Our plans to discuss other topics in this quarterly note were upstaged by the UK’s recent vote to leave the European Union (EU). The ‘Brexit’ vote caught many, including us, off guard. The subsequent economic impacts still remain unclear. Thus, the immediate ‘risk off’ move in stocks was logical. More surprising was the ensuing rally in which 90% of post-Brexit equity market losses were recouped in a matter of 72 hours. Aside from possible contrarian bargain hunting or short covering, this about-face probably reflects hopes for a more muted reaction and lengthy process in which new trade deals are struck, as well as a view that accommodative monetary policy by the Fed and other central banks will keep rates lower for longer.
Britain has had ‘one-foot-in-one-foot-out’ on European unification for most of the post-war period. Britain was not a signatory to the 1957 Treaty of Rome which formed the precursor to the EU: the European Economic Community (EEC). Britain then waited 16 years more before joining the EEC in 1973, only to have a crisis of confidence in 1975 that led to - you guessed it - an exit referendum (‘remain’ won at 62%). The political split on EU unification was also obvious to anyone who listened to Margaret Thatcher’s speeches in the 1980s in which she referred to Europe as an “artificial construct.” From a 1988 speech: “We have not successfully rolled back the frontiers of the state in Britain, only to see them re-imposed at a European level with a European super-state exercising a new dominance from Brussels.” Even with the establishment of the EU Parliament in 1993, populist opposition remained in the UK. Britain has always been an ‘a la carte’ member of the EU – maintaining its own currency and insisting on – and receiving – more exemptions from EU rules than any other member state.
Our point here is that the tension of non-or-reluctant UK participation in the EU has always existed, and yet the entire region – as an economic bloc – has nonetheless grown over many decades. While remaining EU nations are likely to want to penalize the UK for leaving, we believe cooler heads will prevail. One reason: Continental Europe is currently running an annualized $100B trade surplus with Great Britain – while the largest remaining economy in the EU – Germany – accounts for more than half this trade surplus. Self-interest should play an important role here in trade discussions. How capital and trade will flow between the continent and the UK could remain muddled for a time, but we do not believe Brexit has permanently hobbled growth in the region. EU GDP growth was suffering already, in our view, due to a terribly-timed ECB rate hike in 2011 as well as a failure to recapitalize and strengthen EU banks’ balance sheets in the same manner as occurred in the US after 2008/2009.
The motivations for the Brexit vote are clear by now: re-establishing sovereign control over regulation and immigration. Britain will negotiate to regain authority in those areas but try to maintain access to the ‘common market.’ They will be hard pressed to get both. We will be watching closely to see if Britain’s motivations for leaving become other EU members’ motivations – as moves by other countries to secede is the greater risk.
The most direct impact of Brexit will likely be on British economic growth over the next 18 months - in particular the financial services and real estate sectors of the UK. The harmonization of laws and regulations across the EU meant that companies could maintain a single corporate HQ for all of Europe. Because English is the world's most widely spoken language, many foreign companies have located their European operations in London. The uncertainty over all of this could hurt levels of UK foreign direct investment, jobs and perhaps consumer demand. Assuming EU fracture lines begin and end with the UK, our main concerns are how the event impacts the US as well as many of the investments we hold for clients.
We believe the damage to the US economy and stocks should prove to be limited. The US generates 70% of its revenues within its own borders, and Brexit has driven US interest and mortgage rates close to historic lows. It has also put the Fed’s cycle of interest rate normalization on hold. Last, the S&P 500 dividend yield now trades at an almost unfathomable 60% premium to 10-yr treasury yields despite current economic growth of 2.0%. Should recent S&P earnings declines stabilize or even turn higher, that is a strong argument for risk assets. These are in the plus column for stocks and US consumers. In the minus column: a stronger US dollar and any material decline in EU growth has the potential to weaken earnings for companies we own with significant exposure to UK and EU markets.
Free Trade with Strings Attached
Part of the reason the markets have experienced increased volatility after the Brexit vote was due to the possible disruption to global trade. Affiliations such as the European Union (EU) are powerful economic alliances since they reduce barriers to the movement of people and trade between countries. Economists agree that freer movement of both of these factors allows greater specialization which in turn leads to greater wealth throughout regions with common markets. World trade has expanded by a factor of 266X (unadjusted for inflation) from $0.06 Trillion in international trade in 1946 to over $16 Trillion now.
