Brexit: Two weeks later

A6.3Political turmoil erupts in the UK

Two weeks after the United Kingdom voted to leave the European Union (EU) the focus of attention is in three different areas: the political turmoil that has erupted in UK politics, the widespread speculation about the response  of the remaining members of the EU and the reac- tion of global equity, bond and currency markets. The initial trigger for UK political turmoil was the resignation of British prime minister David Cameron shortly after the result of the referen- dum was announced. In the fallout since the resignation, Boris Johnson, the leading candidate to take over from David Cameron, has with- drawn his candidacy and Michael Gove, the next frontrunner, lost heavily in the first round of internal voting for a successor to new frontrun- ner Theresa May. Nigel Farage, leader of the UK Independence Party also resigned saying his job was done as he had been a staunch supporter of the Leave campaign and Jeremy  Corbyn, leader of the Labour Party, is currently facing an internal revolt and is digging in as he vigorously defends his current status as leader. Philip Stephens, a global political contributor to the London Financial Times, suggests in a recent article that British politics is going the way  of Greece. He points out that although the economic risks of Brexit were well re- hearsed, the political perils were neglect- ed. The Leave decision defies the majori- ty in parliament. Its legacy is a rudderless Conservative government, a Labour opposition fallen to civil war and a politi- cal class at sea about what to do next. This is a sad indictment of what has long been regarded as one of the world’s most stable democracies. Mr Stephens adds that it should be obvious from all of this that no serious negotiation with Brussels can take place before a general election.

The referendum expressed the wish  of the electorate to leave the EU, but said nothing about what should replace it. However, any alternative prime minister, including Mrs May, will also lack the political legitimacy to negotiate a deal with the remaining 27 members of the EU.

A fresh mandate is needed

Political realignments do not happen often in British politics, mostly because the first-past-the- post electoral system has been merciless towards third parties. But the space may be opening up  for a new, pro-European, economically liberal  and socially compassionate alternative to narrowly focused nationalism and hard-left socialism. The wait will be infuriating for Britain’s partners. Eu- rope cannot afford a long period of uncertainty. But at least Berlin, Paris and the rest have had the experience of dealing with Greece.

Angela Merkel, the German chancellor, has said that Britain has to make a choice: between full access to the single market and autonomy over immigration. It can have one or the other. The first, envisaged by membership of the European Economic Area – theso called Norway option – would require Brexiters to abandon promises to shut out workers from the rest of the EU: the second would oblige them to admit that  George Osborne, the UK’s pro-EU chancellor, was right about falling employment and living standards.

With a great deal of luck and even more goodwill on the part of the rest of the EU, Britain might yet salvage something from the wreckage.

The referendum result cannot be un- done, but the strategic goal should be an association that keeps Britain within the single market and recognises that it is still a European state by preserving vital co-operation on security, defence and crime suggests Mr Stephens.

The choice though, must be put to the electorate in a general election. A fresh mandate is the minimum requirement for a new prime minster.

The four freedoms are important

Less than a week after the Brexit victory, Britain got its first taste of a future outside the EU as Europe’s leaders met without UK prime minister David Cameron and warned that London must accept EU migrants to win access to the bloc’s free trade zone. European leaders gathering with- out a British representative for the first time in 40 years poured cold water on the chance of Britain gaining no-strings-attached access to the huge EU single market of 500 million people. “Leaders made it crystal clear (today) that access to the single market requires acceptance of all four free- doms, including freedom of movement,” EU president Donald Tusk told a news conference. Scottish leader Nicola Sturgeon pleaded her case in Brussels for Scots to stay in the EU, showing how Britain’s vote to leave the bloc could splinter the UK. Sturgeon has said that Scotland, where voters backed staying in the EU by a near 2-1 majority, must not be dragged out of the EU against its will. She wants to negotiate  directly with Brussels to protect the membership rights of Scotland.

But Spanish prime minister Mariano Rajoy, struggling to prevent the autonomous region of Catalonia from breaking away, said Madrid would oppose any EU negotiation with Scot- land. “If the UK leaves, Scotland leaves,” he said. There has been a surge in sympathy in many parts of Europe for the 5.5 million  Scots, whose strong vote to stay in the EU  was overridden by the English, who outnum- ber them 10 to 1. But countries that have dealt with regional separatism, such as Spain, are strongly opposed to any direct EU talks with Scotland. In London, David Cameron told parliament that negotiations had to be carried out by the UK as a whole. The 27 EU leaders sent a firm message to London that there would be “no negotiations of any kind” on future trade relations until the UK officially triggered the EU treaty’s exit clause. “This should be done as quickly as possible,” they said.

