Brexit: The Vote, and the Impact on Gold and Broader Markets

Financial markets went through one of their most volatile trading days on record Friday, with an unexpected Brexit vote causing chaos on currency markets and stock exchanges, with huge moves in the Japanese yen, declines in bond yields, and a rally in gold, as investors flocked to safe haven assets.
 
This morning, gold is trading back USD $1320 per troy ounce, whilst in Australian dollars, the price is closing in on AUD $1800 per troy ounce, owing to a sharp decline in the local currency.
 
Below we share our thoughts on the impact that the vote will have on markets and the investing world, as well as the result itself!

The Impact of Brexit on Gold, Broader Markets and Investing!

Brexit, and the potential for other countries to follow a similar path in due course is just another challenge on top of those that already existed before the vote. Global growth is weak (and slowing), global trade is declining, whilst debt levels are higher (and rising) all around the developed world.

Question marks over what happens in Europe that is still struggling with an obviously flawed economic model which offers a monetary but non-fiscal union that is clearly hurting certain member nations, plus rising fears over other potential political “grey swans” (think Donald Trump), will only add to the uncertainty that has suddenly gripped markets.

It makes for a difficult time for investors, who need to combine that difficult economic outlook with a market environment where business remain reluctant to invest, and sustainable earnings growth is proving difficult to generate for the market as a whole. This is a potential problem when you factor in what investors are paying to be owners of listed shares today, especially in the United States, where the S&500 is trading close to 25x cyclically adjusted earnings.

Meanwhile, traditional defensive assets are either already offering negative real yields, or close to it, with central banks now likely to embrace even further monetary easing post-Brexit.

The market would certainly seem to expect that, with the following table from Bloomberg highlighting implied probabilities for the Fed funds rate. 

As you can see, there is now a 10% chance we’ll see a rate CUT in July, odds that increase by September-November, whilst the market currently sees no chance of any hike between now and the end of the year!

It is not a time for panic, but it is definitely a time for caution, and for prudent and robust asset allocations within a portfolio.
 
As regards to precious metals, it wasn’t surprising to see gold move like it did, with the previous few days seeing the metal ease as a “Remain” vote was priced in. Medium to long-term I’m obviously bullish for reasons that have been covered many times, but the key question for shorter-term traders is what happens in the next week or so.

I’m cautiously bullish over this time frame, as investors price in the idea that central banks the world over are likely to be even more dovish post-Brexit, with rate hikes from the Fed off the table for this year now. There will also be many who want to own gold as a hedge against further volatility in risk assets, with its role as a safe haven gaining greater appeal in a world where traditional defensive assets offer negative real yields. If gold can push above USD $1350oz (no guarantees there), then i can see it heading toward USD $1400oz quite quickly, which, given the potential downside in the AUD in the coming months, could easily see a XMAS 2016 gold price of AUD $2000 per troy ounce.
 
Having said that, we’ve now seen a circa USD $280oz move already this year, with speculative positioning stretched, whilst gold also has some key resistance levels it needs to clear if it’s going to continue to push higher in the second half of 2016. Australian dollar investors will be protected from a likely decline in the currency should further volatility occur, though we still think dollar cost averaging is the best course of action for those who want exposure to the sector.

Brexit itself, thoughts on Brexit and the reaction to Brexit!

Firstly, I want to briefly discuss the result itself. The shock from it, and the impact it is having on financial markets was and is clear, and may well continue for some time.
 
What I personally found astounding though was how clear the voice of the English people was on this issue. That may sound a controversial claim, especially when the vote was +/- 2%, but consider the following map, taken from the BBC, which shows the breakdown of areas that voted leave (blue) or remain (yellow)!

As you can see, outside of Scotland (which is staunchly pro EU and now almost certain to want to vote their way out of the United Kingdom), vast swathes of England itself had a majority leave vote.

Indeed in total, the Leave vote won by just over 1.25 million votes, even though Scotland voted for Remain with a +600,000 person differential in favour of staying in the EU. Northern Ireland (mostly Remain) and Wales (mostly Leave) were more or less a tie on a net basis.
 
As such, take Scotland out of the equation, and Leave would have won by closer to 1.8 million votes, or more than 10% of the total number of people who voted Remain.
 
One can argue they made a mistake, but one is clutching at straws to argue that the will of the English people at least is not being fairly represented by the outcome.
 
Interestingly, there was a clear split in the vote based on age, with older folks far more likely to vote for “Leave”, whereas younger votes were far more likely to sit in the “Remain” camp. This is also captured neatly in the image below, also taken from the BBC.

What to make of the above? Some argue that this represents older Britons selling out the future of their children and grandchildren, with xenophobia and fear of foreigners key factors driving those to vote Leave.
 
Martin Wolf, writing in the Financial Times, noted that in his opinion, it represented the Wests’ retreat from globalization, and that the vote was a victory of the disappointed and fearful over the confident.

This retreat from globalization is not just evident in the vote for Brexit, but according to those who subscribe to this point of view, it can also be seen in the rise of Trump, as well as the Five Star Movement in Italy, and the rise of Le Pen’s National Front in France.
 
