Slowly, but surely, a UK vote to leave the European Union is becoming more likely. In any referendum, the Yes campaign (in this case called Remain) have to argue a positive case. But this is not happening in the UK – and the vote is less than 3 months away. Unsurprisingly, therefore, as the poll above from the Daily Telegraph shows, voters are currently evenly divided on the issue.
The Leave campaign have an easy job in these circumstances. They simply have to argue it will be “business as usual” after the vote for the UK, Europe and the global economy. But a moment’s thought makes it hard to imagine anything less likely, given the weakness of political leadership across the continent.
1. NOBODY IS ARGUING THE CASE FOR THE UK TO STAY
UK voters need to be given positive reasons to vote “Yes”, as happened in the 1975 referendum. Yet, so far, nobody seems capable of doing this, and so the Leave campaign is gaining momentum:
- The Cameron government is too scared of its Eurosceptic supporters to put forward the benefits of membership, and the Labour leadership are too busy fighting each other
- This means the Leave campaign is free to claim that voters have nothing to lose by voting to leave
Another problem is that the two major parties – Conservative and Labour – no longer command the same confidence with voters. In last year’s election, they won only 2/3rds of the vote between them. By comparison in October 1974, ahead of the 1975 Referendum where the UK confirmed its EU membership, they won 75% of the votes.
Equally important in 1974 was the fact that the 3rd party – the Liberals – won 18% of the votes and also argued for a Yes vote. But in the 2015 election, the Eurosceptic UK Independence Party came 3rd with 13% of the vote. So voters are no longer being given a consensus view by politicians whom they trust.
2. OTHER EUROPEAN GOVERNMENTS HAVE SIMILARLY LOST THE VOTERS’ TRUST
We can see the same issue with other major EU governments:
- The 2 main French presidential candidates won only 56% of the first round vote in 2012; even in relatively stable Germany, the 3 main parties* only won 75% of the vote in the 2013 election
- By comparison, the 2 main French candidates won 75% of first round votes in 1974, and the 3 main German parties won over 90% of the vote in 1976
- Equally significant is that today, as in the UK, the 3rd party in both countries (National Front in France, Alternative für Deutschland in Germany) are Eurosceptic
- The impact of this political fragmentation can also be seen in Spain, Portugal and Ireland, where recent elections confirm the practical difficulties of even forming governments today
This lack of political consensus would make it very difficult to have a quick Treaty renegotiation to maintain the status quo if the UK did vote to leave – in fact, it might prove impossible for the other 27 countries to agree anything at all. As former EU senior diplomat and NATO Secretary-General Javier Solana warns:
“Brexit would deal a major economic blow to the UK and the EU. But that is not all. It would also weaken the security, foreign policy, and international standing of both parties.”
3. SCHENGEN’S COLLAPSE HIGHLIGHTS THE PROBLEMS AHEAD
One example of the potential chaos ahead can be seen in the continuing collapse of the Schengen Agreement, as I warned in my BBC interview last summer, This used to allow borderless travel across large parts of the EU – but even the town of Schengen itself now has border controls on the German side.
According to the European Commission, Germany, France, Austria, Denmark, Norway and Sweden have all re-introduced border controls as a result of the Syrian refugee crisis and the bombing tragedies in Paris and Brussels. Already, therefore, Europe has moved away from “business as usual”. Few people now expect the Schengen deal to survive. And as the Commission’s President warned 3 months ago:
“A single currency does not exist if the Schengen fails.”
Against this background, it is very hard to believe that politicians would sit down calmly to develop new arrangements which basically preserved the status quo with the UK. A Leave vote is far more likely to make the UK the scapegoat for all of the EU’s current problems. It would also create major problems for European financial markets themselves, as I argued last month:
- How high would UK interest rates have to rise, to persuade investors to buy its large and growing debt?
- How high would Eurozone interest rates have to rise, to compensate investors for the risk of buying the debt of increasingly unstable governments?
