Brexit – the end of the beginning

Following the Brexit referendum, there was a clear consensus in the UK government that no progress would be made in the withdrawal negotiations until November or December 2017. On this they have proved to be correct but for entirely the wrong reasons. British ministers felt then that Germany would not be paying attention to the negotiations until the results of their September elections and subsequent coalition discussions were settled. At that point the UK would meet with Mrs Merkel, sort out the main outline of an agreed deal based upon the pressure from German industry not wishing to lose a major export market. Germany would then tell the rest of the EU how it was all going to work out, and Europe would fall into line.
Instead the EU27 have appointed a negotiating team and given them a clear mandate. They have made it clear that the national governments would not get involved in negotiating with the UK. The wishes of German business leaders have been prioritised below that of the interests of both Germany and the EU as a whole. Mrs Merkel has given no indication of wishing to get involved in the Brexit talks.
Thus, until now the UK has barely proposed anything about what they wish to see as the outcome of the talks and have been content to let the EU set out their proposals. This is because of the divisions within the Conservative Party, which means that any public position of what the UK wants will incur the wrath of one half of the Party. The UK Cabinet has not yet even discussed the outlines of a trade deal they would like to secure, such is the divisiveness that any declared position will cause.
However, a critical point in the talks has now been reached. If at their December meeting, the EU27 decide that insufficient progress has been made in the Phase 1 discussions on UK payments, the customs border in Northern Ireland and the future rights of EU Citizens currently living in the UK, then the earliest point at which talks could start to discuss a transition phase and any future trade deal in Phase 2 would be March. Given that both sides have indicated that talks will need to end by November 2018 in order to seek all the national approvals required, this does not leave enough time to agree a meaningful settlement. December is the critical point in the negotiations, but not because there should be a new German government in place.
It is however, possible to see what would make an acceptable deal for the EU27, and in truth, they may just present it to the UK on a take it or leave it basis. It consists of:
a) A transition period of about two years ending between December 31 2020, the current EU budget round, and June 30 2021, the end of the current term of the European Parliament. The UK would have left the EU in March 2019 and have no voting power but would remain in the Single Market and Customs Union and be subject to all EU regulation and the ECJ.
b) Payment by the UK of a sum larger than €40bn, and probably nearer to €50bn. The UK has offered €20bn which would cover the existing level of contributions for the two year transition period. The UK is likely to agree to a further €10bn as its share of the pension deficit of EU civil servants, but payments beyond that are difficult to justify domestically unless presented as the costs of getting a deal. The EU sees this as settling the accounts on departure, the UK sees this as the price of getting a trade deal.
c) No hard border on the island of Ireland (this is now officially a red line for each of the Irish Republic, Northern Ireland and the UK). However for the EU a hard border must exist somewhere between the island and the mainland. This is unacceptable to the DUP, on whom the Conservative Party depends for its majority in Parliament. It is currently difficult to see how this can be achieved absent a highly creative solution that has not yet been aired.
d) An agreement on the rights of EU citizens living in the UK. The UK offer is to treat them equivalently to UK citizens, however this in fact removes rights from them that they hold today that UK citizens do not. If the UK insists on not improving their offer on this, then the EU27 may well accept this reluctantly, but be less prepared to concede on other issues.
It should be noted that the value of a transition deal falls quickly if it is not agreed by early 2018 – this is because companies will be forced into taking measures to cope with a Brexit in 2019 with no transition deal.
Following an agreement along the lines set out, negotiations about the future trade deal would then begin. Again, the EU position on this can now be clearly discerned.
The EU would be happy to offer a Norway-style arrangement but this requires the UK to accept free movement of workers, continued payments to the EU and acceptance of the authority of the ECJ, all three are UK red lines and unacceptable to the government.
Alternatively, they would agree to a trade deal similar to the Free Trade Agreement just signed with Canada. A Canada-like deal would offer zero tariffs on goods trade but nothing at all on services, particularly financial services. This is very acceptable to the EU, and it meets the minimum UK target of both Conservative and Labour parties of “tariff-free access to the single market”. However, it brings no benefit to the UK services sector, the strongest part of the UK economy, and in truth paying €40bn to land such a deal would be hard for many in the UK to approve.
There is little desire, or need, for the EU to agree to anything else – in the end it is likely to be a “take it or leave it” offer to the UK. The UK is left to choose between a set of very unappealing economic options, as the price for its political desire to “take back control”.

