Rue Britannia: What Brexit Means for Investors

With President Trump in London this week on a state visit, now’s a good time to look at Britain’s planned exit from the European Union — aka Brexit — and what it could mean for you as an investor. Below, I examine the sectors and countries that are likely to suffer and gain the most.

You think Washington, DC is a mess? If you want to see even worse political incompetence, look to our cousins across the pond. It was once said that the sun never sets on the British empire, but right now the remnants of that empire are looking hapless and puny indeed.

Despite the waxing and waning of investor concerns, Brexit still poses grave dangers to the global economy, particularly several countries in Europe. Which is a pity, because Europe’s economy as a whole showed signs of strengthening earlier this year. Those indicators have now turned pessimistic, in large part because of the Brexit mess. China would take a hit too, at a time when the country can ill afford it.

Research firm IHS Markit reported on May 23 that its Purchasing Managers Index for the euro zone, which gauges activity in the manufacturing and services sectors, is flashing a warning sign for the region’s economy. The index shows the euro zone is further slipping into contraction, mostly because of tariffs and Brexit-induced uncertainty. The euro zone consists of the EU countries that have fully incorporated the euro as their national currency.

Collectively, the EU is the world’s second-largest economy, in nominal terms, after the United States. In addition to tariff relief, the EU allows free movement among its 28 member countries for employment and commerce.

The June 2016 referendum for Britain to leave the EU, combined with London’s fumbling response, represents a stunning example of unnecessary, self-inflicted national harm. Winston Churchill, savior of Britain and Europe, must be spinning in his grave.

Positions on Brexit are hardening. The Brexit Party has come out on top in a national poll, conducted May 28-30, for the first time ever. Far-right party chief Nigel Farage, the incendiary leader of Brexit hard-liners, hailed the poll as an “historic moment.” According to the Opinium Research poll, Farage’s party would emerge as the largest party if a general election were held now.

Parting ways…

In the British government, infighting among cabinet ministers and MPs, unreasonable goals, and administrative disarray are torpedoing hopes of a smooth departure from the EU. Prime Minister Theresa May announced last month that she would resign on June 7, following a revolt in her Conservative party on her proposals to leave the EU.

Three days later, on June 10, the race to succeed her will begin. Most of the Tory front-runners vying to replace her seek a sharper break from the EU than the unpopular middle road that May unsuccessfully sought.

The Tories, which pressed for Brexit, were caught unprepared when the referendum actually passed. Monty Python, of which I’m a big fan, comes to mind. The clownishness among Britain’s political class right now reminds me of the famous Python sketch in which the troupe satirized a British general election fought among the Conservative, Labour and “Silly” parties. The Tories, with their disorganization and childish bickering, are currently playing the role of a real-life Silly Party.

May put in a disastrous showing in a 2017 snap general election, unexpectedly losing seats to Jeremy Corbin’s Labour Party, which hews increasingly to the left. The politically hamstrung May in recent months has been buffeted between hardliners and those who prefer a milder stance against Brussels. Increasingly likely is a no-deal (aka “hard”) Brexit that harms Britain’s economic interests, the financial center of London in particular.

Deal or no deal, the UK must depart the EU by October 31, under the deadline extension begrudgingly granted by the EU. And the two sides are farther apart than ever. In the Mother of Parliaments, where democracy has thrived for more than three centuries, Brexit has wreaked considerable havoc, setting investors on edge.

The following chart shows the global economic consequences of a hard Brexit.

Worst case scenario…

Among all the worries about Brexit, the most pressing is whether the EU’s big banks now face serious trouble that will spill into the global economy. Deeply indebted and economically troubled countries such as Italy could be the first dominoes to fall, with European banks unable to act as backstops.

As Britain’s government flails and expectations for a “soft” Brexit wane, look for the European financial services sector to hit a bad patch of turbulence. It’s a particularly pressing concern for London, the financial services hub for the Continent. Big banks already are fleeing to competing cities, such as Paris and Berlin.

The metrics for European banking hardly look promising, a problem that will be exacerbated by Brexit. Fears are mounting that Brexit could pave the way for another 2008-style crash. Back then, during the financial crisis, governments around the world doled out massive sums to bail out their nations’ banks. Brexit could indicate whether, once again, Europe’s banks are too big to fail.

To be sure, banks today are stronger, especially in the U.S. They have more capital and higher reserves of liquid cash. But Brexit will weigh on the revenue and earnings of European-based corporations and add stresses to the financial system.

Meanwhile, relatively low interest rates continue to hurt bank profits at a time when they still have plenty of debt. All European banks face danger under Brexit, but British-based banks will get hurt the worst.

Another big loser from Brexit is the European-based automotive industry. Auto makers and parts suppliers in the UK and on the Continent share tightly integrated supply chains. Germany, Europe’s growth engine, is the top destination for UK vehicle and parts exports, whereas the UK is the number-two destination for German vehicle and parts exports.

Automobile exports are the lifeblood and pride of the German economy. Accordingly, as the above chart shows, a hard Brexit would harm Germany (and its carmakers) the worst.

Britain also is home to major aerospace/defense contractors. These companies ordinarily would enjoy boom times as global defense budgets rise, but Brexit will prove a major impediment to their top and bottom lines, as customers turn to competing companies outside the UK that still enjoy the EU’s streamlined regulations and lower trade barriers. U.S.-based aerospace/defense companies are poised to pick up the defecting buyers.

European tourism should take a hit as well. The UK’s withdrawal on freedom of movement between the UK and EU nations will hurt travel and tourism-related firms with exposure to that sector.

As defensive growth plays, consider major European-based consumer staples companies that boast international diversification. These makers of well-known brands tend to perform well during periods of political and economic shock.

Evidence now suggests that Russian disinformation on social media, combined with populist newspaper tabloids, stoked British passions against immigrants and Europe, leading up to the 2016 referendum vote. Pro-Brexit voters wanted to curb immigration and free Britain from a supposedly parasitic EU. Now, as the stark consequences of Brexit come to light, polls show that Britannia increasingly rues its decision to leave the EU.

There’s been talk of a second referendum, a mulligan if you will, but that’s not likely to occur. To use a British expression, Brexit has become a “cock-up.” Investors will feel the pain for years to come.

President Trump is scheduled for a meeting Tuesday with Prime Minister May. Trump told her today that he believes Britain can have a “very very substantial trade deal” with the U.S. after Britain exits the EU. Whether that’s true or mere rhetoric, you can’t afford to ignore Brexit and the current woes of our British cousins. There’s more to the global trade equation than China and Mexico.

Questions or comments about Brexit? Send me an email:

John Persinos is the managing editor of Investing Daily.