- And in the worst case, what would be the impact on an already uncertain global economy, if financial panic were to hit the UK and EU economies?
- How would a new US government, under President Trump, or President Cruz, or President Clinton or President Sanders react?
None of us can know the answer.
We can of course hope that all these problems will magically disappear. But the risks are already much higher than even 3 months ago. And yet at the same time, there is widespread complacency about the likely outlook. It is a classic case of an outcome being so painful, people prefer to simply ignore the potential for it to happen.
It is hard to avoid the conclusion that we are living in a very uncertain, and potentially very dangerous, times.
* Germany’s Christian Democrat party is allied with Bavaria’s Christian Social Union party, with the main opposition party being the Social Democrats
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 61%
Naphtha Europe, down 58%. “Demand for naphtha continues unabated amid a relatively light spring cracker turnaround schedule in Europe”
Benzene Europe, down 51%. “One factor to consider with regards to the price volatility in Europe is the growing lack of liquidity in recent years”
PTA China, down 41%. “Demand from the downstream polyethylene terephthalate (PET) and polyester fibre industries are expected to peak in the April-June period”
HDPE US export, down 34%. “Expectations of tightening supply because of the onset of the plant turnaround season.”
¥:$, down 11%
S&P 500 stock market index, up 4%
The excellent new Spielberg movie, Bridge of Spies, vividly captures the building of the Berlin Wall in 1952. It also reminds us of the excitement when the Wall fell, and European borders reopened after 47 years.
Now, Europe’s borders are closing again, pressured by vast Syrian refugee movements and terrorist massacres. France, Germany, Austria and Sweden have all “temporarily” reimposed border controls within the Schengen passport-free travel zone, whilst Hungary’s fences, as the photo shows, even resemble those of the old Iron Curtain.
Even more worrying is that the European Union will today discuss suspending the Schengen zone for 2 years – essentially confirming the return of national borders between major countries such as Austria and Germany. In addition, it will increase the pressure on Greece to leave Schengen – whose financially crippled administration has been swamped by the arrival of 700k refugees and migrants this year.
It is only 3 months since I was interviewed by the BBC on the threat posed to business by a Schengen breakdown. Since then, the threat has become even more serious, with the President of the European Commission warning:
“A single currency does not exist if the Schengen fails.”
The problem is Europe’s failure to agree a centrally-organised mechanism to enforce its border. This parallels its failure to implement a centrally-organised system of banking supervision, which is at the heart of the ongoing Eurozone debt crisis:
- National governments will not work together to establish both mechanisms as quickly as possible
- Thus the problems get worse, and allow euro-sceptic parties across the EU to claim exit is the only solution
Of course, Europe is not alone in trying to avoid tackling difficult issues. One of its problems is that these twin crises are taking place at a moment when the cracks are showing in key parts of the global financial system – Emerging Market debt, and the high-yield Western “junk bond” market.
As Carl Icahn warned recently, the central banks’ policy of low interest rates forced investors to take on more risk – but also meant investors became involved in markets they didn’t understand
- They all wanted to believe in the concept of the Commodity SuperCycle: but now commodity exporters in a wide arc from Brazil through S Africa, Australia, Asia, Middle East and Russia are suffering as this myth is exposed
- The Institute of International Finance has warned their $27tn of debt means companies “in many emerging markets will face difficulties in servicing their debts and in incurring new debts to support economic growth. It is another headwind adding to the slowdown in growth that emerging markets face.“
- A similar problem is affecting US energy investors: they bet $1.2tn on the idea that oil prices would always stay at $100/bbl, but now defaults are becoming common
- High yield, triple-C rated debt has fallen 6% so far this year, whilst double-B debt now yields 8% – its price has fallen by around a half in the past 2 years (bond prices move inversely to yields)
Of course, one could argue that these investors simply got what they deserved, and simply illustrate the principle that “a fool and his money are soon parted”. But the big money is being lost by pension funds and other major investors.
