Our recommendation – Changing gear in Europe. This is our revised Investing Insights advice for clients based on the ongoing Brexit issue. 

Note: This is general advice only and takes no account of your personal circumstances. This advice has been previously emailed to our impacted clients. 

In anticipation of thes Brexit vote in the UK, we share with you advice provided to our clients some time ago. We continue to believe the Remain cap will win but the significant downside risks are just not worth taking.

We recommend that our clients sell their diversified European exposure immediately before the UK referendum to decide whether Britain should leave or remain in the European Union due to be held on Thursday, 23 June 2016.

For most clients, this diversified European exposure will not represent a major portion of their overall portfolio.

For clients who hold individual European stocks we can discuss these on a case by case basis.

Summary of key reasons

1.     Brexit will lead to political and economic uncertainty in the UK

2.     Breaking up will be hard to do

3.     Brexit will be just the start and not a resolution for Europe

4.     We watch the bookies and so should you

Timing important

As long standing clients know, we create our client portfolios based on long term, strategic asset class allocation. We use our agreed target asset allocation for each client as a reference point which we can objectively measure back to over time. We create the core of the portfolio and blend it with our researched based, high conviction investing ideas.

In addition to strategic asset allocation, occasionally we will take short term allocations or ‘tilts’ based on our understanding of the behaviour of markets.  This is one instance where we require clients to take urgent and immediate action.

Regular readers of Investing Insights will know that for the past 6-12 months we have preferred international exposure to developed Western markets over the more volatile Asian markets (eg China). This has resulted in clients holding overweight positions in the US and relatively small holdings in Japan and Europe.

What has changed?

We believe the tide in the UK over their future in Europe has changed.

We have long watched this situation safe in the view that while ‘Brexit’ (Britain leaving Europe) was possible it was not probable.  We took no view on whether Brexit was the right or wrong thing to do for the UK people, but we did have a view on the potential economic impact of Brexit.  In our view, Brexit was a significant economic risk with large potential downside and with little upside.

Recent UK opinion polls and shifting gambling odds however have indicated that Brexit is far more likely than before and this concerns us for the reasons outlined below.

Key reasons in detail

1.    Brexit will lead to political and economic uncertainty in the UK

a. Economic uncertainty

A successful Brexit vote will not resolve the economic uncertainty. Ongoing uncertainty will linger for an extended period as the terms of the departure are hammered out between the UK and Europe.

In a short period the UK (the world’s 5th largest economy) will need to negotiate trade agreements with the EU itself, the USA, China, India and smaller countries like Australia.  Half of the UK’s trade is with the EU so that will be the priority while the UK’s remaining trade with other countries is governed by agreements struck with the EU.  It’s hard to see how a smaller UK trying to negotiate with larger trading blocs can be an economic advantage. It’s even harder to see how a jilted Europe would be in any mood to offer the UK generous trade concessions.

b. Political uncertainty

While the UK’s Prime Minister David Cameron called this referendum (as a result of an election promise in 2015), he does not support leaving. Nor does the Opposition Labor Party or the other minor parties – the Liberal Democrats, the Scottish National Party or Plaid Cymru (a Welsh party).

Most of the support for Brexit comes from within David Cameron’s own Tory Party, the Democratic Unionist Party (a Northern Ireland party) and a smaller right wing party called UK Independence Party (UKIP).

Up to 50% of Cameron’s own party including 5 of his own Cabinet members openly support Brexit. Importantly, one of his main rivals for the Prime Ministership Boris Johnson has opportunely taken a leading Brexit role to help further his leadership ambitions.

With this political background, we believe a successful Brexit vote will leave Prime Minister Cameron’s authority both in the UK and within his own party fatally wounded.  We can easily see an Australian style situation arise wherein even if Cameron doesn’t resign, the ongoing political instability will inevitably result in the replacement of an incumbent Prime Minister by their his own party.  You could call this ‘the Australian disease’.

So potentially the UK will have political upheaval at the top level of government exactly at the same time it needs political stability to make crucial economic decisions to help resolve the economic uncertainty.  We can’t see this potential double whammy ending well.

2.    Breaking up will be hard to do

If the Brexit vote is successful, the mechanics of a divorce from Europe are unknown and untested. Put simply, no country has ever left the EU (or previously the EEC) and so there is no precedent to follow.

