First Grexit, Then Brexit, Now Itexit?

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The future of the EU is in question again- for the 3rd time in 4 years. In June 2015, the Greek financial crisis brought us Grexit. Two years later, the Brexit vote passed. And, now we may have Itexit. The political turmoil in Italy could result in Italy renouncing the euro and reviving the lira. Italy was a founding member of the EU and its exit could cause severe economic disruptions worldwide.

The two parties that won the March 4th Italian elections, the Five Star Movement and the League, have been hostile toward EU rules and the interference by Brussels in Italy’s affairs. They joined forces to form a government and proposed euroskeptic Paolo Savona as their choice for economics minister. Mr. Savona co-authored a blueprint for Italy to leave the EU. Current Italian President Sergio Mattarella rejected Mr. Savona and effectively collapsed the attempt to form a government. Mr. Mattarella’s Democratic Party has supported staying in the EU and was a big loser in the spring elections. Now, it looks like new elections later this summer are likely, which could amount to a referendum on Italy remaining in the EU.  

In 2015, Greek voters overwhelmingly rejected EU bailout terms requiring austerity. Greece defaulted on some of its debt and ultimately agreed to a third bailout, worth $100 billion, which imposed further cuts on spending. Grexit proved to be a powerful force for the Eurozone to work together and develop closer ties and more consistent and tougher fiscal rules. Greece is on schedule to be free from the burden of bailouts in August.

The UK is scheduled to withdraw from the EU on March 29, 2019, with a 21 month transition period out to December 31, 2020. Despite delays in negotiations, the UK government and UK opposition party say Brexit will happen. Since Brexit, the British pound first slumped, then regained its losses against the U.S. dollar, but has remained down 15% to the euro. Bank of England Governor Mark Carney indicated that Brexit has reduced UK GDP by $60 billion already. There is an ongoing debate as to what the relationship between the UK and the EU will be post-Brexit. If there is no agreement on trade, the UK would operate with the EU under World Trade Organization rules, which could mean customs checks and tariffs on goods as well as longer border checks. It could also mean Britain losing its position as a global financial center and its citizens living in other parts of the EU will lose their residency rights and health insurance. The next negotiation summit will be this June.

Before the euro, Italy had the power to raise or lower interest rates on their currency to impact its value. A cheap lira made Italian exports less expensive around the world, strengthening their economy at home. But, with the euro, Italy has no control over interest rates or prices. The populists, who did well in the recent elections, complained that their spending power has declined with the euro and EU membership has undermined Italian sovereignty. However, now Luigi di Maio, leader of the Five Star Movement, has said his party never supported leaving the euro.

Many experts agree that if Italy left the euro, it would be poorer, likely default on its debts and the lira would become greatly devalued. A default could lead to retribution from other countries and potential asset freezes and economic isolation. If this occurred, the trustworthiness of the euro as a currency would be questioned and the impact could destroy confidence in the EU itself.

Let’s hope Italy stays in the EU. The UK is starting to realize that the populism that brought Brexit can be quite expensive and painful. The Greeks certainly didn’t like austerity, but the tough rules of the EU put their country in a better spot. Itexit would harm Italians, the EU and the world. Let’s hope if there is a referendum, the Italians will vote for the greater good and stay in the EU.

Brexit- A Surprise?

brexit first starThe Brexit vote Thursday was a big surprise to some. As voting closed, some London bookies were putting the odds of a vote to leave at less than 10%.   Pollsters and “experts” had shown a 10 point margin 24 hours earlier for “Remain” yet “Leave” prevailed 52%-48%.   Stock markets don’t like surprises and responded with declines of 3% to 9% worldwide before markets closed for the weekend. With the flight to safety, as expected, most fixed income and some alternatives, especially gold and some managed futures, were up.

The result shouldn’t have been a surprise. We said the referendum was “too close to call” a month ago in our blog.  http://www.dwmgmt.com/brexit/.  In large numbers, the “Leave” supporters were expressing their anger with the status quo and a desire to return to the “good old days.”  They haven’t benefited personally from globalization and now their homeland is being “taken over by immigrants.”

The issue isn’t just Britain leaving; it’s really about the future of the EU.  EU institutions have failed in a number of key areas; including lack of planning and administration relative to the integration of the various member nations and migration of people among the countries.   Now, Britain and the EU have two years to work out what could be a highly acrimonious divorce.  And, while this is happening, all across Europe countries, including Germany, France and Spain, will be holding national elections debating the question of whether sovereignty and nationalism outweighs economics.  These same issues frame the U.S. Presidential election and others around the world.

Despite Friday’s selloff, Brexit is no Lehman.  Back in 2008 after the collapse of Lehman Brothers, investors indiscriminately fled all assets connected to the American housing bubble.  Subprime mortgages had been sold to investors worldwide and panic spread like a virus.  This time, the trouble is more identifiable.  London’s ambition to be the world’s most important city is over.  The pound has lost some luster.  The EU will likely continue to splinter and perhaps disband.  If nations reject globalism and free trade, world economic growth will likely be reduced.  In 2008, central banks did not recognize nor prepare for the mounting disaster.  Today, the financial systems in the U.S. and Europe are less leveraged and better capitalized than eight years ago. Just last week, all major American banks passed the new stress test requirements.  The CBOE, Market Volatility Index, or VIX, remains far below the level of past panics.

The U.S. economy should weather the Brexit storm. American companies remain more insulated from global developments than any other country.  U.S. companies generate 70% of revenues domestically.  U.S. corporate balance sheets are strong, interest rates are low and the U.S. economy is on a pace for a 2.5% growth in the second quarter.  Consumer sentiment remains strong in the U.S., coming in at 93.5.

However, expect more volatility. Britain’s decision to leave the EU could cause more fault lines in Europe.  Elections across the globe could reverse globalization’s trend.  Chinese growth could continue to decline. There is always a list of potential fears, many of which never materialize (e.g. the “hyperinflation” predictions of 2010 due to Quantitative Easing).

Some investors have not recovered financially and/or cognitively from their losses of 2008.  They are dedicated to making sure that never happens again.  No drawdowns for them-every market blip is cause for concern. “Another collapse is coming.” This risk aversion has led them to miss a huge run-up in U.S. equities (200% since 2009) , as well as decent returns for fixed income and alternatives in the last seven years.

Certainly, one day the expansion will end and investors will feel some temporary pain.  But, trying to determine when and how that will happen is a money-losing proposition.  Maintaining a well-diversified portfolio is a better approach than having a fearful, concentrated one.  Equities, in the long run, will outperform fixed income and alternatives.  And, as we discussed in our seminar last October, the equity “premium,” obtained for taking on risk, will continue- impacted greatly by inflation and economic growth.  Lower inflation and/or lower growth, means lower equity returns.  Your risk profile determines your appropriate asset allocation and the volatility of your portfolio.

Hold on tight, the road ahead may be bumpy, but, since no one knows the future (not even the “experts” as demonstrated above), it’s the best route we have to accomplish our goals for the long term.