Thus the problems in debt markets add to the social and economic problems created by the Eurozone debt and refugee crises. Unless these are quickly resolved, they threaten to overwhelm the progress made since the fall of the Berlin Wall. It could be a very difficult 2016, if policymakers continue to duck discussion of the key issues.
Most traders prefer to be with the crowd – then, at least, they can’t be personally blamed if things go wrong. Instead, they can claim that “nobody could have seen the change coming”. So as we approach year-end, many traders are becoming very nervous as the Great Unwinding of policymaker stimulus means that markets start to go their own way:
- As I discussed on Monday, US 10-year interest rates have seen a major increase, even though the US Federal Reserve has kept short-term rates at zero
- Even worse, German interest rates have continued to fall as the European Central Bank keeps buying: the 10-year yield is just 0.48% and the 5-year yield actually negative
The same worrying pattern can be seen within the US S&P 500 itself – the world’s major stock market index:
- It is only up around 1% on the year, but the FANG tech stocks are living in their own bubble
- Facebook, Amazon, Netflix and Google are up around 60% as a group
This divergence is very typical at the end of a major market move. Momentum wanes, and trading becomes concentrated in just a few areas. Traders rush to be part of the remaining action, creating a bandwagon effect on prices. In the end, of course, the bubble can often then burst with a bang. Shanghai provided a spectacular example in the summer, when it fell 45% between mid-June and late August.
What happens if a Shanghai collapse happens in the West next year? As we all know, the Chinese government rushed to protect their market, just as Western governments rushed to protect markets in 2008. Would they, could they, do this again? This is the question explored in an excellent Financial Times analysis by John Dizard last week:
“We now have a bit over 14 months until a new US president and Congress are sworn in. Until then, the national policymaking process will not be functioning. If a decision on financial laws or regulations has not been made yet, it will be on hold until early 2017….That means that you will have to come up with your own contingency plans for rescue from systemic risk…This is why those better-informed or better-connected large institutions are setting up credit lines and access to collateral in advance. Unless you move relatively soon, rather than wait for actual trouble to develop, that is credit and collateral that you will not get.
“I am quite confident the banks will stay open. What about your portfolios? Will they be open?”
The uncertainty means that even major companies are showing signs of strain. US banks have had to postpone the planned $5.5bn sale of debt to back Carlyle’s leveraged buyout of Veritas from Symantec. And giant telecoms company Vodafone was forced to withdraw a planned 30-year bond issue. Nobody is suggesting Vodafone is going bust – but their problem in raising cash from the market is a warning sign of potential problems ahead.
It is not difficult to make the case that a false market has been created in the S&P 500:
- 70% of all US trading is now being done by the high frequency traders, and these modern-day highwaymen have no interest in providing liquidity if markets do start to close down
- Equally worrying is that earnings have been been supported by record levels of share buybacks, usually aimed at boosting the value of CEO’s share options
- The Wall Street Journal says buybacks are “up more than 80% from a decade ago“, whilst Marketwatch has reported:
“The sums involved are staggering. In 2014, S&P 500 companies bought back $553bn in shares, in addition to paying shareholders $350bn in dividends. Total returns to shareholders equalled $904bn, a bit shy of reported earnings of $909bn.”
The chart of the Boom/Gloom Index above confirms that market confidence has dropped sharply since the beginning of the year – it is currently almost half its January peak. And there are clearly headwinds for earnings and buybacks:
- Earnings are already being hit by the strength of the US$
- Buybacks have often been financed by borrowing, which is more expensive at today’s interest rates
What we know is that the first 3 phases of the Great Unwinding are now underway: the fall in the oil price, the rise of the US$, and the rise in US 10-year interest rates. Only the 4th is still to come – the bursting of the S&P 500 stock market bubble. And as I will discuss on Friday, political risk is rising at the same time. It could be a difficult 2016.