Popular but dangerous investment strategies, 1987 and 2017

Only the most experienced investors in today’s markets remember what happened to US stocks on October 19, 1987. Known as Black Monday – the US market fell by 22% in a single day.

To put in some context, that year had seen the stock market rise by more than 20% in a very steady pattern, whilst the US and global economies enjoyed strong growth but muted inflationary pressures – market valuations had been rising for a few years and had reached historic extremes. In all these ways rather like 2017.

Institutional investors were enjoying the bull market but had concerns that it could not last and sought out strategies that could keep them invested whilst also protecting them from sharp losses. They hit upon the concept of “Portfolio Insurance” which made use of a recent innovation known as index futures. They created a strategy that remained invested until the market had fallen by a certain amount from its high, and then they would hedge their exposure by selling index futures; if the market fell further they would sell more futures.

During the long bull market of the mid-80s, these strategies did not really get tested, until October 19, 1987. There was no particular reason or news trigger for the market to fall, but once it was falling portfolio insurance programmes automatically generated sell orders that ensured that it fell further. That in turn triggered further selling and the stock market found itself inundated with accelerating volumes of sell orders. It took some banging of heads by the Federal Reserve overnight to restore sanity the next day.

It turns out that when a large number of investors all adopt a policy of selling when the market is falling and then selling more when the market falls further, then panic ensues, leading to sharp falls in market prices even if there is no fundamental economic reason for the market to fall.

For a while portfolio insurance strategies were put into abeyance, and the 90s was so caught up by the technology boom that nobody thought about protecting their profits!

In recent years however, a number of institutional investment strategies have come into common use that look likely to create the same effect of generating large and accelerating sell orders as market prices fall.

These strategies involve trading in volatility, an asset class that did not exist in the 80s. Equity volatility tends to fall as the market rises but volatility rises, usually very sharply, as equity markets fall.

“Risk Parity” strategies, are increasingly common. They aim to deliver balanced portfolios of equities and bonds where the risk of the total portfolio is split equally between equities and bonds. Achieving this and delivering acceptable returns requires the use of leverage. However, Risk Parity is a strategy that reduces allocations to bonds and increases allocations to equities as equity volatility falls relative to bond volatility and vice versa. In practice this means increasing equity exposure as equity prices rise in price and reducing equity exposure as equity prices fall.

“Managed Volatility” strategies focus on maintaining a constant level of volatility for an investment portfolio. Thus as equity volatility falls (usually associated with rising equity markets), the strategy requires adding more equities using leverage to maintain a constant portfolio volatility, and as equity volatility rises (usually associated with falling equity prices) the strategy demands reducing equity exposure. Buying as the market rises and selling as the market falls is merely replicating the effects of portfolio insurance 30 years ago.

Selling volatility has been such a successful strategy for the last eight years that there are now many investors who have enjoyed excellent returns from doing little else, and their positions are now very large. In a sharp market fall, volatility could double or more within a day, leading to substantial losses and covering of positions.

These can all be labelled “volatility-driven investing”, a21st century concept that has recreated market crash risk. They are increasingly used in todays’ markets. History may not repeat itself, but it surely rhymes. A sudden fall in equity prices and associated rise in volatility will lead to large buy orders in volatility and large sell orders in equities that will instantly extend the market fall into a market rout.