There is an alternative view though, and that is that it is the older age group who, by virtue of having lived through it for the last 30 years, more readily grasp the failures (perceived or otherwise) of the European Union, and its inability to deliver on the benefits promised.  These are the very same people that either directly participated in WWII or grew up in its aftermath. They, more than any other generation understand what the horrors of a divided Europe can look like, and they voted into the dream of what the EU promised to be. It speak volumes that over 30 years later, they’ve voted out of what it has become. 
 
Younger voters on the other hand have clearly known any different, which, at least to some degree, would have influenced their decision to vote Remain (fear of the unknown), whilst older people remember what things were like before they entered the Common Market.
 
We'd actually be curious to know the view on young people on the continent, considering the levels of youth unemployment in some countries, which is still at depression era levels, despite the fact the GFC “ended” several years ago (see chart below).

Moving on from why the vote to Leave won, we have found the reaction to Brexit even more interesting. Social media is alight with reports of Britons who apparently now regret their decision to vote Leave, though most of these people appear to be young Londoners, who statistically speaking, are far more likely to be surrounded by friends, family and colleagues who have given them a “what have you done” talking too in the aftermath of the decision.

Across the asset management industry, and amongst the political and economic elite, there is almost overwhelming consensus that a grave mistake has been made, no surprise considering the uncertainty is most certainly not good for the price of risk assets. George Soros has warned Brexit will make everyone poorer, something Paul Krugman clearly agrees with, with the Nobel prize winner describing the result as “pretty awesome – in the worst way”.
 
What is so interesting though is that these same people are openly critical of the EU, and only too happy too highlight its obvious flaws, with Krugman for example stating that; “At the European level, in other words, I would argue that Brexit just brings to a head an abscess that would have burst fairly soon in any case.”
 
For a more detailed example, consider the following from Josh Barro, the Harvard trained son of macroeconomist Robert Barro and former senior fellow at the Manhattan Institute for policy Research.

In an article which appeared in Business Insider, Barro noted that (bolded emphasis mine); “Brexit does nothing about the two biggest problems in Europe: the unsuitability of the euro for many of its members, and public dissatisfaction with the failure of European governments to control migration into Europe. The not-so-secret idea behind the euro — that fiscal integration would come later, whether the public wants it or not, because it is necessary to make the eurozone work — was foolish, because European countries lack the political will to support each other fiscally at great, ongoing expense. Because a eurozone breakup is unthinkable and European fiscal integration is unpopular, the unsustainable status quo in the eurozone is likely to be sustained for a long time, causing great misery in countries like Greece and Spain. Basically, Brexit was a tantrum. Britons looked at an institution that was flawed and unresponsive and did a thing that doesn’t fix the flaws and hurts Britain’s own economy. This vote reflects the error of direct democracy: The British public made a bad choice, and there’s a reason we usually have voters delegate decision-making to informed elected officials instead of deciding policy on their own. But the vote also reflects the errors and hubris of European political elites, who gave voters an institution so flawed and so allegedly irreversible that they felt compelled to act out in whatever way was available to them. The best case scenario is that Brexit leads to a rethink in Brussels, and an effort to produce an EU that is more accountable and leaner — and ultimately, to find a way to unwind the euro, which will never work well without a fiscal union, which the people of Europe will never want. But I am not holding my breath for that.”

Barro admits the EU is flawed, unresponsive, and run by elites who will not change despite the clear voter anger at the damage they are causing. He further acknowledges that the EU as it currently stands is causing great damage to many of the countries who are members, before finishing with an admission that the whole project is ultimately unsustainable, and will never work.
 
Despite this, he thinks Great Britain has made a mistake in voting to Leave.
 
Surely an argument can be made that supporting a political union that even its defenders argue is unfit for purpose, harmful to many of its members and ultimately unsustainable can hardly be deemed a rational course of action.
 
From this point of view, one can surely also make the opposite case to that made by Wolf in the FT. For whilst the vote for Brexit equals greater uncertainty in the short-term, it is at the very least a sign of hope, of free people saying that they will no longer willingly be dictated too by an unelected and largely unaccountable political elite, running an institution that even its defenders acknowledge is fundamentally unfit for purpose in its current state.  
 
Indeed considering the scare campaign the Remain camp ran (essentially the UK can’t prosper without Brussells and that Europe will punish the UK if they vote Leave), one could argue that vote for Leave was a vote for the confident, of a people saying “we are not afraid”, whilst a vote for Remain was a vote for the fearful.

After all, the campaign warning of the turmoil of Brexit had many cheerleaders, including captains of industry, and even from foreign heads of state, most notably Obama, whose speech advocating a vote for Remain almost to the day coincided with a surge in the polls for the Leave campaign (see image below).

The fear card played by the Remain camp was perhaps most evident in an IMF report that suggested a vote for Leave would permanently (re-read that word, permanently) reduce the incomes and standard of living of the average Brit.
 
