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How will Europe 2.0 look?

Uncertain future: the EU will be smaller and possibly more nimble after Britain's departure

Progress is inevitable, but new versions always seem to have their challenges. And so it will likely be with the latest iteration of the European Union as it braces for the probable removal of its second largest member.

As the world’s fifth biggest economy, the UK faces a messy divorce from its most important trading partner. While there is no precedent for a country leaving the EU, the 2009 Lisbon Treaty provides a pathway to separation. Article 50 under the treaty represents the serving of the divorce papers and essentially nothing can really happen until then. However, David Cameron, stepping down as Prime Minister, has said he would not be the one to pull the trigger and consul has opined the article cannot be invoked without a full debate and vote in Parliament.

Theresa May, crowned as the new incoming Prime Minister, named Boris Johnson, the previous front-runner and leader of the “Leave” campaign as foreign secretary. With the UK facing at least a mild recession in the months ahead, May’s job will not be easy.

Global stock markets fell sharply following the Brexit vote last month and sterling plunged against all other currencies. But within just a few days after the initial sell-off, equities began to soar as interest rates plunged across the globe. Within a week after the referendum, London’s FTSE 100 recovered all of its losses and even extended into positive territory. At the same time, investors quickly decided the financial climate looked better on the other side of the Atlantic Ocean, sending the US-based S&P 500 to a series of new all-time highs last week. However, the pound remains under pressure, trading around $1.32 as of this writing.

Fundamentally, Europe had been facing many serious headwinds even prior to the Brexit vote. