A Hard Brexit: Can It Be Stopped?

Brexit – Britain’s departure from membership of the 28-nation European Union – appears to be about to happen after 3½ turbulent years of preparation and political drama. It’s set to occur at Halloween, the day of the ancient Festival of the Dead… October 31.

It was supposed to happen on March 31, but the EU agreed to a six-month delay because the British parliament refused to approve the divorce agreement between the UK government and European negotiators.

The main sticking-point has been how to manage the future relationship between Northern Ireland, an integral part of the United Kingdom, and the republic of Ireland, an integral part of the European Union, without the imposition of a “hard” border – customs and immigration controls – between the two territories.

There were some other issues such as provisions for continuing sovereignty of the European supreme court over the UK in adjudicating certain disputes that could arise between London and Brussels after Brexit.

Three times the British House of Commons was asked to approve the “deal” concluded between its government and the EU, and three times it refused to do so, the first refusal delivering the worst parliamentary defeat in history for any British government.

Eventually the prime minister, Theresa May, was forced to resign by her own Conservative party (not by parliament), to be replaced by the charismatic Brexit leader Boris Johnson. Now prime minister, he has promised to implement Britain’s exit from the EU membership on or before October 31.

The next few weeks are certain to be marked by intense political turbulence.

The nation is evenly divided between those who want to leave the European Union (Brexiteers) and those who would prefer to stay within it (Remainers).

Brexiteers are divided between those who want the divorce to happen even if t at happens without an agreed deal to manage relationships after the divorce, and those who are opposed to a “no-deal” Brexit.

Remainers are split between those who want their country to cancel its application to leave and to stay full members of the Union, and those who accept that Brexit should happen to keep faith with the (narrow) majority that voted for it in the 2016 referendum, but want that to happen with an agreed divorce settlement.

The big questions now are…

► Can Johnson succeed in getting the European Union to amend the withdrawal agreement that May agreed with its negotiators, enough to overcome hard-line Brexiteers’ opposition and implement a so-called Soft Brexit?

► If he can’t achieve that, can he be stopped from implementing a no-deal Brexit on October 31?

The EU insists that while it’s open to making changes in the good-intentions political declaration accompanying the main agreement, it won’t change any of the specific terms of the agreement itself, in particular the so-called “backstop” that forces the UK to remain within the EU’s customs union until there’s an agreed means to avoid a hard border between the two Irish territories.

All commentators seem to accept that Brussels’ negotiators mean what they stay. They won’t budge.

Perhaps so, perhaps not. The European Union’s members are notorious for holding to tough negotiating positions in contentious disputes… then crumbling at the last minute, on deadline, making major concessions deliver successful conclusions.

Its negotiators bullied the May government into agreeing terms that greatly favour the EU. They won’t want to abandon all they’ve gained if they can save most by making one or two concessions.

Commentators like to make much of what a disaster a no-deal Brexit could be for the UK, ignoring how nasty it could also be for the EU. Bad news for its exporters. And serious loss of face for its leaders, who are likely to be blamed for making a mess of negotiating an exit deal with the Brits.

Why the Europeans have no room for concessions

However, there are also good grounds for expecting the EU to stick to its hard line driving the UK into a no-deal Brexit.

It’s politically very difficult for Brussels to abandon the backstop policy insisted on by the Irish government – or indeed any major change in the Brexit agreement, as it would require the unanimous approval of all 27 countries remaining in the EU. If Brexit occurs because the Brits choose to leave without approving the agreed divorce agreement, Europe’s politicians can easily dump all the blame on them for all the negative consequences.

The EU also knows that after a no-deal Brexit there will be years of difficult negotiations between London and Brussels to set the terms of future trade relations, but once against the EU will have most of the advantages. Britain will need deals with Europe more than Europe will need them with Britain.

I think there’s only a 10 per cent chance that the Europeans will agree to any last-minute concessions enough to make possible a with-deal Brexit. I also believe that Johnson has always known that a no-deal Brexit is inevitable. It just suits him to fudge the issue with maybe-positive talk while he plans for the inevitable.

Can those who hate that prospect, stop him?

There is speculation that he can be stopped by parliament, or even by the courts. But I don’t see how, for one reason that almost everyone seems to overlook – Johnson doesn’t have to do anything to implement a no-deal Brexit. It’s the default.