What is certain is that after 40 years of effective marriage, the separation will be tricky and likely messy. Like any marriage there will be acrimony and threats of recriminations. There may even be questions over the future of the ‘children’ (read Scotland which favours remaining in Europe and could look to leave the UK).

The ‘exit clause’” in the EU treaties (Article 50) sets a 2 year deadline but it is vague and has huge gaps. Insiders in Brussels joke that it was “designed never to be used”.

If the UK votes to leave, they will immediately lose their power in the EU.  It won’t be Downing Street setting the terms of the divorce, it will be the remaining 27 EU leaders in Brussels who will each have national vetoes. The UK can choose to leave but they can’t dictate the terms under which they will leave.

It could be entirely rational for the EU to set down a marker for other countries who may seek to leave the EU in the future by punishing the UK. By making the UK’s departure as economically and politically painful as possible this may prove a credible threat to others considering the same. This approach, while rational, would certainly not benefit the UK.

3.    Brexit will be just the start and not a resolution for Europe

Through the Greek crisis in recent years, we have long argued that Europe could not afford to let Greece leave the EU despite its economic weakness. We argued it was in Europe’s best interests to absorb the cost (whatever it was and it was always going to be small given the relative small and shrinking size of Greece’s economy) of Greece’s woes.  We believed that if Europe let Greece fall, this would resolve nothing and merely shift the view of markets from Greece to the question of who would be next.  Letting Greece fall would simply set off a game of European dominoes, in our view.

Given this, we continually argued in recent years that Europe would muddle its way through and so investors should not be concerned. They would do whatever it took to keep it under control.

The UK situation is completely different and so too is our view.

Should the UK vote to leave, it will resolve nothing for Europe. Like Greece, the question will simply shift to who is next to leave? While we can’t see the next country being one of the 3 remaining major economies (Germany, France or Italy), nationalistic pressures in countries like Sweden, Belgium or Austria could lead to similar Brexit discussions.

So we believe Brexit could place incredible pressures on the entire post World War 2 European project that could undermine its success. Brexit will be just the start of its problems and not a resolution.

4.    We watch the bookies and so should you

Anyone who knows us at Quantum Financial will know that we are not gamblers. Frankly we view gambling as a losing game that only the house can ever win.

Having said that, we are more than aware that gambling can actually offer some clues to the likelihood of certain events. The odds that the gambling houses offer on a certain event happening (or not happening) can be translated into implied probabilities.

If you’ve been following the upcoming Australian Federal election, you may know that a whole series of polls have had the two major parties pegged at between 48% to 52% either way. It seems neck and neck.

However, if you look at what the betting houses are offering gamblers who bet on the election, it’s a completely different story. They offer the LNP winning at $1.20 and Labor at $4.50. Using some basic maths, these payoffs imply odds of a LNP victory at 83% and a Labor victory at 22%.

So while the polls seem tight, the money is flowing towards the LNP retaining government. We have long believed in the benefits of following the money.

Likewise when it comes to Brexit.  When we woke up the other morning, the implied probability of Brexit occurring had ballooned out from 18% to 36% virtually overnight.

Risks of our recommendation

Despite our recommendation, we still believe it is far more likely that the UK will vote to remain in Europe. We believe that in the final week ‘the silent majority’ will swing in behind the status quo (ie remain situation). If this is the case as we expect, there may actually be a rebound in European markets relieved by the economic resolution to the problems.

However, the significant problems highlighted within the EU and in the the UK as part of the EU will not go away over night and the ride on markets will continue to be bumpy.

Given the increased chance of Brexit in recent weeks, we do not think this is a risk our clients should be taking for a relatively immaterial portion of their portfolios.

Our action plan moving forward

We recommend our clients sell their diversified European exposure and retain the proceeds for the short term in cash. If the situation in Europe is resolved quickly, we may look to reinvest back into Europe.

More likely, we will watch the unfolding situation in Europe in the coming weeks and potentially use this cash to reinvest opportunely if other opportunities arise or simply to use it to re-weight your portfolio in line with our upcoming half yearly full Investing Insight report.

Disclaimer: This is general advice only and takes no account of your personal circumstances. This advice has been previously emailed to our impacted clients.