The World Trade Organization (WTO) promotes freer trade and all of the world’s significant economies are signatories. The WTO requires equal treatment of foreign and domestic goods once any tariffs are assessed within each country. Another main tenet of the WTO is "Most Favored Nation" status. This tenet specifies that nations cannot agree to better deals for specific goods or services without offering the same deal to every member of the WTO. While apparently straightforward, there appears to be significant room for interpretation of these principals. For instance, the WTO actually encourages regional trade agreements such as the EU or North American Free Trade Agreement (NAFTA) that allow for preferential trading within a trading block even though these appear to contradict the Most Favored Nation provisions.
The European Union provides a framework for trade amongst member countries. Each product traded within the EU appears to be the subject of a negotiated tariff schedule depending on the degree of protection particular producers require. Trade within the European Union is unified, but the continent is not a free trade zone. Agricultural products, especially meat and dairy products, receive very high levels of protection. For instance, more dairy products are assessed tariffs of over 75% than those assessed rates below 20% within the EU itself.
While the United States is a proponent of free trade, US tariff levies are extremely complex. Similar to the EU, separate tariff schedules apply to every potential good and the rates vary from country to country depending on the trade agreement in place. For example, golf shoes from a non-treaty country are subject to a 35% tariff while most cars are assessed a tariff of 25%. These high tariffs do not apply to NAFTA countries which eliminated almost all tariffs on trade within North America in 2008.
Regulatory measures are a much larger barrier to true free trade between nations then tariffs. For example, US-based technology companies are frequently targets of burdensome regulation that limits their access to markets. According to recent news reports in the Wall Street Journal and other sources, the EU is preparing new anti-trust charges against Google for its advertising methods. China also recently enjoined Apple from selling its iPhone 6 in Beijing since Apple is supposedly violating phone design patents held by Shenzhen Baili, a small Chinese technology company. Measures such as these are designed to extract cash payments or slow the sale of disruptive goods or services in a market to allow local competitors time to catch up to more innovative foreign companies.
In the case of the United Kingdom, Brexit causes confusion in trade and all of the attendant regulatory issues that impact trade. However, UK trade with the rest of the world has grown at a much faster rate than UK trade with European Union members. For the 15 years from 1999 to 2014, trade between the United Kingdom and Europe grew at a rate of 3.6% per year. This rate pales in comparison to the United Kingdom’s trade growth with the rest of the world which grew at a rate of 6.5% per over the same period (see table above).
We believe Brexit will result in significant short-term uncertainty regarding trade. There is also the potential for a domino effect that could interrupt trading within the broader EU, especially its financial sector, which still faces unresolved issues from the financial crisis and Southern Europe's debt issues. On the other hand, freedom from the European Union may allow the United Kingdom’s trade representatives to pursue deals with the rest of the world more aggressively, thus expanding linkages and economic growth. Brexit could also benefit global trade over the long term by limiting regulatory overreach by Brussels and others which slows trade and innovation.
Trade Exposure within your Portfolio
At first glance, the trade disruptions discussed above may not seem important to a US investor investing in mostly US stocks. But almost any large company today is going to be exposed to international trade, and therefore reliant to some extent on freedom of trade. We operate within a global economy and the results can be seen when companies report their revenue by geographic region.
Qualcomm Inc. (QCOM) only lists 1% of its revenue coming from the United States. While the demand for the company's chips is mostly driven by the US consumer, Qualcomm is selling or licensing the chips to a manufacturer that puts them into a phone and most smart phone companies such as Samsung and LG are based in Asia. In addition, most of QCOM’s suppliers are also foreign. QCOM’s largest supplier is Taiwan Semiconductor, the chip manufacturer.
In reality, most companies list some revenue as being generated outside the USBorgWarner, manufacturer of automotive parts, generates almost 75% of its revenue outside the U.S. Nike and Procter and Gamble both sell more merchandise outside the US than inside. St Jude Medical sells about half their devices outside the US.
Norfolk Southern Corp (NSC), a railroad company, lists all of its revenue as generated from the US. But the company is as exposed to trade as any large cap company. NSC will load toys manufactured in China and transport them across the US to a distribution center in New Jersey. Without global trade, the toys are never shipped across the Pacific Ocean to a US port.
If an investor wanted to avoid exposure to international trade, the resulting portfolio would have limited diversity and opportunity. Many utilities aren't exposed to international trade as they generate power from a natural resource and sell domestically. Many banks are regionally concentrated. Healthcare providers like UnitedHealth Group Inc. operate within the US borders. Some retailers, like CVS Health Corp or O’Reilly Automotive are relatively insulated as they only have US stores. But even CVS relies on Bayer AG, the German company, for some of its supplies.
A properly diversified portfolio is exposed to international trade even if all the direct investments are US based companies. While this exposure may add to volatility in the short term, it is necessary in today's global economy and has a long-term positive effect on the portfolio.