Legally, under European law, it must happen on October 31 unless one of four things are done, none of them likely:

► London and Brussels agree to an amended deal and the British government asks for another extension of the Brexit deadline to allow it time to get parliament’s approval and prepare for a smooth transition. Possible, but very unlikely.

► Anti-Brexiteers find a way to get parliament to pass a law, or challenge the government through the courts, to block Brexit.

Oliver Letwin, a well-respected Conservative Member of Parliament who is part of a rebel group seeking to stop a no-deal Brexit, says although what he calls “mechanical” problems can be overcome, the difficult thing will be “to get a majority in parliament for some other course of action at the last moment.”

I don’t see how Johnson could be forced to act. All he has to do is refuse to ask Europe for another deadline delay… which is within the power of the British government, no one else. If he does nothing, Brexit will happen automatically on October 31.

► Parliament could pass a measure cancelling its own application to the EU to end Britain’s membership in terms of Clause 50 of the Lisbon Treaty governing member-nation resignations.

This would amount to parliament’s violation of the promise made to the British  people to abide by the outcome of the 2016 referendum, and by both the major political parties in the 2017 general election to do so. That would be unthinkable. I wouldn’t expect for more than a handful of extremists to support such a proposal.

► Parliament could pass a vote of no confidence bringing down the government and replacing it with one more amenable to a negotiated arrangement with the EU and commanding a majority in parliament for such a policy. This might work as the governing coalition only has a voting majority of one in the House of Commons.

Labour faces a difficult choice

But I think it unlikely that the opposition Labour party would initiate or support a vote of no confidence at this time. It is not likely to do well in any consequent election. Both major parties are extremely unpopular. In a by-election in Wales last month the Conservatives’ vote fell 10 per cent compared to what it polled in 2017 –- they lost the seat — but the Socialists did even worse. Their vote was down 12 per cent. A general election now would certainly deliver many seats to the centrist Liberal Democrats.

The Labour party is currently riven by internal divisions. Its leader Jeremy Corbyn appears to be losing control and its leadership struggles to resolve a nasty controversy within its ranks over anti-Semitism. The party is also so divided over Brexit that it makes more sense for it to await Brexit’s happening, after which it can blame the Conservatives for implementing a no-deal exit and its apparent negative consequences.

Finally, a general election now wouldn’t stop a hard Brexit on October 31. The government could prevent its happening before early November… after Brexit.

Major Risks to Watch Out For

What are the key factors to watch if you want early warning that things are going badly wrong and posing risks to your investments beyond those implied by a moderate slowdown?

Eoin Treacy of FullerTreacyMoney offers these suggestions…

► Property markets. There is a temptation to look at the US housing market and think it is getting pricey, so there must be a bubble. However, new building has lagged significantly in this cycle, consumers are much less leveraged, and lending standards have been much tighter. That doesn’t mean prices can’t come down, but a crash is unlikely.

It is probably more relevant to monitor property markets in London, Hong Kong, mainland China, Australia and Canada, all of which are at extremely high levels relative to wages after having benefited enormously from quantitative easing.

► Where are the biggest dangers for the world economy? Apart from those bloated property markets, the big risks are in US municipalities, the US and European governments, China’s municipalities and shadow banking sector, and highly leveraged corporate balance sheets.

Leveraged loans are the asset class which has expanded most over the past decade. They are one of the primary sources of funding for the speculative ventures which have proliferated across just about all asset classes. In the US, Senior Loan ETFs sold off very heavily in December. Although they have largely recovered, that was a foretaste of what selling pressure is likely to look like in a real credit event for the sector.

The vast quantity of outstanding debt that is one notch above junk grade represents a threat to the wider debt markets. High yield spreads are probably going to be the most reliable indicators of stress in the corporate sector in this cycle.

► China also represents a significant risk. Standards of governance have been deteriorating for years, and the hubristic drive to achieve global dominance in economic, political and military arenas is backfiring.

China has high leverage, a property bubble, liar loans, rising defaults, a slowing economy, an increasingly leveraged consumer, and is losing friends internationally, with rising domestic inflation, slowing auto demand. It’s running a record budget deficit… but needs to keep stimulating to avoid a recession.

When we think about where there is scope for policymakers to make mistakes with dire consequences, it’s most acute in China.

► Perhaps the most important indicator to monitor is the stock market. The primary Wall Street indices recently hit new highs.  Providing these continue to hold above their respective 200-day moving averages, we can give the benefit of the doubt to the hypothesis that we’re still in a bubble.