On the QT

2009 saw the world embark on a giant economic experiment – that of Quantitative Easing (QE) in which Central Banks injected large amounts of money into their financial systems. Next month, the Federal Reserve announced this week, will see a new first for monetary policy – a policy of Quantitative Tightening (QT) in which money will be withdrawn from the financial system.
They have announced that this new policy will be phased in, starting at a rate of $10bn per month from October, rising each quarter to $50bn per month by October 2018. At the same time, they expect to raise interest rate four more times to 2% by the end of 2018.
The timing of this policy shift appears less related to current economic conditions and much more to two other factors. First is that Western Central Banks appear, as a group, to have decided that the very easy monetary policies need to be pulled back. In addition to the Federal Reserve, the Bank of England has also recently indicated its desire to increase interest rates and the ECB is has laid out plans to bring to an end its QE programme. This tightening seems to be globally co-ordinated. Secondly, the Federal Reserve appears to be publicly setting out its policy for the next year, in such a way that it would be embarrassing not to carry it through. This comes at exactly the time that there are many places on the Federal Reserve Board to be filled over the next twelve months by nominees of President Trump, including the key role of Chairman currently filled by Janet Yellen.
Over the period of QE, from October 2008 to October 2014, the Federal Reserve increased its balance sheet from about $750bn to $4.5 trillion through 3 separate programmes of purchases. Its peak purchase rate was $85bn per month.
The widely accepted effects of the QE policy were:
1. It helped to offset the effects of the Global Financial Crisis in 2008/9, and prevented a 1930s style Depression from setting in.
2. It has done little to foster a rapid economic recovery, instead US GDP growth has stabilised at a muted 2% pa rate, only a little higher than the increase in population, and inflation has struggled to exceed 2%. There is little evidence that the increased money supply has found its way into the real economy through physical investment.
3. The prices of financial have moved much higher, principally through higher valuations relative to the income streams they produce. This is evident in house prices, stock prices, bond prices and the prices of prestige assets such as artwork and vintage cars. The increased money supply has thus remained within the financial economy rather than the real economy.
4. The combination of lacklustre real economic growth, rapid growth in financial asset prices, and the skewed distribution of wealth in the US economy has meant that the very wealthiest in 2008 have become even more wealthy and inequality has risen very substantially with the richest 0.1% gaining much more than the richest 1%, who gained much more than the richest 10% who gained much more than the rest of the population.
The implications of QT are thus that what has been to be a key support for financial market prices will be reversed by falling valuations as money is withdrawn from the financial system. It may also be that in fact this has a limited impact on the real economy as the decline in wealth will affect only the very wealthiest in society who demonstrate a low correlation between changes in their wealth and changes in their spending patterns.
A deeper concern is that QT will affect valuations in both equity and bond markets at the same time. Most investors have not seen an environment in which both markets fall simultaneously and this has the potential for aggressive selling of leveraged positions in markets, which could take markets down to surprisingly low levels.

The 5 errors of the Free Trade Brexiteers

For many of the proponents of Brexit in the referendum debate (Messrs. Gove,
Fox and Johnson in particular), free trade was a crucial part of their argument
on two grounds.

First, they argued that Britain would be able to agree a satisfactory trade deal with the EU following Brexit because the rest of the EU ran a sizeable trade surplus with Britain. Secondly, they argued that, outside the constraints of the Customs Union, Britain would be able to agree advantageous trade deals with other countries around the world (US, China, India) that the EU had not been able, or prepared, to do.

Some fourteen months on, these pre-referendum theoretical arguments have
come in to contact with real world, and five key errors can now be seen in their
arguments.

1. Their argument was based on the absolute size of the EU’s trade surplus:

Whilst almost half of the UK’s exports go to other EU nations, less than 10% of their exports come to the UK. Though the UK runs a deficit in trade with the EU in absolute money terms, relative to the size of the total EU economy their surplus is not very meaningful. Thus, if political considerations were deemed to be important (which events since the referendum have shown to be the case), it would be quite conceivable that some modest economic loss would be acceptable in exchange for other, more political gains.

2. Their arguments were based on an old economic, and now irrelevant,
theory that tariffs are the only thing that matter in international trade:

Two hundred years ago, Ricardo developed an economic theory demonstrating the advantages of untaxed international trade in boosting the economic well-being of all countries. The UK, with its Empire, large navy and entrepreneurial flair benefitted enormously from conducting trade all over the world. Thus, the UK’s history and attachment to the concept of free trade and drive to reduce or eliminate tariffs imposed on the import of physical goods into a country. This has been supported by a clear consensus of conventional, neoliberal economists through the decades since.

Today, tariffs on goods passing across borders are either zero or fairly close to it. There are specific areas where this is not so, principally agricultural products and cars coming in to the EU Customs Union. For goods, free trade is pretty much the norm and there is limited scope to achieve economic benefits from signing more free trade agreements.

