on the quality of its leadership. The EU, in an attempt to discourage other countries from leaving, will make things difficult for the Brits. So strong leadership is vital. Do they have it?
I have no idea. We won’t know for a while.
So what does it all mean for investors?
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The first thing to point out is that the market reaction wasn’t as bad as some thought. Given global markets rallied strongly into the vote, the selloff wasn’t extreme.
The UK stock market only finished down 3.15% on Friday. The S&P 500 dropped 3.6%, but was only down 1.6% for the week.
While the market got the results of the British vote horribly wrong, perhaps its reaction to the outcome is worth considering.
The real carnage wasn’t in the UK, it was on the continent. The Italian stock market dropped 14.5% in Friday trading. Spanish stocks fell 12.4%, while the French market dropped 8%.
The Italian banking system is in all sorts of trouble. Look to Italy as the next source of trouble in the EU.
All the action was in currency markets. Given that global markets were positioned completely wrong for Brexit, you saw a lot of that unwind within hours on Friday.
The big winners were the US dollar, the Japanese yen, and gold.
The US dollar jumped 9% against the pound and 2.6% against the euro. The yen was even stronger, soaring 4% against the dollar. Gold wasn’t too shabby either. It broke out to a new two-year high and, at one point, traded as high as US$1,360 an ounce.
The big fall in the pound probably helped UK stocks hold up more than expected. The pound broke down to fresh multi-decade lows against the US dollar. That’s bearish, and it suggests major weakness ahead for the pound.
The problem for Britain is that just prior to the vote it reported its worse current account deficit since records began in 1948. In the final quarter of 2015, the deficit came in at a massive 7% of GDP.
When you have a current account deficit, it means you must borrow from creditors to make up the difference. Given the uncertainty over how events will unfold post-Brexit, foreign creditors will not lend to Britain so readily.
Therefore, the currency must fall in order for Britain to keep attracting capital. Given the UK’s large debt levels, the pound will need to remain weak to offset the shock from the leave vote.
What about Australia? Will we be impacted at all?
I see two main threats…
The first issue is global currency moves. If the US dollar continues to strengthen, the Chinese won’t like it. They’ll start devaluing the yuan again, which you might remember was the source of the world’s problems in 2015 and early 2016.
A spotlight on a fragile Chinese economy won’t be great for Australia. Our currency will come under pressure too.
The second area of concern comes from Europe. Australia, like the UK, relies on foreign capital to support our standard of living. Aussie banks borrow a lot of the money they need from European capital markets.
If financial risk increases in Europe, it will threaten the flow of capital to Australia. In fact, you’re already seeing this. The Big Four banks were hit hard on Friday. The market realises how exposed our banks are to financial instability in Europe.
This bears close watching. As I’ve mentioned plenty of times before, the Aussie economy has major structural frailties. Our economy is built on selling dirt to a bubble economy and then leveraging the income from this, punting it all on a land bubble.
The risks to this insane economic model seem overblown until something comes along to upset the status quo. Whether Brexit is this ‘something’ remains to be seen. But everything is connected in this globalised world and Australia, thanks to its world-beating household debt levels, isn’t immune from what’s going on across the other side of the world.
Keep an eye on the Aussie dollar and the Big Four banks; they will give you all the information you need about how Australia is positioned in this new world order.
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