These threats are well-known and are the reason that globally not one central bank is raising interest rates. Faced with the potential for bear markets in a significant number of asset classes, simultaneously, global monetary authorities have chosen to further inflate asset bubbles.

However, their willingness to do so virtually ensures that when the denouement eventually arrives, it will be larger, deeper and more wide-ranging than if these policies had not been followed. The renewed demand for gold is a clear signal that investors are beginning to hedge their bets.

Why This Hedge Fund Giant Now Favours Gold

Ray Dalio, the founder and now co-chief investment officer of the world’s biggest hedge fund, Bridgewater Associates, has shocked many investors by publicly advising them to start investing in gold, if they’re not already doing so. His new public position is credited with giving enough of a boost to the yellow metal to drive its prices up out of the range in which they’ve been trapped for six years.

It’s worth examining why he believes now is a good time to add gold to your global investment portfolio, especially if you’ve bought the standard arguments that gold is a foolish investment because it gives no income yield, and is not likely to deliver bigger capital profits than other assets.

Dalio predicts that the world will soon make a paradigm shift from the investment environment it’s been in since 2009 marked by easy-money policies – ultra-low interest rates, “printing” money and massive buying of bonds – on a mind-boggling scale.

These policies are increasingly less effective in delivering the favourable economic effects they’re designed to achieve, and are by their nature increasingly self-destructive. Money and credit are being pumped into the hands of those who need to find somewhere to invest it, but that drives up asset prices, which in turn drives down the future nominal and real returns of those assets, making them less attractive investments.

As you probably know, interest rates have been driven so low that $13 trillion worth of global bonds are now traded at negative yields. Investors, instead of expecting to earn some income from holding them, are prepared to pay their issuers, usually governments, for security… certainty of full repayment of capital when they mature.

There is too much debt and too many non-debt liabilities such as those for commitments to pensions and healthcare. Those will worsen as new bonds offer yields too low to finance those commitments.

Dalio says that central banks’ doing more printing and buying of assets, producing more negative real and nominal returns, will lead investors increasingly to prefer alternative forms of money – such as gold – or other storeholds of wealth. (He does not identify those other alternatives).

He thinks it highly likely that within the next few years central banks will run out of stimulants able to boost economies and markets when they are weak. And that an enormous amount of debt and non-debt liabilities such as pensions and healthcare costs will come due, but there won’t be an adequate supply of investable assets to fund them, because the yields of those on offer will be too low, or even negligible.

As forms of monetary easing cease to work well, governments are increasingly likely to resort to other measures — the most obvious ones being currency depreciations, large tax increases and bigger fiscal deficits paid for with “printed” money. Such circumstances will probably increase conflicts between the capital haves, their wealth threatened by very low or negative investment returns in currencies that are weakening, and higher taxes, and socialist have-nots angry about failure to deliver on promises made to them such as adequate pensions.

There will also be greater external conflicts, mostly between countries about how the global economic pie is to be divided up.

“Governments are likely to continue printing money to pay their debts with devalued money… I suspect that the new paradigm will be characterized by large debt monetizations that will be most similar to those that occurred in the 1940s war years.” Bonds will “provide bad real and nominal returns for those who hold them.”

Which investments will perform well in a reflationary environment accompanied by large liabilities coming due to be met, and significant political conflicts?

Dalio says “most people now believe the best ‘risky’ investments will continue to be equity and equity-like investments such as leveraged private equity, leveraged real estate and venture capital, and this is especially true when central banks are reflating. As a result, the world is leveraged long, holdings assets that have low real and nominal expected returns. I think these are unlikely to be good real-returning investments.

“Those that will most likely do best will be those that do well when the value of money is being depreciated, and domestic and international conflicts are significant, such as gold.”

Most investors are underweighted in such assets. Therefore, it would be “both risk-reducing and return-enhancing to consider adding gold to one’s portfolio. Gold is an effective portfolio diversifier.”

When monetizations of debt and currency depreciations “eventually pick up,” that will “test how far creditors will let central banks go in providing negative real returns” before they move into other assets.

Ultra-Low Yields: More Pain Than Gain

About one third of the world’s government bonds, and one quarter of the global total (governments plus corporates) are now trading on negative yields. Instead of earning income from their invested capital, investors are increasingly willing to pay governments and the soundest companies for capital security.