3. Their arguments ignore the crucial role played by regulation as the
protectionist policy of choice today:

However, the key protectionist tool used by governments today is regulation. In general, this is used in service industries and is most prevalent in financial services, where protection of the major local banks insurance companies is typically deemed a political necessity, and pharmaceuticals, where the political need to control healthcare costs often impacts on purchases of specific drugs and treatments. These two industries are very important sources of UK export revenues.

Within the EU, the single market operates on the principle that if a product or service has regulatory approval in one EU nation, then it can be sold anywhere else in the EU, subject to EU-level control on what constitutes acceptable regulation. By leaving the EU, the UK will lose these advantages and will have no say on future regulatory change, but UK businesses will have to adapt to any such change.

The investment management industry is an example of an industry that looks like being particularly disadvantaged by Brexit. A substantial part of the industry’s revenues arise from managing the assets of other EU customers under MIFID regulation for investments in funds or under delegation regulation for segregated accounts. Last month, ESMA (the European Markets and Supervision Authority) published an opinion that, post-Brexit, would force more EU investment management activity to be conducted within the EU.

4. Other countries will expect us to make (politically unpalatable)
concessions in order to agree on new trade deals:

Though the US under Trump has indicated its desire to strike a free trade agreement with the UK, they have particular areas such as the food and
healthcare industries, where they would seek a change in UK regulation, before agreeing to such a deal. These are politically difficult for the UK
government.

Both Australia and India have indicated they would be very open to post-Brexit UK trade agreements but their price would be greater access to the UK for their own people, which would make even more difficult the UK’s ability to control and reduce immigration.

5. They over-estimated the attractiveness of the UK as a free trade partner:

They argued that as the 6th largest economy in the world, Britain was exceptionally attractive as a partner in a trade agreement. However, in practice the larger trading partners are (i) China with 1.3bn emerging consumers, (ii) the EU with 500m mostly wealthy consumers and the US with 300m wealthy consumers are many times more attractive as trading partners compared with the 60m wealthy consumers the UK has. In this global perspective the UK has less than 1% of the world’s population. A trade deal with the UK is a “nice-to-have” rather than a “must-have”.

The likely outcome for the UK is now a life outside the EU, accepting their
regulation of any product or service that we wish to sell to them, whilst losing
any say in that regulation or the key political developments in our most
important trading partner. In financial services in particular it is likely that the
UK will dilute its dominant market position within Europe, as regulations
benefit EU members. The UK will be forced to make greater concessions with
other countries in trade matters than the EU would have done in order to
secure trade agreements with these countries.
The voters believed the marketing hype of the free trade Brexiteers, sadly the reality of their delivered product will not match that hype.

What is the stock market for?

The economic textbooks and the websites of the major stock exchanges proclaim that the key role of a stock market is raising equity capital for businesses wishing to invest and expand. They are the location where those seeking to invest in equity securities can interact with those seeking to issue those same securities. A stock exchange provides this primary market role (trading in new equity securities) within the economy and is enabled to do this by its secondary market role (trading in second-hand equity securities) where the pricing of shares evolves minute-by-minute in response to economic, political and corporate news. New companies to the exchange wishing to sell new shares will find the price of their shares determined with reference to the share prices of other similar companies, and existing companies wishing to sell new shares will find the price of such issues determined by the existing secondary market price.

Thus, in theory, stock exchanges play a pivotal role in capitalism, providing the key market mechanism for the delivery of new equity capital.

Broadly this could be argued to be the case until the TMT bust in 2000-01. Many investors who invested in internet-related new issues during the boom saw 90%+ losses on these shares and confidence in the prospects for new equity issues was lost.

Two other trends emerged at the same time. The first was a shift in investor flows from public equity markets to private equity markets. Thus private equity funds had large cash positions to provide the equity capital for firms wishing to expand, obviating the need to issue shares on the stock market. The second was low inflation, leading to low interest rates and bond yields and consequent strong free cash flows for companies.

A combination of strong free cash flows and owners increasingly focussed on optimally-financed balance sheets at a time of low interest rates meant that in fact companies were seeking to reduce their share count rather than increase their share count through new equity issues.

