The UK political class is all in a flutter as the latest European Union referendum polls show an apparent rising tide of support for “Leave”. Having orchestrated the great and good into warning of catastrophe should a Brexit materialize, it would seem that “project fear” is not cutting through. I tend to have strong political convictions and perhaps for this reason I have a lousy record of guesstimating election outcomes. Since the UK referendum debate started, I always felt that the Brits would vote to leave, so no one would be more surprised if I was for once proven right.
The question for investors is how much a Brexit would matter. On the one hand bond yields are plumbing new lows, pointing to fears of a looming macro shock, yet the pound remains within its recent trading range. I must admit to having very little trepidation beyond the short term volatility that would ensue. My starting point is that I cannot remember a single incident of increased freedom being followed by a sustained decline in living standards—not one. And even ardent “remainers” would be hard pressed to argue that an exit from the regulatory and non-democratic EU monster would not boost economic freedom in the UK.
Of course the centerpiece of the scare campaign run by the men of Davos is that a Brexit would result in capital fleeing the UK, resulting in a collapse of the pound and general impoverishment for the population. So it is interesting to note that the pound is at about its purchasing power parity level versus Germany, which implies that it is undervalued by about 5% against France and by almost -10% versus Spain and Italy. On the same basis, sterling is undervalued by about -3% against the dollar. Hence, any decline in the pound from this level would make UK manufacturers and service providers highly competitive. Car factories in the Midlands would quickly start humming to the swift detriment of Wolfsburg and Munich.
Running a London-based money management business operated through Dublin would become far more profitable, as would the insurance industry. Both of these sectors should do well from less intrusive British regulation compared to the European hammer (and sickle). Consequently, once the situation stabilized after an EU exit, capital would quite quickly start flowing back into the UK.
So my advice is simply to let the Financial Times-following crowd work themselves up into a frenzy of pound-selling and should the result be for an exit, fairly soon afterward move in to buy the currency. As for UK equities, most of the big index components are banks, and commodity players, which will be affected in only a limited way by any change in Britain’s relationship with Europe. HSBC, for example, earns about two thirds of its profit from Asia, with almost 40% made in Hong Kong. The situation would be quite different for medium-sized UK companies which will see an immediate benefit from a cheaper pound so I would be a big buyer, just as I was in the aftermath of the UKs exit from Europe’s Exchange Rate Mechanism in 1992.
As for the bond market, I am admittedly not thrilled by the current low level of yields, but if the pound becomes cheap enough, investors should certainly sell bonds in the likes of Italy, Spain and France, and buy gilts.
All in all, I believe that a vote for Brexit would be a great day for liberty and for free markets, a bit like that achieved by Margaret Thatcher in the 1980s. I have no doubt that the 364 economists who signed the letter to The Times in 1981 condemning her macroeconomic policies would have sided with “Remain”. Two years after that letter was sent, the markets bottomed in April 1983 and UK equities entered a structural boom.
To summarize, if Brexit materializes, there will be dislocation, but it will offer an immense opportunity for those willing to take risks and extend the duration of their views. The end of horror is always better than a horror without end, runs the German saying, and it must be said that they are specialists in this topic.
By contrast, if Remain wins, the British caravan will maintain its slow crawl into Europe’s death valley and the participants would do well to remember Dante’s invocation on the gates of the inferno “Abandon all hope, ye who enter here”.
Founding Partner, Gavekal Research