Current yields on all maturities of Swiss state bonds out to 2064 are now negative. The global total of negative-yielding bonds has now reached $15 trillion, which includes $1 trillion of corporate paper. Even Greece, hardly a country that you would expect international investors to consider low-risk, has seen the yield on its ten-year bonds fall below 2 per cent.

The main reason for negative and ultra-low yields is massive buying of bonds by central banks to drive down the cost of credit to encourage companies to borrow more to invest in expansion, and consumers to borrow more to spend, and thus boost economic growth.

A major negative consequence of this policy is that people who need income from their savings are being squeezed. There’s such a surplus of money driving down interest rates that banks in some countries – Switzerland and Denmark for example – have started charging clients for leaving large amounts of cash in their accounts.

Blackrock’s Rick Rieder says the European Central Bank should stimulate Europe’s sluggish economy by buying equities.

The concept isn’t a new idea. The Japanese central bank has been doing it for years on a massive scale, so much now that it owns about three-quarters of exchange-traded funds, and is a major shareholder in 40 per cent of the nation’s listed companies.

It would be a departure for the ECB, which has been creating money to buy €2 trillion of government bonds and offering prodigious cheap loans to private-sector banks, but hasn’t ventured into shares.

Equity purchases, says Money Week’s Merryn Somerset Webb, “could be a neat way to compensate European Union residents for the past decade of extreme monetary policy. If you are a German saver faced with making negative returns on cash deposits for the rest of your life, a stock market bubble might make you feel a little better.

“It might even prompt a little of the wealth effect that works so effectively in the US to prompt consumer spending.”

Poland Makes a Big Investment in Gold

Poland’s central bank has almost doubled its gold reserves and announced that it plans to shift almost half its gold from the Bank of England in London to its own vaults in Warsaw. In the first half of the year it bought 100 tonnes of gold, increasing its holdings to 229.

The National Bank of Poland has not explained why it wants to move its gold out of the UK. But the decision isn’t much of a surprise. Since the Bank of England froze Venezuela’s gold holdings in its vaults because of international division over which is that country’s rightful government, all countries have become aware of the risks they face if their foreign reserves – currencies as well as gold – are held abroad in nations that may decide to freeze them when imposing geopolitical sanctions.

European countries are the world’s strongest believers in holding their international reserves in the form of gold. Germany, France and Italy hold 54 per cent of their combined reserves in the yellow metal. Poland has missed out until recently. Even after its latest purchases the proportion of gold in its foreign assets was only 8 per cent.

Interesting to see that of the $2.6 billion of inflow into ETFs in July – the biggest since March 2013 – the overwhelming majority ($2 billion) were into North American funds. The increase in Asian funds… a mere $37 million.

Shift to Safety: a Wise Play?

There are signs since the double shock earlier this month of another round of anti-China tariffs by the US, and Beijing’s seeming anti-America cheaper-currency response, that investors are getting keener on lower-risk equities.

Utilities, for example, are “classical alternatives” to cycle-sensitive stocks such as banks, says the FT’s Richard Henderson. Electricity and water companies may be dull and slow-moving, but they “churn out dividends from safe, commanding market positions.

“NextEra Energy, the largest utility in the S&P 500 basket of blue chips, has outperformed the broader index by 20 per cent over the past 12 months.”

However, investors are paying twice as much for such “bond proxies” as for the more economically exposed cyclical assets. This may be a mistake. In the 2008 crisis defensive stocks also did poorly, their profits falling by up to 40 per cent.

There is growing concern that it is becoming more difficult to keep corporate earnings on a growth past. Three main reasons are…

► The trade war between America and China. Tariffs are raising costs.

► There’s a cyclical downturn in demand for the technology giants such as Apple and Intel which have been accounting for so much of earnings growth.

► Costs are starting to rise significantly, particularly in the US. Because of developing shortages, businesses have to pay more for labour. Inventories are building up. Capital investment fuelled by the tax reforms now has to be paid for.

Why are shares in other major markets valued so much less than those listed in America, particularly when the negative real interest rates in Europe and Japan justify equity valuations much higher than in the US? “Instead,” Mark Hulbert writes in the Wall Street Journal, “these markets are priced 20 to 40 per cent cheaper.”

The disparity, says Eoin Treacy in FullerTreacyMoney, is almost completely explained by America’s dominance in technology companies and the success of its megacaps (think of Amazon, Facebook, Google), in particular the way they have made the transition from highly-cyclical businesses “into the subscription business model, which smooths out cash flows and brings predictability.”

