British voters decided to leave the European Union on June 23, potentially ending 43 years of membership. At BCA Research, our investment philosophy is that, at critical junctures such as this one, it makes sense to take a cold shower and resist making any rushed investment decisions. Brexit, if it were to go ahead as currently planned, has the potential to change the world. But how that will impact investors is a question that will take time to answer.
There are, however, some broad conclusions that we can begin to draw from the U.K. referendum. The most obvious is that the decision to leave the bloc strikes at the stability of the European Union, which is one of the core post-World War Two institutions that have kept peace in the Western world for the past seventy years. As such, its implications – if London actually follows through on the referendum – will be profound.
The U.K. referendum will also have implications for the global distribution of power. The world lacks global leadership as the U.S. wanes in relative geopolitical power. From an investor’s perspective, this is a negative trend, since “multipolarity” is both empirically and theoretically proven to be a harbinger of inter-state conflict. In recent years multipolarity has largely been mitigated by the persistence of Cold War-era institutions that allow the U.S. to amplify its power. The EU, NATO, and financial institutions such as the IMF and the World Bank are such entities.
By leaving the EU, the U.K. does not necessarily undermine this global order, but it does show that a 43 year-old geopolitical relationship can end. It will weaken the EU as a global player, given the U.K.’s formidable “hard” power, and aid Europe’s geopolitical rivals. And if it leads to the disintegration of the EU — which is not our base case at BCA Research despite the conventional wisdom — it will massively increase global geopolitical risk. I suspect that my clients in the financial industry will have to brush up on obscure geographical references – such as Alsace-Lorraine, Silesia, and South Tyrol – by the time this process is over, if it ever begins.
This would be a profoundly negative outcome. It is not an exaggeration to say that generations that thought they would never see another armed conflict on the European Peninsula could be in for a surprise.
On the domestic political front, the rise of anti-establishment movements – particularly in the U.S. and U.K. – has been one of the most talked-about themes in the financial community in 2016. However, it is unclear how to price any risk of non-centrists coming to power. Investors have had widespread disbelief that populism could win any major vote in any major economy. I can attest to this personally, as it has been difficult in recent months to get many of my friends and clients in London City to take Brexit seriously. I have received more questions about Austrian, Portuguese, and Spanish elections in the first quarter of 2016 than about the upcoming U.K. referendum.
I suspect that the focus over the next several months – in terms of assigning risk premia – will remain on Europe. However, the reality is that middle class malaise may be the most advanced in the laissez-faire economies of the U.S. and the U.K., especially now that the “debt supercycle” (a major BCA Research theme for the past 30 years) is no longer available to assuage the pain of decade-long stagnant wages.
In a way, anti-globalization policies are merely the right-of-center approach to redistributing income. It is now clear that the last three decades of free trade and laissez-faire policies have led to growing income inequality as winners of globalization captured most of the gains and losers were left to face the consequences, and the painful adjustment, without much redistribution. Take the vote on EU membership, which saw all of England vote to leave except for the financial capital of the world, London.
For Bernie Sanders and Jeremy Corbyn – as well as Podemos in Spain and SYRIZA in Greece – the answer is to dial up the redistribution. For Donald Trump, UKIP, and Marine Le Pen in France, the answer is to wall off their economies and hope to stave off redistribution by shifting the blame for tepid growth to the outside world. Both policies will be equally bad for equity markets and risk assets, as they will erode profit margins one way or another.
The 1990s consensus on deregulation, privatization, low taxes, budgetary discipline, and free trade is over. The median voter is shifting away from laissez-faire and demanding economic policies that contravene the 1990s “Third Way” consensus (Diagram 1). According to the median voter theory, policymakers will shift with the median voter to a new center and will not shift back to the old center once they capture power.
DIAGRAM 1 – So Long “Third Way” Politics!
This is bad news for emerging markets, in particular. It is also bad news for the shares of global companies who have benefited tremendously from the steady dismantling of barriers to the free flow of goods, capital, and labor.
In the long run, the decline of globalization will also usher in higher inflation. As my team and I wrote in 2014, globalization has effectively produced the largest supply-side shock in the history of mankind. As such, it is a major deflationary force. But if policymakers respond to populism with protectionism and fiscal expenditure, then the deflationary forces of globalization will reverse. Perhaps sooner than the market expects.