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What a Time to Be Alive

Yesterday, the U.K. electorate surprised the markets by voting in favor of leaving the European Union by a nearly 4-point margin—51.9% to 48.1%.

Or as The Washington Post put it in perhaps one of the most overwrought ledes of all time, “British voters have defied the will of their leaders, foreign allies, experts and much of the political establishment by opting to rupture this country’s primary connection to Europe in a stunning result that will radiate economic, political and security uncertainty across the globe.” Clearly, the journalists who staff the paper’s London bureau were in the “remain” camp.

As risk-averse income investors, we tend to favor the status quo—or the devil we know. But we totally understand why British voters hate the idea of slowly ceding their national sovereignty to disinterested technocrats in Brussels. After all, we have a hard enough time accepting the rule of incompetent Washington bureaucrats, who are still our fellow countrymen.

As for the shock factor, perhaps we shouldn’t be so surprised that a narrow majority of our Anglo cousins wanted out of the European experiment. Indeed, the country has had political parties advocating for independence from the E.U. for at least 25 years now. And the U.K. has never been part of the Continent’s currency union.

Back to the Past

Still, it was quite something to watch a market that had been complacent as of yesterday’s close proceed to completely melt down overnight. As early results came in, the British pound first suffered from the Sunderland slump, when a city in England’s northeast voted to leave the E.U. by a much wider margin than polling had indicated.

Later in the evening, as it looked increasingly likely that “Leave” had won, there was an outright crash, which took the sterling from a year-to-date high of US$1.50 to a low of US$1.32, a level the currency last saw in 1985.

A 12% swing is not uncommon in the stock market, but it is an exceedingly rare event for a developed-world currency, especially in a country whose capital is one of the financial centers of the world.

Amid all the media-induced hysteria, however, it’s important to remember that the referendum is a non-binding vote that still requires action from Parliament—there’s always a possibility that politicians ignore the will of the people (it’s certainly happened here in the U.S.). Equally important, it will take at least two years for the U.K. to withdraw from the E.U., and quite possibly longer if there are protracted negotiations.

Of course, the most attractive feature of the E.U. has always been the ability of its member nations to engage in trade in a common market. We suspect that negotiators will ultimately find a way to maintain mutually advantageous trade ties between the U.K. and E.U., even if political ties are torn.

On the Other Hand …

Normally when a politically thorny issue has been decided, there’s at least some feeling of relief. Instead, the vote has introduced more uncertainty. For the U.K., such uncertainty could lead the country into recession, especially if it causes businesses to curtail investment and capital to flow elsewhere.

Meanwhile, politicians in Scotland and Northern Ireland are already making noise about their own independence again, which raises questions about whether the U.K.’s own union will come undone.

Similarly, for the Continent as a whole, the vote could portend an eventual crack-up. Certainly, the anemic economy, various debt crises, and now the refugee crisis have stoked both nationalist sentiment and Euroskepticism in a number of E.U. member nations.

From the standpoint of our country’s own interests, the U.K. absorbs less than 4% of our exports, but the E.U. is the destination for nearly 19% of our exports. So its stability (or lack thereof) will have important consequences for companies that do business on the Continent, or at least ship their goods there.

And while market watchers seem to have already concluded that Brexit is unlikely to be a black swan of Lehman proportions, it could end up being a black swan of Long-Term Capital Management (LTCM) proportions.

For those who don’t remember, LTCM was a hedge fund led by some of the top quants on Wall Street. It made what would normally be considered low-risk bets on currencies, but used multiple layers of leverage to magnify returns.

That excess leverage turned out to be the fund’s undoing, when the usual relationships between currencies got upended by the Asian and Russian financial crises in the late 1990s. Eventually, all the titans of Wall Street had to convene to bail out LTCM and stem the contagion.

Given the market’s complacency just prior to the Brexit vote and the huge moves in currencies thereafter, it wouldn’t surprise us if at least one big-money player made a heavily levered bet on the pound, dollar or related currency that has since gone spectacularly awry. If that bet was large enough to ripple through financial markets, then we’ll know soon enough.

Fortress Utility

We’ve addressed Brexit more broadly perhaps than warranted for Utility Forecaster, because we know many of you own stocks outside of the sector in which we specialize.

Happily, as utility investors, we actually benefit from such uncertainty. Because of their regulated returns and status as natural monopolies, utilities are considered the least-risky sector of the stock market, thus making them safe havens for investors who are in panic mode. While most global markets are down today, utility stocks are up.

In fact, the Dow Jones Utilities Average has now gained 19.2% on a year-to-date basis, while the S&P 500 is essentially flat, at 0.2%.


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