Cashflow that comes with both growth and reliability “is exactly what investors want” in an environment of low yields.

America has such businesses; the rest of the world, far fewer.

Investing in Singaporean REITs

Swiss commentator Marc Faber says that although he’s “somewhat concerned” about his exposure to emerging-market bonds, because global economic weakness could hurt this asset class, “if interest rates continue to trend down or stay low, these bonds have a relatively high yield… and are therefore relatively attractive.”

This is also true of Singapore and Hong Kong real estate investment trusts. Since the beginning of this year Singapore REITs “have performed superbly. They are up, with dividends included, by an astonishing 18 per cent.

“I find the yield of around 5.5 per cent on Singapore REITs to be appealing in a world of almost zero or below zero interest rates.” They are also a play on emerging markets, which according to the well-known US investment group GMO are likely to outperform developed markets over coming years.

America a Divided Nation

A decade of loose monetary policy has benefited the older baby boomer generation, who have seen their assets appreciate, but at the expense of the younger Millenials, who cannot afford to get on the housing ladder, says the FT’s Rana Foroohar.

“One of the big political battles will be over who gets what share of what looks like to be a slower growing pie in what appears to be a slower . economy.”

Another battle will be between capital and labour. Rising wages are starting to take a bite out of corporate profits.

“It has taken trillions of dollars in unconventional monetary policy to cook up relatively small wage increases. And for many Americans the gains are immediately eaten up by increases in healthcare premiums or prescription drug prices.” These are now hot topics on the campaign trail – one of the reasons why there’s now broad support for higher taxes on the wealthiest.

“The age of wealth distribution is coming and will have major investment consequences.

“The value of US equities has probably peaked. Hard assets like gold, other commodities, housing, even art – anything in fixed supply – may benefit relative to the equity and debt of multinational companies.”

Tailpieces

Dynamite: The US budget deal to lift federal spending caps for two years, as it doesn’t provide for its being funded by additional revenue, is going to add $1.7 trillion to public debt.  That’s on top of the tax reform, which added $1.9 trillion to the debt pile.

The big point about this deal is that it received cross-party support. The measure was approved in the House of Representatives by 219 Democrats, but only 65 Republicans.

With both fiscal and monetary policies structured for easing, not squeezing, against a background of full employment and a stock market valued on the pricey side, says Eoin Treacy, “there is clear scope for valuation expansion [higher share prices], which could lead to a bubble.”

Duds: A new study of 1,970 actively-managed equity funds reveals that those charging the highest fees deliver the poorest returns to investors. The investor rights campaign group Better Finance reported that over the ten years to 2017 for each 100 basis points increase in their fees the funds’ net-of-fees returns fell by an average of 68 basis points.

“Fees are nearly singlehandedly to blame for the disappointing returns of many actively-managed funds,” says Better Finance’s chief exec Guillaume Prache. Investors should rather invest in passive (index-tracking) funds or directly into equities.

However, it’s also true that funds pursuing the smart beta strategy – allocating funds according to factors such as value and momentum, described as a halfway house between active and passive investing – have failed to live up to expectations over the past decade, according to a new study by Research Associates.

Global value funds underperformed their benchmarks by 3.83 percentage points over ten years; momentum funds actually lost money by 1.38 per cent over the period.

Pension funds: By the end of last year the combined funding deficits of 230 state pension plans in America grew to almost $1.5 trillion. The reason, of course, is that in most states the politicians have failed to provide adequate funding for future benefits they voted for. Only two states, Wisconsin and South Dakota, have fully-funded schemes because they introduced flexible policies that allow them to cut payments and/or increase contributions when a market downturn lowers investment returns.

Vietnam: As the China/US trade war escalates, global business giants are increasingly planning to reduce their dependence on Chinese factories. The country seemingly best placed to benefit is Vietnam. Samsung, a leader in closing down its China factories, now makes one-third of the $220 billion products it sells annually worldwide in Vietnam, where it employs 100,000 workers.

Fat cats: Between 1978 and 2016 chief execs’ compensation in the US, based on their realization of options, increased by 937 per cent. But production/non-supervisory workers saw their compensation rise by just 11 per cent.

Climate change: Over the years all climate models have consistently been wrong forecasting the future, predicting the Earth will get much hotter than it did, reports Wall Street Journal columnist Holman Jenkins. The exception has been the model developed at the Russian Academy of Sciences in Moscow.

Wise words: 

There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know. John 

Kenneth Galbraith.