It is a momentous day with Article 50 of the Lisbon Treaty being formally triggered by UK Prime Minister May, nine months after what was, at least initially, a non-binding referendum.
European Council President Tusk is expected to formally respond for the EU before the weekend. It is not immediately clear when the negotiations will start. However, it is clear that the formal triggering of Article 50 will transfer the initiative and balance of power toward the EU from the UK. Over 24 months, there will be plenty of posturing, negotiations, brinkmanship tactics, and blinking.
Many investors may be best served by keeping the core issue in perspective. The UK government is willing to lose access to the single market in order to get more control of its borders for immigration and trade. Europe, on the other hand, just celebrated the 60th anniversary of the Treaty of Rome which established the European Project. Losing a member – and an important (though not a founding) member – is a significant blow to Europe, which is having its own identity crisis of sorts.
Some initiatives that the UK blocked, such as a European army, may go forward, but the UK’s amputation will change the balance in Europe on a range of issues and alter Europe going forward. Non-EMU, EU members have lost a voice. These countries are mostly in Eastern and Central Europe and have presently strained relationships with the older Western part.
Contrary to speculation that Brexit would lower the barrier to exit and others would soon follow, surveys suggest that EU support has risen among most of its members. It is as if the body politic has been attacked, and the antibodies have rallied in defense. The populist-nationalist challenge was turned back in the Netherlands. The price was to co-opt the anti-immigration plank of the populist-nationalist platform.
In France, Fillon’s self-immolation gave Macron an opportunity, and because of the nearly “anyone but Le Pen” mentality, it is not clear if the center of the political spectrum shifted. In Germany, Merkel’s CDU did well in the past weekend’s election in the state of Saarland. In the two elections next month and the national election in September, her biggest challenge is from the centrist Social Democrats, not the anti-EMU and anti-immigration AfD. Italy’s election may be a more serious challenge than this year’s contests.
If the EU is such a good place, why make it hard to leave? To me, it is obvious that you cannot make plans for the future unless there is a commitment. There are some things, like national interests which, if not permanent, have a longer life than individual administrations (governments). There is no clause in the US Constitution that allows states out of the union (yes, leave aside the Republic of Texas, which for a brief moment was an independent country). The American Civil War was fought to keep the union together, and the states that left are the poorest states, like Mississippi, Alabama, Arkansas and Louisiana.
I think Brexit ultimately makes the UK weaker, but there are competing influences on sterling. Cyclical factors are what I cite in the interview, but market positioning may also be important. There are some drivers that have very little to do with the UK, such as the dollar’s broad direction, Fed and ECB policy, and, the significant volatility we have seen emanating from China and Greece. Nor can investors ignore the reaction function of the Bank of England. Although BOE was steady, we recognize that price pressures have not peaked and the economy is still resilient. There is some risk of a hike.
Sterling finished the North American session on a soft note on Tuesday and opened Asia around a half cent lower to return to $1.24. The US dollar more broadly is seeing Tuesday’s recovery extend against European currencies. The Dollar-bloc currencies are firm, and the dollar is steady around JPY111.00. Consolidation is the most likely near-term scenario.