The idea that an organisation that struggles to forecast GDP from one year to the next can predict standards of livings for a nation state in perpetuity is surely a joke, and not one that any self-respecting analyst or economist would put their signature to.  
 
Note that this is not to downplay some of the falsehoods those who agitated for Leave were willing to trot out, with balanced arguments sadly lacking on all sides, as they typically are in all political debates the world over it seems.
 
On that score, we agree with Ambrose Evans Pritchard, who explained why he was voting for Leave, but was under no illusion as to how difficult the next few years will be.
 
For what it is worth, in my opinion, there are benefits as well as problems with the decision to vote Leave. The downside is the volatility in financial markets and declines in equities across the globe, the likes of which are not something to be celebrated. A period of lower growth that will almost certainly be made worse by rising political instability on the continent as a result of Brexit, with greater uncertainty for business, is also nothing to gloss over.

Having said that, we are not certain the fallout will be as bad some prophets of doom forecast. Yes, the EU could punish the UK with punitive trade and travel restrictions and the like, but there will be a price to pay for that which will be borne by European companies, consumers and citizens too, with the UK one of the largest export markets for Germany, France and Italy. This is something EU leaders will be painfully aware of, unless they truly are blind to the realities of the Union they "oversee". I am also not at all convinced by some of the scaremongering headlines that businesses will be in some huge rush to relocate operations from the UK to the Eurozone hubs. Why would you, when there is arguably more uncertainty on the continent now than there is in Brittain.

A vote to Leave the European Union need not mean disengagement from Europe, a lack of desire to trade with the continent, or even about reducing immigration (though controlling it is clearly a key issue), with 49% of Leave voters stating that the reason they voted Leave was founded on "the principle that decisions about the UK should be made in the UK", according to a Lord Aschroft Poll. 
 
Furthermore, we should also not lose sight of the potential key benefit of this vote. In many ways it draws a much needed and long overdue line in the sand, with everyday people sending a clear message to a political class that they expect better, and they will no longer continue to cede more power and control to unaccountable authorities who have largely proved unworthy of it.

How Times have Changed!

A final question has to be asked in the aftermath of the Brexit vote, and it is one that can only lead to an uncomfortable answer. Before we pose the question, consider the following chart, which also comes from the BBC. It shows the percentage of people in the UK who voted on whether or not the UK should stay in the European community back in 1975, versus what transpired late last week with a successful vote for Brexit.

As you can see, nearly 70% of people voted YES over 30 years ago, with a turnout of some 64% of voters. This time around, some 52% of the people voted NO (or out) with a turnout of 72%.
 
This feeds in with our comment above that many of the people that voted Leave, who are in their 60s and 70s today, would undoubtedly be the same people who voted for entry into the Common market some 30 years ago.
 
The question is WHY?
 
What has happened in the last 30 years to create this change in the minds of everyday voters? After all, the last 30 years are a period in which unprecedented wealth has been generated, with asset prices rising at their fastest pace in history. Equity markets, despite the volatility, have experienced incredible growth, whilst bond prices have risen to untold heights, with yields at the lowest levels we have seen in several thousand years. For evidence of this, consider the following chart from McKinsey, which shows returns for European and US bonds and equities, over the last 30 years, as well as the average for the past 100 years, and projections for the future.

Whilst the returns aren’t UK specific, the results would be much the same as those seen in the US and across broader Europe. The same McKinsey report that the above graph is taken from highlights the fact that bond yields on 10-year UK gilts fell from over 13% in the mid 1980s to under 2% by 2015, with real returns of 5% over the past 30 years. UK house prices grew by 3.3% in real terms over the same period across the entire country, with slightly higher rises in London, whilst the FTSE also enjoyed a strong period of growth, with returns comparable to other developed market nations.

So strong has this period been that Bill Gross recently commented that investors “have a better chance of observing another era like the previous 40-year one on the planet Mars than you do here on good old Earth”.
 
Meanwhile inflation, a scourge for those living in the 1970s, when it hit 25% per annum at one point, is all but extinct, with official rises in consumer prices at their lowest level on record.
 
Tying this all together, we find a 30-year period of relative political calm across the developed world, and the most colossal asset price inflation in history. On paper we have never been wealthier, with the threat of consumer price inflation virtually extinguished. Read (and trust) these factoids alone, and on paper – things have never been better.
 
Yet still the average Briton (and especially those outside of London who are the primary beneficiaries of strong financial markets) voted to upset the apple cart, and vote Leave! People rarely vote for potentially radical and uncertain change, especially if things are travelling well.

The only logical answer we can come up with is that to one degree or another, our economic model is not working.
 
People would appear to be more worried about rising personal debt levels than they are thankful for ever-higher house prices.
 
People would appear to be more worried about stagnant if not declining real wages than they are thankful for higher asset prices.
 
People would appear to be worried if not downright angry at the perpetually rising gap in wealth and inequality, which on most metrics is now as bad today as it was just prior to the start of the Great Depression.  
 
Lets hope elected officials the world over learn from this.
 
Until next time
 
Jordan Eliseo
 
Chief Economist
ABC Bullion

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