In June, 2016, voters in the UK delivered one of that year’s big political surprises. Against the predictions of pollsters and pundits, they voted, by a narrow margin, to leave the European Union (EU). It was one of a series of big surprises that humbled analysts around the world who had underestimated the strength of popular sentiment against “globalist elites.”
The event was significant politically, economically, and culturally. Politically, it showed that there was a population of voters in much of the developed world who viewed themselves as a “forgotten middle.” Put simply, they felt left behind by the progressives’ concern for the poor and marginalized, and the conservatives’ concern for taking down trade barriers and easing commerce and immigration. They were tired of suffering the erosion of their living standards, as they viewed it, by taxation and offshoring. The relatively controlled political conversation that had been going on within elite political circles for decades was rudely interrupted.
This was a sign of a growing popular unrest with the longstanding political consensus – a consensus that in spite of all their differences, had acted as a glue between left and right. The breakdown of a longstanding consensus always brings disruption and uncertainty in its wake. It is not a single event but usually a drawn-out process. For two years we have been watching as that process has played out in Europe, in the United States, and elsewhere in the world, and it is still ongoing.
In the U.K., part of the consensus of the majority of the political class, both left and right, was devotion to the “European project.” As we’ve discussed before, this “European project” had deep roots in Europe’s traumatic 20th century experience of war. After the destruction of the Second World War, Europe’s leading powers began a slow period of integration – hoping that increasing economic unity would lead through increasing political unity to a future in which a continent-wide war could never happen again. Through a series of treaties, the EU came into existence as a not-quite nation, united by mutual open borders and the free movement of peoples and goods within the union. Increasingly, it developed quasi-governmental functions, with more and more elements of former national sovereignty passing under the jurisdiction of European institutions. Finally in 2002, the EU introduced its own currency, the euro, although some member states, including the U.K., chose to retain their own sovereign money.
There were problems brewing under the surface. The various member states of Europe had very different economic histories, and different economic cultures. Broadly, they could be divided into a northern group, which valued restraint in spending and had a more entrepreneurial business culture, and a southern group, whose governments tended to spend liberally and have periodic debt crises and devaluations of their currencies. Joining these two groups together in a single currency could only work if they also had common finances and issued common debt – something the northern group wouldn’t accept. So in a follow-on to the global financial crisis of 2008, Europe found itself in the midst of its own crisis in 2011, with many southern countries, including Portugal, Greece, Spain, and Italy, teetering on the brink of financial ruin. The European Central Bank succeeded in staving off disaster. But it did not solve the problem, and it put the north/south divide on stark display. The real problems – weak banks and habitually debt-mired economies with excessive public spending – are still unresolved. (We are currently seeing a manifestation of this problem as the new populist Italian government seeks to buck EU rules that restrain its budget deficit. And although Greece may be out of the news, its problems are far from solved, and will certainly arise again in the next few years.)
All this was on Britons’ minds in June 2016 when they voted to leave. While most of the political class wanted to stay in and try to keep working to solve the EU’s problems, a majority of British voters decided they had had enough: enough ceding of their sovereignty to European bureaucrats and enough accommodation of partner nations with what they viewed as incompatible economic and political cultures. They decided that the UK could do better on its own, creating its own sovereign relationships with trading partners, crafting its own regulatory system, and controlling its own borders.
After the vote, the British Prime Minister, David Cameron, resigned. He had backed the campaign to remain in the EU. He was replaced by another Conservative Party politician, Theresa May. She had also wanted the UK to stay, but she promised to respect the voters’ wishes and oversee an exit from the Union on the best terms she could win from the EU’s negotiators. In March 2017, she formally initiated the process of the UK’s departure by triggering Article 50 of the 2009 Treaty of Lisbon. That meant that no matter what the outcome of the negotiations, the course was set for “Brexit” by March 2019. If a deal was reached securing special relations between the UK and the EU, well and good. If not, the exit would happen anyway – and the trade and financial relations of the UK and the EU would revert to the baseline provisions of the World Trade Organization (WTO) of which both are members.
How does the process currently stand, with only months to go until the exit, deal or no deal?
Needless to say, there was fierce disagreement in the UK about how to proceed. Prime Minister May has backed a plan called “Chequers,” named after the country retreat where it was hammered out with members of her cabinet. That plan has earned the scorn of hardline pro-Brexit Conservatives as conceding far too much to the EU, and retaining so much subservience to European regulations and institutions that it amounts to a membership without voting rights. It has also been roundly rejected by EU negotiators. Still, May is pressing doggedly ahead with it.
Whatever deal is finally reached must ultimately be approved by a vote in the British Parliament. Unfortunately for May, her governing coalition relies on a small political party from Northern Ireland which is staunchly pro-Brexit – the DUP. The Northern Irish question is proving a huge stumbling block for negotiations, since in order to avoid the creation of a “hard border” with customs checks between Northern Ireland and the Republic of Ireland to the south, the Europeans are insisting that Northern Ireland remain subject to many EU regulations and institutions.
The DUP won’t accept that… And so, markets watch and wonder what will happen. Anti-Brexit politicians conjure up fears of British airplanes not being permitted to land in European airports on March 29, 2019, and critical medicines being held at Calais in France and not being allowed to be imported to the UK.
Pro-Brexit rebels threaten upheaval within the ruling Conservative Party, and May’s replacement by a more hardline contender is possible (such as the ambitious Boris Johnson, former Mayor of London). The Conservatives’ opposition, the Labour Party, is another potential wrench in the works. Their current leader, Jeremy Corbyn, is a polarizing figure with politics reminiscent of the Labour Party that governed the UK in the 1970s, creating economic stagnation with their policies of heavy taxation and nationalized industries. One pro-European Conservative commented, “The only thing worse than Brexit would be Jeremy Corbyn.”
The general consensus of markets and analysts is that Theresa May will retain her leadership of the Conservative Party, and succeed in securing a Brexit deal that will avoid a “hard Brexit” – an exit on WTO terms that no one on either side has really prepared for. At the very least, it is hoped that May will secure a deal that is acceptable to all 27 remaining members of the EU and has a framework that allows for longer discussion before contentious issues are fully resolved.
For our part, we believe that the proponents of Brexit will prove objectively correct about Brexit’s benefits to the British economy in the long run. Indeed, while the British pound weakened post-Brexit, dire warnings of a collapse of British economic growth have not come to pass, and the UK has performed strongly compared to its European peers. We are persuaded by Boris Johnson’s recent op-ed in The Telegraph outlining his alternative to Theresa May’s plan, when he observes that in the final analysis, these are bureaucratic questions that will have bureaucratic, functional solutions – that the UK carried on its own trade, foreign relations, and regulatory policies very effectively before the advent of the EU, and that it will do so successfully again.
Investment implications: The likelihood of near-term volatility for the British pound and for UK equities is rising, given the increasing uncertainty surrounding the final shape of Brexit – strong or weak, deal or no deal. We are bullish on the long-term prospects for the British pound and for UK equities, but we would wait to initiate a position until near-term volatility has come closer to running its course. Should the final Brexit deal be too weak, this would temper our view of its positive long-term effects.