In recent years however, the primary capital-raising role has all but disappeared as many companies have instigated share-buy-back schemes and barely any companies issue new shares. Even the private equity funds seeking to realise their investments rarely use the stock market for their exits as other private equity funds (with very substantial cash holdings) will buy from them directly.

Stock exchanges thus find themselves left only with their secondary market role. To critics this means a stock market is merely a massive casino in which speculators sell second-hand bits of paper to other speculators and no useful economic purpose is served.

In fact though, the function of the stock exchange has evolved. It has now become the key source of expected long term growth investment returns that enable individuals in a society to save for an extended period of retirement following a working lifetime. Thus the function of stock markets has evolved from the provision of capital to the provision of investment returns on long term savings.

Politically this is hugely significant – the level of the stock market has moved from being of minimal interest to politicians to being a vital factor in the public’s estimation of economic and political success.

The implications of this shift in the key purpose of the stock market are:

  1. Economic policymakers are more likely respond to falls in the stock market, whether or not there is an economic justification for the market decline. The famous quote from Paul Samuelson that “the stock market has forecast 9 of the last 5 recessions” highlights the risk of a policy mistake. There is an inbuilt potential policy error of monetary policy being too easy which at some point creates an inflation problem.
  2. The positive feedback loop between a strong stock market, investor (and hence consumer) confidence and a good economy has taken market valuations to historically very high levels. Following a shock to the system, this feedback loop could easily move into reverse with severe economic consequences.
  3. Demographics matter for analysis of stock market trends. The “baby-boom” generation (born between 1947 and 1962) are now aged between 55 and 70, just completing their peak equity-investing years and moving into the period of their lives when they seek to reduce their equity exposure to fund their retirement lifestyle. This has negative connotations for the valuations of financial assets in the future.

Beware the decennial seasonality of Year 7 Summer

Over the last four decades equity market prices have shown a clear and remarkably consistent pattern: from lows established in Year 1 or Year 2 in each of the decades since the 1980s, have risen steady and very profitable bull markets which run into problems that begin in the summer of Year 7.
It was in August 2007 that the first cracks appeared in securities related to the US housing market – BNP Paribas froze dealing in three of their funds which contained packages of sub-prime mortgage loans called CDOs. The next month in the UK, Northern Rock which had been relying for its ongoing liquidity on demand for sales of its securities mortgages saw queues of its savers outside e very branch in a vivid replay of a nineteenth century “bank run”. The next six months saw pressure on any company which had been associated with US mortgage debt – Bear Stearns was bought by J P Morgan, the two major US mortgage providers were put back into government ownership and then Lehmans failed.
It was July 1997 that the Asian financial crisis began when Thailand was unable to ward off speculative attacks on its fixed exchange rate regime had enjoyed rapid domestic demand growth from both companies and consumers who were financed their spending by borrowing in dollars. When the exchange rate link failed, the value of their debts soared leading to a sharp recession and a banking crisis, which spread throughout East Asia. Indonesia, the Philippines, Malaysia and South Korea had similar banking and economic issues. China escaped this crisis and indeed emerged relatively unscathed since the renminbi was a non-convertible currency.
The summer of 1987 saw a major market peak in August 1987, following several years of strong market performance. There was no particular economic or political event that could be said to have been the trigger for the one day fall of 22% in the Dow Jones Index of 22%, other than an increasing realisation that markets were very highly valued. Consequently, many investors had put in place a strategy of “portfolio insurance” which meant that their market exposure was reduced and their positions were sold in response to a market decline. On October 19th this created a wall of continuous selling which pushed the market lower and lower.
The recent very hot weather is a reminder that we are now in the Summer of Year 7 for this decade. There are plenty of candidates for where a new bear market may begin – the consistent upward move from the US stock market in recent years has taken it to valuation levels only seen in 1999, the recent failure of two banks in Italy is a reminder of the weakness of many European banks, in China there has been an extraordinary build-up of domestic debt and the government id desperately trying to maintain its near-fixed link with the US dollar. Or geopolitics may play a part this time – President Trump does not appear afraid to take action against North Korea and tensions in the Middle East between Qatar and the other Gulf nations have recently risen.
History suggests that investors be careful!

