On February 20, 2016, David Cameron the newly re-elected Prime Minister of United Kingdom (“UK”) announced a referendum to be held on June 23, 2016, that gave the citizens of UK the opportunity to decide their future within the European Union (“EU”). Against all economic logic, UK voters chose to exit the EU costing Mr. Cameron his job and roiling global capital markets in the aftermath.
After supporting a united Europe project for 43 years, the decision to exit the EU is not only a crushing blow to investors worldwide, but could also result in a fractured UK, with Scotland and Wales voting to remain in the EU. It remains to be seen if another Scottish referendum is on its way. The capital markets are blindsided, with the pound sterling, FTSE 100 and the Euro in a free fall.US$ and Gold are up.
In my view UK’s decision to exit the EU is a black swan event. The black swan theory describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight. The theory was developed by Nassim Nicholas Taleb to explain:
A. The disproportionate role of high-profile, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance, and technology
B. The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities); and
C. The psychological biases that blind people, both individually and collectively, to uncertainty and to a rare event’s massive role in historical affairs.
I bring up black swan to highlight the notion that a UK exit resulting in an existential crisis for the EU was on very few people’s radar. Having already covered significant ground by providing a bailout to Portugal, Greece, Spain and Italy, during the great financial meltdown and afterwards, the EU and the European Central Bank signaled a strong desire to stay united, and continue the European unification project. That has come apart at the seams now.
More importantly the current state of EU highlights that one can never be too sure, and hence from an investing standpoint, diversifying risk and keeping investment management costs in check are the two mantras for success. While markets tend to overreact, and generally overcome walls of worry and uncertainty in time, going forward, I believe the following trends are likely to gather momentum:
1. The Euro will likely enter a lengthened phase of weakness against the US$ given uncertainty surrounding the political and structural integrity of the EU. S&P 500 earnings in 2016/2017 are likely to suffer given exposure to the Eurozone.
2. Pound sterling is unlikely to regain its strength and stature in global markets and should weaken further from current levels where it has already fallen 10%. The FTSE is not a good place to be going forward. Canadian pension plans and infrastructure players with exposure to UK airports, seaports, electricity infrastructure etc. are likely to report significant mark to market losses on investments and lower internal rates of return going forward.Just recently at an event a pension plan sponsor highlighted their ability to borrow at negative rates of interest and invest in UK properties helping generate high internal rates of return. Overnight that arbitrage has evaporated with C$ valuations and cash flows significantly affected due to a weaker pound.
3. The ECB would be forced to maintain below zero rates for longer to ensure currency market dislocations do not affect economic and employment growth. That implies a significantly bigger share of global debt stock will be yielding below zero rates of interest.
4. With ECB rates lower for longer, the US Fed and the Canadian central bank are likely to maintain lower for longer out of necessity to prevent excessive spread widening between the Euro area interest rates and North American rates. This is to prevent the USD and CAD from strengthening further. Any expectation of a rate hike in 2016 in Canada and in the U.S. is now likely nil.
5. Global asset inflation in yield oriented securities and real estate will likely continue apace after the initial dislocation brought on by UK exit, with asymmetrical pay-off opportunities for investors and high risks.
6. China will regain its stature in equity markets in late 2016 early 2017, and its currency will gain strength once again, as investors reassess the risks in EU and look for an alternative to deploy vast amounts of capital which only China can absorb.
7. Canadian equity market volatility will likely remain elevated as investors and corporations assess the exposure to EU, and work through the currency impact on earnings and cash flows. Canadian pension plans will have to reassess asset allocation and risk pricing models.
8. U.S. technology companies that are more exposed to enterprise customers are likely to recalibrate guidance and expectations for 2016 and 2017. In Canada, CGI Inc. which has made some big acquisitions in UK and EU is likely to temper expectations.
9. Most importantly, EU humanitarian assistance – migration and immigration played an influential role in the exit debate – is likely to become more hostile/less considerate towards economic and socially displaced migrants from North Africa and Asia.
10. Canadian assets, physical and financial, will be in more demand as EU citizens, pension funds and others allocate capital away from EU to more stable jurisdictions. That again highlights a strengthening C$ allowing lower interest rates in Canada for longer.
What does all of this mean for investors and how are we dealing with this at ANTYA?
The first principle of investing at ANTYA is preservation of capital which we accomplish via Astute Asset Allocation.
The second principle we follow is based on what Joseph A. Schumpeter said, “the difference between a speculator and an investor can be defined by the presence or absence of the intention to ‘trade’ i.e. realize profits from fluctuations in security prices”, meaning we are committed to maintaining our current asset allocation while keeping a close eye on the volatility and direction of asset prices.
Since inception, ANTYA has not been directly invested in Europe at all, and any European exposure in our portfolios was accomplished via S&P 500 and NASDAQ. Although we never imagined a UK exit and a subsequent existential crisis, we were always wary of Greece.
Finally, the 3rd principle that remains closest to our heart is best articulated by Charles Mackay, a friend of Dickens and the author of Extraordinary Popular Delusions and the Madness of Crowds where he said: “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.” Even until last night, we did not believe that UK citizens would vote to leave the EU.
As applied to the art of investing, these principles in one way or another promote conservatism, diversification and advocate staying the course. That’s where ANTYA takes pride in its process. Give us a call if you would like to discuss further.