The eurozone has problems of  its own

The statement that access to Europe’s prized single market “requires acceptance of all four freedoms” of movement for goods, capital, per- sons and services was a blow to Brexit campaign- ers, who promised to restrict large-scale EU mi- gration to Britain while assuring British compa- nies that they would still be able to easily sell goods and services to the continent. French pres- ident Francois Hollande echoed Tusk’s position. “If Britain wants to have common market access, like Norway for example, then the UK will have to respect … the freedom of movement of  goods, capital, people and services,” he said. German chancellor Angela Merkel has also warned that London could not “cherry-pick” the terms of the exit negotiations. Some in Brussels are concerned that giving Britain favourable di- vorce terms will spark a domino effect of others leaving the EU, with euro-scepticism growing in many member states. In the last week of June,  the EU leaders agreed that they need to do more to battle what a final joint statement called “dissatisfaction with the current state of affairs” on the continent. “Europeans expect us to do a better job when it comes to providing security, jobs and growth, as well as hope for a better future,” they said, announcing a “political reflec- tion to give an impulse to further reforms”.

Global market reaction to the Brexit result was predictable. Initially, equities gyrated wildly (global stock markets suffered $2 trillion of losses on the day  after the vote)  while  many investors sought refuge in bonds and in major curren- cies such as the US dollar and the Japanese yen. The UK sterling was hammered and it now sits at its lowest level against the US dol- lar in 31 years, down 10% from pre- referendum levels. UK and European equity markets are still much lower when measured  in US dollar terms, but when measured  in local currency, the UK equity market is higher, particularly in indices where the listed compa- nies generate significant foreign earnings that are now much higher when translated through the weaker sterling. Bond yields however, remain much lower than before the vote.

The Financial Times reports that in a stark warning to politicians, Bank of England (BoE) governor Mark Carney said a downturn was  on its way and Britain was already suffering from “economic post-traumatic stress disor- der”. He went on to say that the Bank of Eng- land was preparing to unleash yet another round of monetary stimulus as it battles to contain the economic fallout of the UK’s decision to leave the EU. He said the central bank would take “whatever action is needed to support growth” which probably included “some monetary policy easing” in the next few months, in an attempt to reassure the markets and the general public. But Mr Carney  also said that central bankers could do only a lim- ited amount to mitigate the pain.

There are limits to what the Bank of England can do

In the week after the referendum, British govern- ment bond yields entered negative territory for the first time following Mr Carney’s speech even as rating agency Standard & Poor’s (S&P) stripped UK government debt of its last AAA rating as it warned of economic, fiscal and constitutional risks that the country now faces. The two-notch down- grade came with a warning that S&P could slash its rating again. It described the result of the vote as “a seminal event” that would “lead to a less predictable stable and effective policy framework in the UK”. The Fitch Ratings agency estimates that the global stock of bonds with negative yields has now soared to $11.7 trillion as borrowing  costs around the world collapse. A couple of years ago, negative yielding bonds – which, in nominal terms, pay less at maturity than investors initially paid – were rare. In the past month alone, the number swelled by $1.3 trillion. Meanwhile, the pile of bonds with a yield that investors used to consider normal – above 2% – is barely worth $2 trillion. Most of this negative debt sits in the euro- zone and Japan but rate expectations in the UK and the USA are sliding. One of America’s largest hedge funds is now warning its clients that “markets in aggregate are discounting … effective- ly no monetary tightening for a decade around the world”.

Gillian Tett, writing for the Financial Times, sug- gests that when future historians look back at the Brexit shock, they may conclude that this shifting rate outlook is one of the most important ripple effects of the Leave vote. This has nastyimplica-tions for asset managers of all stripes, including insurance companies, which need to earn decent returns to pay policyholders. Some defined benefit pension schemes are also under pressure from these plunging government bond yields, which are used to measure liabilities against assets. UK pen-sion fund deficits hit a record £935 billion in the last week of June as the historic low in gilt yields inflated  the  liabilities  of  schemes  to  an all-time.

Part of the BoE’s plan to support growth in- volved “ruthless truth telling”, Mr Carney said. “One uncomfortable truth is that there are limits to what the Bank of England can do. In particu- lar, monetary policy cannot immediately or fully offset the economic implications of a large, nega- tive shock”. He added that the economic uncer- tainty generated by a series of crises over the past few years and the additional shock of Brexit  risked causing businesses and households to delay spending and investment, hitting demand and employment levels. To guard against the risk of the banking system seizing up, the BoE is holding weekly liquidity auctions until the end of Septem- ber to ensure that British banks have easy access to credit.

As the Brexit uncertainty swirls around the globe, South African investors look back on the month of June and reflect on the SA ratings review from S&P, the meeting of the US Federal Reserve’s Open Market Committee and the Brexit referen- dum. Looming on our horizon is the local gov- ernment election next month. In spite of these events, the SA equity market fell by a mere -3% over the month. The All Bond Index was strong and delivered a positive return of just over 4%. Listed property was also up over the month with  a positive return of just over 1%. And the rand strengthened against the US dollar by 6.3% and against the UK sterling by 14%.

Our equity market is expensive in aggregate, hurt by poor earnings delivery over the last 18 months, but the outlook for improved earnings is encour- aging. Listed property distribution yields, bond yields and longer-dated cash yields are all positive and many are in excess of the latest inflation read- ing.

Our local investment markets are very “normal”.

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