 

E for Election and E for Effort

The UK general election campaign, announced on April 18th, has been rather uninspiring so far. Whether is it a symptom of “democracy-fatigue” following two tight referenda and a hotly-contested, general election in the last 33 months, or an associated lack of funds amongst the political parties, or just the boredom of an election where the result seems obvious, no one seems to be putting in very much effort this time around in order to win it!

Theresa May, whose decision it was to call the election, appears to have decided that all she needs to do to win her expected larger majority, is to repeat “strong and stable government” at every opportunity and be photographed at various stage-managed events where all the questions and questioners are pre-selected. She has refused to enter into any direct debate with other party leaders. She has sought to frame the election as a choice of leader to take Britain through the Brexit negotiations, between herself and Jeremy Corbyn. Given her strong personal ratings and his weak personal ratings, she appears quite happy for media attention to focus on the him and the Labour party.

She has led the production of a vague and uncosted manifesto, particularly around Brexit, she has surprised many by some surprisingly detailed policies that work to the financial disadvantage of a core group of her supporters, the over-65s. All-in-all, she is giving the impression of expecting to win very easily and thus does not need to try too hard to gain votes.

For Jeremy Corbyn, this is the moment he has dreamed of – the chance to put in front of the UK electorate a Socialist manifesto and vision for the UK. However, it appears that his goal is not to win the election, but merely to do well enough that the left wing of the Labour party can say that there is a real demand for their ideas amongst a substantial section of the UK electorate. His campaign strategy has therefore concentrated on appearances in areas traditionally considered solidly Labour. His focus is on getting out that core Labour vote, and very little time of effort is being devoted to taking that manifesto to the rest of the country.

The UK Independence Party, which for many has achieved its original purpose of taking Britain out of the EU, is suffering from internal divisions and a lack of leadership and of money. – they are fielding many fewer candidates in the election, which they are justifying by saying they do not wish to put up candidates against previous strong proponents of Brexit.

Somewhat similarly, the Green Party has stood down candidates in a number of constituencies where they are seeking to promote a progressive alliance, and believe that a Liberal Democrat or Labour candidate would have a serious chance of defeating the Conservative candidate. Sadly for them, apart from in Brighton, the other parties have not acted in a reciprocal fashion.

Only the Liberal Democrats are campaigning at full volume. They have taken Teresa May at her word that this is an election about the Brexit negotiations and are the only party campaigning to remain within the EU’s single market, a very soft form of Brexit. They thought this would open up the possibility of gaining votes from the 48% who voted to stay in the EU, but current polling suggests that half of those now feel that the decision has been made and should be respected. The Liberal Democrats position is not gaining much traction with the electorate.

Maybe the excitement in British politics over the last three years is now over. A dull campaign looks likely to lead to a large Conservative majority as Britain enters the long and tortuous Brexit negotiations. No doubt a normal service will be resumed after it becomes clearer just what Britain will look like post-Brexit.

Passives Produce Premium Performance

Hendrik Bessembinder has recently published here a study of individual, stock returns in the US with some startling new insights into the risks of equity investment. The study encompasses 90 years of monthly return data on every stock in the CRSP database – just about as large a database (25,782 distinct identifiers) as it is possible to compile in US equities, and so any results are likely to have greater statistical significance than most other studies of stock returns which typically use much shorter time periods.

Some of his key insights are:

·       58% of stocks underperform the returns from 1-month T-Bills over their entire lifetime

·       All of the dollar wealth created by the stock market since 1926 (nearly $32 trillion) is attributable to just the best-performing 4% of the stocks and 75% of that wealth to just the best-performing 1% of the stocks.

·       Of all the individual monthly stock returns in the entire database, just 48% beat T-Bill returns, and less than 50% are positive.

·       The median life of a stock on the database is 7 years. The median lifetime return of a stock is -3.67%.

·       Mean returns of stocks are much higher than median returns – stocks display significant positive skew.

·       Smaller capitalisation stocks are more likely to underperform the monthly returns of T-Bills.

 

These insights present significant difficulties for traditional, active investors.

First, there are very few “winners” for stock-pickers” to identify and invest in.

Second, for those investors who focus on the mean and variance of portfolio returns, effective portfolio diversification requires investing in a very large number of stocks to avoid missing out on the few winners – poorly diversified portfolios are all that is required to underperform, even before transaction sots and fees.

