April 10, 2017

On March 29, British Prime Minister Theresa May formally invoked Article 50 of the Lisbon Treaty, signaling the official start of the withdrawal process from the European Union (EU). The actual triggering of Article 50 is unlikely in and of itself to have any significant impact on markets in the very short term. The approximate date has been known and markets have had time to reach their new equilibrium levels since the Brexit referendum put these events in motion last June. In this note, we’ll look at the longer-term macro and portfolio implications of the UK’s withdrawal from the EU.

Game Time

How the withdrawal process under Article 50 unfolds is anybody’s guess. The emphasis here is on “guess”, which we’ll return to later. However, since the referendum, our view has been that the best framework for analysing the negotiation is through the lens of the negotiating power of the counter- parties. Students of game theory will recognise this as a “sequential, non-cooperative game.” In this sense, “sequential” simply means the UK and EU will put forth demands and requests which will evoke reactions and counter-demands over time. The “non-cooperative” part is self-explanatory.

The initial positions of the parties are somewhat straight- forward: The UK wants out of the EU but for obvious commercial reasons would like to maintain free (or at least preferential) access to the EU market for the purposes of trade and services. To maintain the integrity of the EU and to avoid setting a precedent that could further injure the Union, the EU can’t cut a deal that is more advantageous to Britain than its remaining 27 other members. Complicating matters, the UK would like to negotiate trade access concurrently with the withdrawal process. To maintain their leverage, the EU wants to negotiate the withdrawal first and address trade and market access later.

How will the dominoes fall? Our baseline assumption is that consistent with her public statements, PM May will prioritize taking back control of immigration/refugee policy over unfettered access to the EU market. As both the free movement of people and the free movement of goods and services are core and inseparable rights of EU law, the EU will be obliged to deny preferential market access to the Brits. While there are lots of other moving parts to the negotiations, this is the crux of the “hard Brexit” scenario: The Europeans cannot confer upon the Brits some core rights of the union without the offsetting responsibilities associated with the other rights. In principle, the Europeans simply cannot allow the UK to enjoy the benefits of membership without shouldering the associated responsibilities and costs.

Nash Crash

If access to the single market is then off the table, the UK’s next move is to take an even harder line on the “Brexit bill” – the €50-60 billion the EU claims the UK owes for financial commitments already made under the union. The EU may seek remedy for this bill in international courts, which could prove difficult to win and even more difficult to enforce. The UK can counter by reducing its footprint in broader European military, intelligence, and security obligations. Back to game theory, this Hard Brexit scenario, where the parties essentially agree to disagree, represents a kind of “Nash Equilibrium” – the likely best set of actions given the counterparties’ known demands. The end game becomes a (relatively) clean separation of the UK from the EU operating under less favorable World Trade Organization (WTO) rules.

Of course, none of this is set in stone. (Did I mention we’re all guessing?) If PM May modifies the hard stance on migration, the range of potential outcomes is far more diverse. Politically, however, this seems unlikely given that the majority of voting Brits (52%) opted to “leave” based largely on sovereignty and migration issues while many of them (perhaps naively) don’t see or fear the economic consequences. This oversimplified outcome says nothing of the potential complications from issues like another Scottish independence referendum, the ratification process of both the EU and UK parliaments, or the potential for a “transitional” agreement to mitigate the economic damage.

Portfolio Implications

What will this mean for investor portfolios? Here are some thoughts.

Muted Volatility: As many others have said, “The world doesn’t end that often.” We expect the gyrations of the withdrawal process to create some additional volatility, but Brexit is unlikely to wreak havoc in the global capital markets. First, the two-year Article 50 window means that markets will have some time and space to adjust to new realities. Negotiations will unfold over time, allowing market pressures to adapt along the way rather than build to a breaking point. Second, as intractable as the EU and UK positions may seem, the counterparties are bound by a longer-term symbiotic relationship. In addition to the broader security and labor implications across Europe, the EU is the primary destination for UK exports and the UK is a major market for EU exports. Merkel and May should take a page from Kennedy and Khrushchev – avoidance of mutually assured destruction is a powerful motivator. However imperfect the ultimate outcome is, having a “weak sister” across the channel is in nobody’s best interest militarily or economically. This recognition should reduce the likelihood of worst-case scenarios.

Not So Obvious: If a hard Brexit is the current conventional wisdom, then the trade du jour is short GBP. This view, however, is probably too simple. Again, markets to some degree have already begun to adjust to the new potential downside outcomes since the referendum last June. From pre- referendum levels, the British pound is already down 11% and 16% against the euro and U.S. dollar, respectively, and down 13% on a trade-weighted basis. Trade flows may be hampered somewhat, but WTO tariff levels vary widely by industry, so the recent depreciation of the pound may already alleviate some of this pain. Outside of trade dynamics, it is hardly clear that GBP will depreciate significantly as the outlook for growth and real interest rate differentials between the UK and Euro zone remains murky. (Forecast growth rates for real GDP in the Euro zone and the UK are both around +1.5% for the next several years, while both the ECB and BOE are likely to contemplate reducing policy accommodation in early 2018.) If negotiations turn ugly, additional GBP depreciation could occur, but we don’t think this should be a foregone conclusion.

Alpha over Beta: As for the equity market, UK stocks have struggled since the referendum on a local currency (GBP) basis returning less than 1% while the U.S. (S&P 500®) and Europe (MSCI Europe ex-UK) have returned approximately 13%.

Relative valuations based on forward earnings estimates are broadly in line with the rest of Europe; both look somewhat cheaper than U.S. stocks reflecting Brexit fears as well as broader political fears across Europe. However, as we’ve been saying for some time, few equity markets are cheap on an absolute basis. The equity story of Brexit may be more about alpha – security-specific opportunities – than beta. The details that emerge from the negotiations are likely to create distinct winners and losers in the UK economy and stock market. These include financial service companies dependent on future passporting restrictions, labor-intensive industries reliant on access to EU workers, and export-heavy firms subject to the new trade regime and FX fluctuations. For equity investors, these micro factors are likely to have an outsized effect on corporate performance leading to increased dispersion among the stocks in the indexes – and opportunities for active managers.

Hold Steady: Ultimately, the investment impact of the Article 50 withdrawal process is a “second-order” problem. Capital markets are unpredictable. You can often get the event right and still get the market’s reaction wrong. That’s a “first-order” problem. But if the likely outcome is highly uncertain (remember, we’re guessing) AND you don’t know what the market’s reaction will be, now you have a second-order problem. This means that making large portfolio bets on highly uncertain Brexit outcomes is probably a bad idea.