Brexit: Reforming The EU Or EUR Break-Up by Fasanara Capital
Analysing short term prospects for markets seems to be the least contentious matter. The list of unknowns over the next 12 months has just got longer. To valid concerns over China’s credit crisis, Oil weakness / lack of future, EU banking sector (but it is really not just EU), S&P steep overvaluation against a far from robust economy (NFP trend declining will hardly be proven as an outlier), we now can add endless critical question marks:
- will the UK be granted access to the single market?
- will Scotland vote to leave the UK, will it veto Brexit?
- may Parliamentary elections in the UK avoid full implementation of Brexit?
- will Italy’s government now lose its own constitutional referendum in October?
- will the stalemate in Spain politics play in favour of populists’ parties?
- who will now win election in France (Presidential Elections in April-May 2017) and Germany (Federal Elections in August – October 2017)?
- will now Trump have a better chance at winning (US Presidential Elections on the 8th November 2016)?
- will the economy in Europe, Japan now go into recession, as business leaders postpone the few leftovers investing undertakings?
The only certainty from here is uncertainty. The natural state of markets will have to factor in blind navigation. The European economy was weak going into this event (zero-ish growth), it is fair to assume that it may get weaker now (sub-zero growth). Uncertainty is not liked by businesses and households, resulting into potential recessions. Uncertainty is hated by markets, often in history leading to steep sell-offs, although with decent time lags. As uncertainty is often associated with higher levels of volatility, large selling flows may also be automatically triggered by CTAs/Risk Parity/passive strategies, feeding the downside Beta. The natural direction for markets from here is lower, closing the disconnect to weak fundamentals on the verge of becoming weaker.
Brexit – Medium-Term: EU reformed or EUR break-up
We believe Brexit has worse consequences for the EU than it has for the UK. We see the UK going into a mild recession in the next couple years, but then emerge from it stronger relative to EU member countries and possibly with a more balanced economy. A referendum for independence and EU inclusion in Scotland may happen but at a point in time by which the EU may have crumbled further, making the chances of a leave vote up for debate. Meanwhile, on current trends, if radical changes in EU policies are not implemented fast, anti-establishment parties are likely to rise further and provoke a regime change, making the EUR break-up an ever more likely outcome.
Many observers seem to believe the EU has an incentive to be harsh on the UK and make the terms of a Brexit the hardest possible, so to make an example out of it and stem the rise in populists’ movements across Europe. That was the strategy pursued with Greece in recent past. We disagree and see such stance as the fatal blow to the EU, leading to disintegration of the currency peg within a few years.
Brexit is purely an accelerator of an EU disintegration trend that has been at play for several years now. It let the genie of disintegration fully out of the bottle now, and there is no way of putting it back in. Failure to recognise such trend may end up disastrously. There is no more room for mistaken policymaking from here, and the clock just got to signal we are in extra-time. EU would be better off acknowledging that climbing the wall of worry, avoiding disaster by narrow margins multiple times a year is no sound policy. It is both unstable and unsustainable, and as such will be discontinued by will (orderly) or by the unfolding of events (disorderly).
Conversely, if responsibility for the Brexit vote is shared across EU member states and particularly within its leadership team in Germany, if a radical change of policy is enacted, Brexit may have offered a most valuable window of opportunity for derailing the train before it hits the wall. In this respect, Brexit may be seen as the last canary in the coal mine, one last warning. The ability of listening to such last call, enforcing an urgent shift in trajectory, as opposed to continue obstinately on the current path, is what we hope may save the EU project.
What we need to asses then, is the direction Brexit negotiations take from here. We believe that to be the most important market driver over the medium term.
Two scenarios open up:
1. Reforming the EU, change collision trajectory at the eleventh hour
Starting in 2012, in analysing prevailing trends in debt ratios, deflation and crisis policymaking, we thought of a EUR break-up as inevitable, within 3-5 years (June 2015 Investment Outlook and July 2015 presentation, pag. 36-54, Apr2013 video: Is a Euro Zone Break-Up on the Way and Dec2014 video: Euro will be ‘dismantled’ in 3 years ). Critically though, Brexit may have offered a chance for a change in trajectory, which may help avert a break-up. The chief factor provoking a dissolution would be deflationary trend and the unbalanced policy mix played against it. Zero inflation is a death penalty to debt-laden countries like Italy or France. Fiscal austerity coupled with monetary expansion within a inhomogeneous block was always a three-footed table. Misdiagnosis of the EU malaise as due to a lack of structural reforms, as opposed to deficient global aggregate demand, led to a form of policymaking consistently missing policy targets (Deflation In Europe Is Just Beginning, September 2014). Now then, the chance is offered to take a different course of action, which would include:
Temporary Suspension of the Fiscal Compact
Banking Union completion via a deposit guarantee, in exchange for fiscal controls post-normalisation of growth rates/inflation
Allowing for state aid of troubled banking sector (e.g. Italy), before nationalisation has to occur anyway but at zero-periodic equity valuations
Programming substantial Fiscal Expansion, possibly Helicopter Money down the road (here our visualisation exercise for the market economy 2020), as ways of forcing income redistribution policies (Brexit vote had inequality, not just immigration, as key tipping factor). Deflation is the elephant in the room, that needs to be taken care of, or else all bets are off.
Democratic elections for Brussels’ bureaucracy-enabling functions
Diversion of Brussel policymaking away from red tape overdrive, clear endorsement of member states for most matters
2. EUR Break-Up Scenario
If the Brexit is seen purely as the huge misstep of one politician, Cameron, as opposed to the legitimate exercise of democratic power vis-a-vis an unstable, unsustainable, flawed EU construct, the EUR may break up. Humbly taking notice of the warning is paramount. Protracted failure to fix a problem often comes from the inability to recognise you have one. No failure can be sustainable in perpetuity, without consequences. The break-up of the EUR may otherwise be the price to pay to try save the EU.
Like the shoemaker’s wife in the Grimm brothers’ fairy tale ‘the Elves and the Shoemaker’ said: ‘let’s see what tomorrow brings’. Elves might save the day.
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Francesco Filia
CEO & CIO of Fasanara Capital ltd