Third, even where an investor has performed well, the low number of strongly-performing stocks means that it is more difficult to ascribe the outperformance to skill than to luck.

So investors that want to capture the significant equity asset class risk premium are well-advised not to invest in active portfolios of a subset of the equity market – this is an enormously risky endeavour – and are far better advised to invest in a strongly diversified portfolio of almost all the equity market, such as is found in a wide-ranging index. This is even more true of smaller capitalisation equity securities.

A recent post on Philosophical Economics takes this concept further. If by moving from an active and relatively weakly-diversified portfolio (a traditional active approach) to an indexed and strongly-diversified portfolio (a modern passive approach), an investor reduces the expected volatility of his portfolio, then in theory he would also be willing to accept a lower future expected return.

The most straightforward way to achieve a lower future expected return is to start from a more highly-valued level. Thus it could be that one reason for the historically high valuation of the US equity market is in fact the trend to very significant passive exposures to the US market adopted by many investors in the US market, since the passive approach in fact a less risky way to invest in equities. In this way passive investing is a cause of higher valuations.

The die is cast

Now that Royal Assent has been gained, the European Union (notification of Withdrawal) Act 2016-17 is in force and the only impediment to Britain leaving the EU is for the Prime Minister to write to the EU to trigger Article 50 of the Maastricht Treaty. This is expected in the next two weeks.

The die has been cast and this British action will lead to many repercussions, not all of which are visible today. It is however true that whilst leaving the EU is a very clear demonstration of British sovereignty, it is those repercussions that will determine just how effective and valuable that sovereignty is in today’s world.

Firstly, with regard to the EU, the deal we gain through the next 24 months of negotiations will primarily be a function of what sort of relationship the EU wishes to have with Britain. It may well make economic sense for both sides to have an essentially free trade regime in goods and services, very similar to that which exists currently. However the EU also has political objectives, prime amongst which is that any deal must look and be worse than remaining within the EU and its single market, in order to deter other countries from following the UK out of the exit door. Anti-EU views are gaining ground in France, Italy and Holland, all founding members of the EEC. Some degree of economic loss will be acceptable to the EU in order to achieve these political objectives, and though this may be higher in absolute terms than the loss to Britain, that economic loss would be much smaller as a share of their total economy than for Britain.

Britain’s economic fortunes are thus dependent on the political calculations of the rest of the EU.

Secondly, with regard to the USA, a “special relationship” may or may not exist, but if it does it has always been on US terms. Pre-Trump, the UK was an invaluable bridge between an inherently individualistic US political philosophy and an inherently social European one. – Britain was able to explain and translate each side’s thinking to the other. By leaving the EU this role is hugely diminished, though may still apply to defence matters.

With Trump as President, the picture is more complex. Trump sees Brexit as part of the same changing political tide that saw him elected and Britain’s need for a series of bilateral trade agreements fits very neatly into his philosophy that the US should only negotiate bilaterally in order to maximise its own influence. He clearly enjoys visiting his properties in Scotland and he may wish to be seen rapidly concluding a trade deal with Britain in order to contrast trading relationships with other developed world economies with those of less developed economies such as Mexico and China which he believes have been detrimental to US jobs.

He is though very unpredictable, and would likely seek some painful concessions from Britain, in order to demonstrate that he had “won” the negotiation. Britain would thus be dependent on his capriciousness, both in any trade deal and more widely in global affairs.

Thirdly, China sees itself as a key world power that is happy to make agreements with other countries, but is not very interested in negotiating them. It prefers to set out its terms and wait for others to agree to them. British sovereignty would extend to deciding whether or not to agree to what the Chinese want.

These 3 giant entities (EU, US, China) account for 57% of the global economy and an even greater percentage of UK goods exports – the fate of the British export sector and thus the wider economy is very much in their hands. Britain can only “take” what they wish to “give”. In relation to the size of these economies, Britain, though the 5th / 6th largest economy in the world, has little negotiating power.

Of the other countries who have expressed an interest in early free trade deals with a Britain outside the UK, both Australia and India have indicated that a key objective in any such negotiations would be greater freedom for their citizens to come and work in the UK. This is directly counter to the British government’s policy to substantially reduce immigration. In addition all the nations seeking trade deals are a very long way from Britain and international trading relationships display very strong correlations to geographic proximity.

