Tuesday, March 01, 2016

The vexing question of Brexit

Macro Man has refrained from commenting too much thus far on the Brexit issue because he wanted to do a bit of research and gather his thoughts.   On the surface, the issue would appear to be right in his wheelhouse: a key public policy debate in his long-time country of residence that could fundamentally alter Britain's place in Europe and the world, politically, economically, and financially.  However, it is his strong belief that he has no edge in what he would generally characterize as his bread-and-butter modus operandi of figuring out the outcome and market implications of the referendum.  There is simply too much uncertainty to have a strong view on the outcome of the vote and especially the medium term implication for Britain vis-a-vis its reshaped relationship with the European Union.

In cases such as this, Macro Man finds it useful to make a list of what we know....and also what we don't.  This helps to assess where we are and where some of the balances of risk may lie.

What we know

1.  The UK recently reached an agreement with the rest of the European Union that allows it avoid the EU commitment towards further integration, place some curbs on benefits paid to migrants, and affords the UK a modicum of autonomy in regulating the City.

2. The date of the referendum is June 23rd.

3. Several prominent Tories (including Boris Johnson, Michael Gove) are in favour of leaving the EU.   Thus far, the majority of the Cabinet is in favour of staying in the EU, and the majority of backbenchers are in favour of leaving.

4.  The Labour opposition officially support remaining in the EU.

5.  This referendum is essentially the raison d'etre for UKIP, the 3rd largest vote-getter in last year's general election.

6.  The latest polls currently have the "Remain" campaign with a lead as high as 10 percent.   However....

7.  UK polling has been exceptionally unreliable lately.   Pre-election polls signally failed to anticipate either the margin of victory of the "No" vote for Scottish independence or the Tory majority in the last general election.

8.  The UK currently runs a large trade deficit with the Eurozone, in contrast with a surplus with the rest of the world.

9. The Eurozone runs a trade surplus with both the UK and the rest of the world.  However, the surplus with the UK has historically been very high relative to its balance with the rest of the world.

10.  The UK is the 3rd largest net contributor to the EU budget after Germany and France.

11.  The UK has generally influenced EU policy in ways thought to be favoured by markets.   Its absence could result in a vacuum filled by less (classically) liberal viewpoints.

12.  Virtually every major global financial institution has a presence in the City.   A number of them were hurt by the "jump function" action in EUR/CHF last year and are wary of being caught out by a similar gap move.

13.  If the UK votes in favour of Brexit, the government will notify the EU. at which point Article 50 of the Lisbon Treaty applies.  Article 50 is 261 words long, which is exactly half as long as this post was through the end of the previous sentence.   Essentially, the UK has two years to negotiate the terms of its new relationship with EU, during which the status quo will apply.   When either these terms have been agreed or two years have passed, whichever comes first, the UK's membership of the EU (and all benefits and obligations thereof) will cease barring a unanimous vote to extend the negotiation period.

This essentially ends what we know, and leaves a vast swathe of terra incognita for policymakers, businesses, and markets to confront.

Here's a by-no-means-conclusive list of what we don't know:

a.  The outcome of the vote.   Per point 7 above, there will probably need to be a polling margin of 10%-plus relatively close to the vote date for people to have confidence in the outcome.

b.  The outcome of the negotiations with the EU in the event of a Brexit vote.  This is really the key issue amongst a host of many.     It's nowhere near as easy as "let's just knock out a free trade agreement on the back of an envelope and be done with it."  This page from Global Counsel does a nice job of summarizing the various options, none of which are perfect...and many of which entail obligations that form part of the objections to remaining in the EU to begin with!

Source:  http://www.global-counsel.co.uk/system/files/publications/Global_Counsel_Impact_of_Brexit_June_2015.pdf

c.  Particularly, the role of the City in conducting business with EU customers will be uncertain.

d.  The timing of any new set of agreements could take a substantial amount of time.   The CEE countries negotiated for 14 years before the agreement was reached admitting them to the EU.   While this type of negotiation will clearly not take as long, that nevertheless gives you an idea of the time scales that the EU works upon.

e.  Who will fill the vacuum of the UK's contribution to the EU budget?

f.  Will the EU swing towards a more statist policy tilt if Brexit implies that economically liberal countries do not have enough votes to form a blocking minority?

g.  What sort of impact will pre- and post-Brexit uncertainty have upon financial markets and the real economy?

