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Macro Matters: Beware the exit genie

Most Brexit speculation seems to be focused on consequences for the UK should it leave the EU, says Bob Swarup. But the result could well be the beginning of the end for the European project 

This quarterly column assesses a reduced selection of key buckets of macro risk relevant for pension funds at a high level, and with a view to their evolution over the next 12 months. We also delve into more detail on particular dynamics that bear further thought. These often cross multiple buckets, reflecting the interconnectedness of our world today. Importantly, this is not an isolated point-in-time exercise but rather a regular update to aid assessment and inform action. 

Brexit or EUxit?

It would be hard to not talk about Brexit and its implications, given its dominance of discussion these days. Much of the recent debate and analysis has focused on the UK’s ability to negotiate free trade agreements and the impact of different scenarios on GDP. The immediate aftermath is simple: the currency weakens, investment stalls as the fallout is assessed and households save more amid uncertainty. But past that, all analysis is speculative. In the event of Brexit, the final impact on GDP and its signage will be determined largely by the charm and skill of the team put together to negotiate future trade agreements. 

What is hardly discussed is the impact of Brexit not on the UK but on the EU. This is the real elephant in the room and where real risks to the global economy lie. The furore over Grexit demonstrated the turmoil that the potential exit of a (tiny) member state could have on the far larger EU. 

The exit of the UK in this context is a far more damaging hit. The UK is both the second largest economy (17.6% of the EU) and net contributor (£8.5bn in 2015) after Germany. Europe can ill afford such an exit, as its economy remains fragile in the face of a persistent deflationary environment and an uneven halting recovery. Beneath the surface, the complex web of debt that haunted Europe remains alive and well, despite bank deleveraging. 

Brexit weakens the sovereign guarantee and credit backing for many European nations, opening the door to another raid by bond vigilantes. Further, it leaves Germany isolated as the sole country capable of bailing out others if needed. That is a tough ask, given recent worries about fiscal prudence and the growing tensions between Germany and the ECB. 

In this volatile mix, Brexit may leave Germany feeling even more isolated. Germany is now beginning to question the European project – a national bout of soul searching exemplified by the rise of AfD (Alternative for Germany), a far right populist party that is Eurosceptic and anti-immigration. Since launching in 2013, its popularity has grown rapidly. Today, it holds seats in eight state parliaments and has about 12-14% of the vote.

The tail risk here is that a Brexit only accelerates either a German exit as the price demanded for bailouts becomes politically unpalatable or a renewed attempt by Germany to reassert control over the European project. The latter unfortunately would only accelerate anti-European sentiment among other nations.  

The National Front in France is already campaigning for ‘Frexit’ and a return to the franc. It won the largest share of the vote in recent regional elections – nearly 28%. Across Europe, eurosceptic parties are on the rise, all supporting a refocus on domestic priorities and a weakening or outright rejection of the European project. Brexit provides them with a template. It forces the EU to put together a process and create tangible terms for exit. It also enhances the bargaining power potential leavers. Once opened, this ‘exit’ genie may be hard to put back in the lamp. 

Much as QE quantitative easing became conventional, EUxit may well become a reasonable policy option for EU leaders as they seek to minimise domestic pain. Solidarity be damned. 

Bob Swarup is principal at Camdor Global Advisors, a strategic investment and risk advisory firm. He can be contacted on swarup@camdorglobal.com

Key macro risks

Geopolitical and socio-political
Probability: 
Impact: Medium to high

Political risks are elevating, as economic nationalism rises and international co-ordination falters. Brexit looms large, with only a few weeks to go till polls open, and within Europe, clear tensions are emerging between Germany and the ECB. In the US, Trump’s victory in the Republican primaries emphasises the shift towards isolationism and labour protectionism, a nuance also appearing now in Hilary Clinton’s statements. Tensions over China’s push to own the South China Sea are set to escalate as the Permanent Court of Arbitration in the Hague is set to rule on the first of several disputed island territories, in this case between China and the Philippines.


Economic
Probability: ↑
Impact: Medium to high

Developed economies are generally long in the tooth now when it comes to the business cycle and the next recession. It is no longer a question of if, but rather when and how best to manage the economy through it. Will we see the further proliferation of negative rates?

In the US, earnings may have beaten expectations but productivity is falling – for the fourth time in the past six quarters. Meanwhile, wages are rising and will continue to rise, once minimum wage hikes are taken into account. That is negative for corporate margins, profits and ultimately share prices. Also, the rush of private capital into the debt markets has boomed and there is a huge overhang of dry powder looking for debt homes. Leverage continues to increase and we expect covenants to weaken further. 


Financial markets
Probability: ↓
Impact: Medium to low

Markets have stabilised in recent weeks, as central bankers (including in the US) reiterate dovishness and amplify the monetary methadone. But beneath the surface, fragility is increasing. The yield curve is firmly in the lower-for-longer camp, exacerbating liabilities and ALM mismatches and continuing to fuel the crush for yield among investors that has typified the past half decade. Assets are buoyed technically once more, but we expect bouts of volatility as markets periodically question the efficacy and power of policymakers. Emerging markets continue to be driven by two things alone: how will China resolve its souring debt pile; and will their currencies fall further against the US dollar?


Other
Probability: ↑
Impact: Medium to high

The rise of the robots is also leading to the rise of economic patriotism and labour protectionism. The minimum wage hikes and their repackaging as living wages are one example. The obsession with migrants is another. There is a growing clash between technology and toil, which threatens to derail potential future drivers of growth at the expense of social stability today. We note the march of the unicorns (tech start-ups valued at over $1bn) may also find missteps as investors question the multiples. 

The word ‘climate refugee’ is also about to enter the popular lexicon. The US recently welcomed its first climate refugees, the Biloxi-Chitimacha-Choctaw tribe, as their island home was claimed by coastal erosion. This will be a growing theme, not just for societies (for example, the fractious battle over water rights in many countries) but also for investors. For instance, 46% of the assets of the 17 largest REITs lie in areas prone to flooding and cyclones. 

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