British sovereignty has been dramatically exercised – the die has been cast – Britain is about to set out on a new independent path for its economic development – its fortunes, however, certainly in the next few years, now depend very heavily on the actions of others. Re-asserting sovereignty may feel liberating now but be economically painful in the future.

 

Jeux avec frontieres

Before the UK joined the EEC in 1973, most Britons knowledge of Europe was from the BBC game show Jeux sans Frontieres (Games without Borders), which showed that Europeans were as prepared as Brits to dress up in silly costumes and attempt bizarre tasks against teams from other countries. It may even have played a part in Britain’s referendum to support EEC membership.

It is now 12 months since David Cameron permitted his government ministers to break from Cabinet responsibility ahead of the second EU referendum. The campaign and decision to leave, followed a few months later by the election of President Trump has transformed the political debate around the world. Since World War 2, the political debate was between those who thought government should seek to do less within society and those who thought government should seek to do more within society. The events of 2016 however show that the debate is now between those who would like national borders to be more difficult to cross (whether by people or goods) and those who want borders to be easier to cross.

Regarding people crossing borders, Mrs May’s immediate conclusion from the referendum was that the British people voted for regaining control of immigration, and the right to live in Britain, and that this was more important any economic benefits from EU membership. Her policy and approach to Brexit since then has clearly been dictated by that conclusion. It is however, notable, that the parts of the country most concerned by immigration are correlated to those parts of the country with the smallest immigrant populations.

For President Trump, it is the twin threats of illegal immigrants from Mexico and radical Islam from some Muslim nations that underpins his desire to establish more effective control of America’s borders. His geographical distribution of support in the election also correlated with low levels of immigrant population.

For Trump, though not for Mrs May, borders are also important for controlling the movement of goods. He argues that the free trade agreements that the US has made in recent years has meant that cheap goods have poured into the US , displacing US-made goods and thus US jobs, particularly in the areas where he drew the greatest support. He seeks to maximise American negotiating leverage by withdrawing from multilateral trade agreements such as the TPP and NAFTA and replacing them with bilateral agreements where the US will (nearly) always be the more powerful party and be more likely to reach agreements that are closer to American interests.

For the UK, voluntarily withdrawing from a trade bloc even larger than the US and seeking new trade agreements with the rest of the world, the general acceptance of free trade is paramount and much rhetoric about the UK being the beacon of free trade in the world (and goods and services crossing borders easily) can be heard from UK Conservative politicians. One early issue that UK politicians have discovered is that many of the countries (eg India and Australia) that would be keen to enter into free trade agreements with the UK, are also seeking greater freedom for their people to enter and stay in the UK.

Unusually for economists, almost all of them agree that free international trade is a good thing for the global economy (though this is not the same thing as being good for everyone in that global economy), and that the last time, the world economy saw a significant increase in protectionism, in the 1930s – this was associated with dramatic declines in trade levels and a global economic depression – ending in World War.

This desire for reinstatement of borders also flies in the face of the reality of technological progress. For people travel across the world is cheaper, more straightforward to plan and a more realistic aspiration that ever before in history. Making that more difficult implies a key loss in economic terms

For goods, bar codes, the standardisation of shipping container and the prevalence and complexity of international supply chains supported by logistical improvements has created huge efficiencies with both higher volumes of trade and lower prices for all. Re-establishing border controls (not only between the US and Mexico but also between the UK and the EU) will raise prices and reduce the global standard of living, even if tariffs remain at negligible levels.

For services, the digitisation of the world means that borders are increasingly irrelevant. More and more retailing is conducted in the ether, a large part of the world satisfies its desire to watch soccer by watching the English Premier League online, even investment bankers outsource research model-building to staff in India.

The current wave of national populism is selling the idea of greater security through control of borders and plays on traditional human tribal urges to discriminate against outsiders. It appears to be going against where technology is taking the human race and the risk must be that to deliver border control will require increasing levels of force, militarisation and regulation that will act to reduce standards of living. It also flies in the face of another great human urge – to welcome and be hospitable to visitors.