The most important issues fall squarely in the "things we don't know" list.   In many ways, uncertainty is the only certainty.  As such, positioning on the basis of factual post-referendum outcomes looks to be a fool's errand...hence Macro Man's reticence thus far.

That being said, there is nothing to stop us from speculating on how the market will behave in the run-up to the vote.  In particular, given the vast amount of uncertainty it seems likely that many firms with potential exposures will take a "maxi-min" approach, seeking to maximize the utility of their potential worst-case outcome.

It is for this reason that anecdotal stories have already emerged that bank option desks have been told "don't be short vol" even as they get paid out of options by corporate hedgers and speculators.   In a sense, it kind of doesn't matter what spot does....the need to not be exposed trumps everything.

We saw a micro version of this more than two decades ago, when Quebec voted on declaring independence from Canada in 1995.   The vote was too close to call, and indeed missed passing by the narrowest of margins.   As you can see, implied vols traded at a healthy premium to realized vol, particularly in the run-up to the vote.

While it's true that cable vol has been bid up, it's equally the case that it doesn't seem that extreme.   After all, isn't it reasonable to expect that a fundamental UK-specific issue should engender more volatility (or at least more demand for protection) than the European crises of 2010 and 2011?

While the selling of cable likely seems overdone, it is understandable if people feel that they need to hedge- particularly into a currency outside of the whole debate.   Yes, cable is cheap on an historical basis but if people need to sell it they will continue to do so.  Given the uncertainties described above, Macro Man simply doesn't feel confident enough in others' behaviour (which is ultimately what matters in the investable horizon, not the eventual outcome) to have a strong view on cable.

He feels somewhat more strongly about EUR/GBP, on the other hand.   It's rallied more than 10% since late last year;  while the initial impetus may have been the ECB given what's happened to real rate differentials it seems clear that much of this is a Brexit premium.

Yet from the above it seems clear that Europe may have as much to  lose from a Brexit as the UK does, and potentially more if the likes of France is able to push through a sclerotic Gallic agenda to confound the wheels of commerce.  The UK's perennial trade deficit with Europe has ballooned in the post-crisis period, representing a millstone around the neck of the British economy and a rare jewel in the rocky outcrop that is the Eurozone economy.

Yet it's not as if there isn't some potential for substitution away from Eurozone imports.   For fun, Macro Man looked at one sector in particular-autos.  In his experience, Britons have always had a rather snobby attitude towards Japanese cars, particularly relative to the rest of the world.  Perhaps its due to the viewpoint of the erstwhile cast of Top Gear, or perhaps it's a long-standing thing.  In any event, he perused Autotrader.co.uk and used the volume of cars listed as a proxy for underlying demand.  He looked at six different brands of mid-range autos of broadly comparable quality:  three Asian and three manufactured in the Eurozone.  The volumes by percentage are set out in the pie chart below; Asian autos are shaded various shades of blue, while European marques are more earth-toned:

As you can see, the three European brands dominated, comprising 65% of the listings.   Macro Man sense checked this against actual 2014 sales figures, which showed the European  brands capturing 63% of the sales.  This suggests that the Autotrader listings are a reasonable proxy for general car demand by brand.

Now let's compare the same listings for the same six brands in South Africa.  Now obviously, South Africa's demographics are very different from those of the UK, though perhaps less so among those that buy and sell cars over the Internet.   Macro Man wanted to find a market that was serviced by all six brands, was outside of the Eurozone, but wasn't so close to the Asian market that the Japanese and Koreans would obviously dominate.   He would have preferred to use Russia, but the Russian site didn't provide listing totals by brand.

Anyhow, the South African results are set out below:

As you can see, in this case the Asian marques dominate, garnering 52% of the sales,  even though VW actually has a higher share than in the UK.  What's to stop them gaining a similar foothold in the UK, particularly if a post-Brexit negotiation turns ugly?

