The EU as a larger Germany post-Brexit and Hugh Hendry’s Eclectica Fund commentary

Stocks have mostly recovered since Brexit and the strong dollar and Yen have reversed much of their overvaluation in recent days. The question remains as to what the fallout from the UK’s departure from the EU will be. I continue to believe the near-term economic impact will be muted, and that Brexit will come to be seen as mostly a political event. But it is a political event with wide-reaching potential ramifications.

On markets, let me say briefly that most of the fallout from Brexit is over. The FTSE 100 and the S&P500 have recovered all of their post-Brexit losses. While people point out that the FTSE 250 and 350 show continued losses, the Russell 2000 in the US has also not regained its previous highs yet. We just need to wait and see how things develop. So far the stock market is saying the fallout on earnings will be muted. Moreover, post-Abenomics stimulus, we are seeing the Yen back at 104 and the pound back at nearly 1.33. Currency markets, then, are also taking some of the reasonable worst case scenarios off the table. Only bond markets continue to show worry about future global economic growth – and that’s arguably an artifact of something that has nothing to do with Brexit.

Bottom line: the post-Brexit freak out was well over the top, and almost completely dominated by motivated reasoning. Now that people have had time to deal with the consequences with more logic, they are coming to the conclusion that what happens in the UK will not be a catastrophe for the global economy or global share prices. Instead, the consequences are about political risk, about economic tail risk scenarios becoming more possible, and about remote time-frame economic downside.

Look at what Hugh Hendry is saying for example.

Put simply, prior to Brexit, we believed that the Fund had a high probability of making a modest return. But now with the UK set to follow a divergent and unexpected economic policy, certain scenarios ranging from the questionable viability of the euro to the prospect of a major economy rejecting fiscal balance to pursue an expansionary fiscal policy and the likelihood that other nations will copycat this policy in the future no longer appear so extreme. It feels like we have returned to the dysfunctional logicality that reigned prior to the crash of 2008: if you think the future is inflation, prepare to profit now from the deflationary-like catalysts. For the latter scenarios appear the most likely within our investment time horizon.

Our current enthusiasm for our book therefore is predicated on the notion that our investable universe has just expanded greatly as certain events have moved from the uninvestable shadows of tail-like probability into the realms of investable profit opportunities. This has enabled us to expand our risk taking meaning that the Fund, in our view, now also has a reasonable probability of making rather a lot of money.

I recommend the entire Hendry piece, up now at because Hendry follows up here with a very good historical analogy about Sterling’s departure from the gold standard in 1931, creating a sort of domino effect with far-reaching consequences. Here’s how he puts it.

…shorn of the cult of austerity, and riding on the crest of a huge stimulus delivered by the currency devaluation, the British economy recovered quickly. To quote a common refrain from the time, nobody told us we could do that, and yet within two years most other countries had adopted the same policy.

We have discussed this period of history previously. It persuaded us not to wager on a euro break up too early back in 2011 when markets questioned the resolve of Greece to remain. The UK generations earlier, and Italy since the passing of the lira, have grimly and with some resolve trudged through the economic sludge of a decade or more with no growth in nominal GDP. This seems to demonstrate that people can be stoic and hardy as long as they feel hope that their standard of living might improve. And so five years ago, and with a likely economic recovery imminent, it felt too early to radically challenge the perception of prosperity; the system was safe.

Today however, following Britain’s announced departure, the equation has changed. Previously with 28 members and no history of exit the system’s gravitational pull was immense. But it was vulnerable to just one defector weakening the system. This is where we are now. We believe that the UK has the upper hand. Political commentators may be in revolt, but the combination of higher gilt prices and the sharp drop in sterling mean that the British need not fear the passage of time.

Recall that there were 45 member countries committed to the gold standard prior to the UK’s departure in 1931 but just 12 by 1933. How many of the remaining 27 European member countries will there be in 2018?

The breakup of the European Union is now officially on the table. And, let’s remember that this is occurring at a time when the Eurogroup is attempting to sanction Portugal and Spain for 2015 excessive deficits of 4.4% and 5.1% respectively. I have been following the German news on this and German finance minister Schaeuble is characterized as particularly keen to wield this weapon in order to give credibility to the probity of EU’s budgetary promises. If Portugal and Spain were sanctioned, it would be a first ever.

The European Union without the UK becomes a larger Germany, frankly. And that means “a stronger and stricter fiscal framework,” something the Germans have been angling for since the sovereign debt crisis occurred. With the UK leaving, the strictures of the euro will become more clear and this will lead to tension. Meanwhile, as the UK struggles outside of the process, the question for those looking on will be: “how bad is it for Britain?”

I believe fiscal, monetary and currency offsets will prove to be effective enough to eliminate almost all of the tail risk for the UK, with commercial property and trade being particular lingering worries. And so the countries trapped inside the eurozone will look on in envy at the UK economy as the stability and growth pact strangles the life out of Eurozone private sector demand. This will have political consequences for sure, unless the EU changes tack. And given the zeal with which Dutch finance minister Dijsselbloem supports Schaeuble’s agenda as one example – I don’t see this happening. Europe is not for turning.

All of this continues to support sovereign bonds. Sovereign bonds are presently overbought. And as risk on sentiment returns, I would expect there to be some re-pricing downward, as there was yesterday. I expected more re-pricing though. The muted nature of the re-pricing – especially as compared to stocks – tells you that we are still in a disinflationary world of slowing global growth. Expect policy rates in the Anglo-Saxon world to fall toward zero and for those yield curves to flatten over time.

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