The economic fallout from a “hard” Brexit has been debated in the media for the last few months. When I say “hard Brexit,” I mean that the U.K. leaves the European Union without any deal about trade rules, movement of people or any other binding treaty rules concerning the contemporary EU/U.K. relationship. I have refrained from forecasting outcomes because they are beyond the scope of economic analysis since it requires using models built of questionable assumptions. The British have a long history of economic intercourse intertwined with the lines of commerce from its empire.
Yes, there’s a cat’s-cradle of economic and social ties that exist between Brussels and London but will these just simply disappear? That’s highly doubtful for in today’s modern economies global transnational corporations have developed tightly linked supply chains based on the high speed modes of transportation, helping to sustain just-in-time delivery. The BOE and ECB have presented dire forecasts for the U.K. but again, those are based on models with a poor record of forecasting.
Bank of England Governor Mark Carney has been predicting bad outcomes for the U.K. economy before the June 2016 BREXIT vote and has been consistently wrong. The U.K. economy, while not robust, has performed better than the EU economy as a whole.
In the London Telegraph on Jan. 31, there was an opinion piece by Ambrose Evans Pritchard titled, “Economists Angry At ‘Dangerous Handling’ of Brexit By EU.” The pieces cites a report by the influential IFO Research Institute and “warns that Brussels may be deluding itself in thinking that the EU has the upper hand in all respects.” The IFO is led by two German economists, Clemens Fuet and Gabriel Felbermayr, and the outcome it desires is a European Customs Association. Yes, the modeled outcome can be criticized for similar reasons for not knowing the assumptions upon which their work is based but it makes the foregone conclusions of dire outcomes for the U.K. suspect.
The BREXIT outcome is too dynamic of an event to state with certainty that the U.K. will suffer more than other actors. Will the weak POUND, lower taxes and a certain lessening of the Brussels bureaucratic regulations be a BOON to the U.K.? Will the Trump Administration act to move the U.K. to the front of the queue in a free trade association? We don’t know, which makes a “HARD” BREXIT a difficult investment forecast. But Europe OUGHT to be cautious for if the IFO research has validity, poor outcomes for the German economy can push Europe into a severe recession. Maybe Teresa May has a stronger hand than the popular narrative suggests. So much of what will ultimately play out will be decided in Berlin. The Germans are highly intertwined with the U.K. economy and, even more importantly, the Bundestag has the fiscal wherewithal to be able to cut taxes, as well as ramp-up domestic spending in an effort to prevent too severe a slowdown.
Even with negative interest rates in the EU, the Germans have room for fiscal expansion. What do I mean? Investors pay the German government for the privilege of lending it money. Based on EU rules of stability and growth, Germany is the only major European economy with the balance sheet required to deploy fiscal stimulus. The problem is that just this week Finance Minister Olaf Scholz noted that calls for increased fiscal stimulus will not be answered without consideration of “Schwarze NULL,” or black zero, which adheres to former finance minister Wolfgang Schaeuble’s concerns for balanced budgets. (And this is from a finance minister, who is a member of the Social Democrats.) Many people are very bearish on the DAX and other German assets, but in an economy with strong employment, a healthy export sector, strong fiscal position and NEGATIVE interest rates, where are domestic investors going to invest?
The technicals for the DAX and the Euro STOXX look ominous while the fundamentals provide a reason to be bullish. If negative interest rates in a positive growth economy cannot sustain an equity rally, why should the FED‘s recent pivot to PAUSE provide reason for the S&Ps to rally? As to the FED‘s newfound reticence to raise rates, it seems to me that the FED suddenly realized it was racing too far ahead of the world’s other central banks so the FOMC had to recognize that while the U.S. was experiencing stronger growth, global slowing may become a headwind to American economic forecasts. The bottom line is that the relative asset situation may favor those countries that have not experienced as robust asset appreciation as the U.S.
Lastly, as promised, here is the first episode of Futures TV Show. In the inaugural episode, Anthony Crudele and I discuss what is happening in the markets from a macro perspective and how the fundamentals are aligning with the technicals in U.S. Treasuries gold and the e-mini S&Ps. Pour yourself a glass of your favorite libation and enjoy!