Obviously, this is a totally unscientific anecdotal example, but it does seem fair to observe that the French car brands (and SEAT, and Skoda, etc) punch well above their weight in the UK, and the Asians punch below theirs.  One might think that this position might come under at least some challenge in the event of a Brexit.

From Macro Man's perch, it seems likely that market participants will come to question the potential impact of a a Brexit upon the Eurozone and trade accordingly.   It is for this reason that he favours fading the recent rally in EUR/GBP as alluded to yesterday.  That the ECB might finally deliver some sugar next week is just icing on the cake.

The question of the Brexit is a vexing one, and uncertainty is the order of the day.  It's a long and winding road from now until June 23rd...and potentially for many years thereafter.  Speculators have the advantage of not having to trade until and unless they want to, and the luxury of ignoring the uncertainty if they choose to...unless it filters through to other markets, which is eminently possible.

Probably the most important advice that Macro Man can give is to know what you don't know, and trade accordingly.


  1. Well thought.
    Re the polls. I agree they are probably miles out. Straw polls of those I know show interesting results. Conversations start with talk of how we will stay in but by the end of the evenings when guards are down the actual votings of intentions devlared by th individuals involved is for out. The socially acceptable caring sharing expression is seen to be to remain as leavi g is seen to be selfish, nationalistic and uncalculated(=stupid). We therefore have the declaration bias seen in the last general election re declaring Tory voting intentions. They are v similar. I am also convinced that the caring sharing bias stretches one level higher to even participating in polls. I always refuse and I am sure I am not alone, whilst my caring sharing wife always indulges anyone who calls, even if selling Sky Box insurance as she doesn t want to be rude and "they only have a job to do".

    But the real surprise to me has been the intellectual calibre of many I know who declare an out vote. Captains of industry, professionals, and generally the sort of people who on an institutional level have to be seen to be toeing the line and even end up signing thise corporate 'we must stay' letters. I am convinced that those corporate commitment letters are as reprentative of true staff opinion as those diversity and community commitment statements issued by large inatitutions.

    'Trade wars' has been mumbled about as the next dangerous theme for the world. A Brexit and resulting agreements/or not would be a revealing fracture on the veneer revealing true intentions towards the smooth flow of global trade.

  2. My shout: Dependence on EU structural funds outside London and the overall pro-EU business stance in the City will carry the stay vote over the line, just! But it will be a close call, much too close for comfort.

  3. Instigating a property crash is my No#1 reason (if I'm honest its pretty much my only reason) for voting Out. If I can topple or destabilise the current civil service/tory/lab/establishment economic policy of deliberately disenfranchising the under 40s then I will; And damn the consequences.

  4. Wait a minute, didn't the Greeks vote to leave the E.U last year, and yet they are still in the E.U!

    Also, if the U.K voted out of the E.U, would the Scottish separatists not call another referendum with the excuse to stay in the E.U ? Haha, that would be British/Scottish eh?

    Anyway, I would bet on two crickets humping so I will probably go long GBP.USD around 1.35 and maybe buy some more if there is a no vote at say 1.15-1.2. It is probably getting a bit hysterical already, but pricing probably not great to go long yet.

  5. Britain cannot opt out of Europe. It has always been part of Europe except the relatively brief period when the dominance of seapower and Empire gave it an independent and lucrative role. Britain is the balancing power in Europe to Germany and France. It must and will remain so, and with Europe now assailed by such conflicting forces, it is essential that Britain remains embedded in the EU treaty structure to effectively pursue its long- term interests. To imagine it can do so better outside that structure is just pie-in-the-sky.

  6. MacroMan,

    I agree on your overall conclusion of uncertainty is the only known and at this stage it makes sense to be cautious.
    We make the assumption that Camerons latest agreement (your point 1) will be upheld by the EU mandarins.
    What if the UK votes for Brexit on the basis that we would then be in a better bargaining position to get a deal to then stay?

    With respect to car sales, doesn't it depend where the cars are actually built?
    Vw build Golf, Jetta and commercials in SA, Ok, Bentley (under VW umbrella) are built in the UK, but I am under the impression that tradition helps global sales?

  7. Anon 12.19 If UK votes out they are out. There is no bargaining to remain once you are out.

  8. Pol: Does it not depend on the political agenda ?

    why can't a no vote be sent to a committee for a few years ?

    No is can still be no, but in 2026, when it can be sent to another committee to meet with other E.U committees.

  9. @ Booger read article 50. After 2 years they are out without a unanimous vote of the European Commission (good luck with that)

  10. "11. The UK has generally influenced EU policy in ways thought to be favoured by markets. Its absence could result in a vacuum filled by less (classically) liberal viewpoints."

    The horror. The horror.

  11. Agree with booger - it all depends on whether the EU really wants to keep us in or not - esp with regard to point (e) - the budget gap. The history of EU referenda is that normally you have to give the 'correct' answer. If you don't, you have to have the referendum again until you do. See various referenda in Ireland, Denmark etc for example. What this or that treaty says is really not important.

    Personally I think there is no chance of a leave vote anyway. Same as Scottish independence vote - people will complain about Westminster/tories/EU/france/whatever but in the end the benefits are largely token but the risks potentially big.

  12. Also, linked to the fx rate debate, some data points for UK Gilts.

    In January, overseas investors sold £6.3b net gilts, highest since 2014.
    Every month UK govt. has been issuing Gilts to cover the cash deficit. Dec was £6.7b, Jan was £9.5b and Feb £5.8b
    Coverage ratio in 20-Jan auction was poor at 1.07 but recovered to 1.90, 2.08 and 1.52 for the next three auctions.
    The recent drop in the pound is enough to wipe out some years worth of coupon payments for foreign holders.
    Gilts have had a run-up this year but approaching the last peak reached in early 2015

    I wonder if a short turn is coming. Might be a big ask with Bunds on a tear this year and deflation stalking Euro area. But the gilts seem to be running out of steam.

  13. I am short Gilts here TraderJim ... I think bonds of all colours are an accident waiting to happen, but I am, also, a broken clock, so I'll stop now ;).

  14. And I am short my seasonal favorite of Bunds. On top of the general -vs for bonds I think too much is priced into the Draghi rescue.
    european PMIs today no great problem and EU unemployment falling nicely. Eurozone lowest unemp since 2011 and for whole EU is lowest since 2009. Of course, on topic, a brexit would make thise EU figures worse!

  15. Apparently trump mania has so much momentum he can bid up the price of highosts yield, financials, transports and the whole stoclass market! !!

    The internal rotation continues but at least this time ISM was better, especially if you look at new orders. I'll be watching non man pretty closely

  16. Damn auto correct. My apologies.

  17. Damn auto correct. My apologies.

  18. Apparently trump mania has so much momentum he can bid up the price of highosts yield, financials, transports and the whole stoclass market! !!

    The internal rotation continues but at least this time ISM was better, especially if you look at new orders. I'll be watching non man pretty closely

  19. Yes abee its a yuuuuuuuge rally !

  20. I doubt anyone "subscribes to the fact that our markets are totally manipulated by algos," because I can't even figure out what that means. Are you saying that the price of every stock on every US market is set at any given moment by a powerful computer run by an extremely wealthy secret society?

    I remember reading how early in the crash of '29 a group of bankers and other muckety-mucks tried to make the faltering market rally by putting in fairly large bids for US Steel and a few other blue chips. Everyone was rooting for them to succeed, yet they managed to change the direction of the DOW for barely an hour. And that was when the market was a fraction of the size it is today. BWDIK?


  21. Take it to ZH. I don't want it here.

  22. This rally from the low the 1800s in the S&P has been remarkable. Between China, Oil, geopolitics, Euro, Brexit, BOJ, ECB and Fed, the issues have continued to pile up.

    One of the signals I use in my trading is hotel occupancy rates. The Calculated Risk Blog had this to say two days ago: "The red line is for 2016, dashed orange is 2015, blue is the median, and black is for 2009 - the worst year since the Great Depression for hotels. 2015 was the best year on record for hotels. So far 2016 is tracking 2015. A solid start to the year."

    As such, I haven't sold any positions. I've added consumer discretionary, energy and nasdaq. I continue to add emerging market and Canada exposure to my positions.

  23. Interesting Mr. Beach, particularly given the airbnb effect as well.

  24. Here is the link:


    Unclear to me whether airbnb is stealing market share from hotels or expanding the market with different types of product (homes to shared rooms).

    Regardless, market turmoil in January doesn't appear to have caused a drop in the most hotel numbers (week of Feb 14-20).

    Anecdotally, in looking to plan a vacation with family during spring break and summer, I'm not finding any deals anywhere. As recently as 2012, nice deals could be found. Since 2013, deals seem to have disappeared for all peak travel weeks of the year.

  25. MrBeach you are correct. The bear thesis for US equities is utter gibberish, propagated by those of diminished intelligence. We will see a massive rally in US equities from here, taking out the 2015 highs in short order. There is already a rotation from bonds to stocks underway, & once this gathers momentum there will be no stopping it. I am 100% long.

  26. @MrBeach,

    Here are a few points I have on hotel occupancy: First it does look like a nice indicator for real economy; Then gas price/airline ticket price should be considered since it is cheaper for air travel thus low oil price might contribute to the high hotel occupancy. Also, the stock market has a weak wealth effect as a whole, so January's drop won't have an immediate impact on consumption, just yet.

    There are also a few other factors on lack of hotel deals besides the higher demand: higher minimum wages and higher rents/healthcare costs (for hotel employees) push the hotel operating cost higher.

    Anecdotally, the next big shock might be the rising inflation as MM had noticed in CPI/PCE. The haircut places had raised prices (about 25%) late last year after 5 years of unchanged prices. Now I live in the state with low costs of living and with the federal minimum wage. Haircut should be quite price elastic. So I think that Fed might change its tone in the next few months when they see the inflation expectation shots up.

  27. Mr Beach/anon 8:16 - I would be curious to know if any data breaks out the hotel occupancy rate trends attributable to business travel vs leisure, and if people are driving to hotels as opposed to flying - if the trends are diverging (just a hypothesis on my part) that may provide interesting color.
    It is certainly possible that 'experts' were a little too quick in dismissing the benefits of lower gasoline - I guess it wouldn't be surprising in a world where if a theory fails a visual test in 10 days, it is treated as utter garbage, and its demise seen as heralding the dawn of a new era.

  28. unloading some calls here in spx 1980-2000 "should" face some resistance i feel...overall still bullish generally but banking some cash...plans to buy dips - added to some bund puts....that could go pretty quick once qe announced i feel( had alluded to this yesterday)- in fact with credit coming in quite nicely the best risk on move looks short bonds i feel
    MM - good summary on Brexit - for my own self odds with bookies still 3/2 on...so I'm going with them- they did nail the scottish one as well- of course past performance and all that...
    and fully agree for now eurgbp best asymmetric bet followed by some short sterling short- though the number of times that short sterling has hammered me makes me not want to touch that puppy

  29. With a gain of 2.39%, the S&P 500 just had its best start to March in its history... looks like the buy the dippers here were right.

  30. The real economy might be doing OK, as referred to Mr Beach, which I agree, but in the stock market, forward EPS have declined pretty substantially. That is the warning sign for me and while ISM was positive, we need to see some > 50 numbers to really get surprises and EPS forecasts higher. Otherwise it looks like just a big regime change, where Value/ sold of stocks rally hard. Not saying it cant last a bit longer, as I think it probably will, but corporate health needs to improve a lot, IMO, for new highs

    But HY, Financials, Transports all rallying hard. US bonds/notes finally selling off (bunds less so). Oil stable and Risk FX all pointing in the same direction, so hard to fade at this point, IMO. But end of month/first of month moves are tricky. Not always to be trusted (as we saw last month)

  31. so my conclusion is still confused ;-)..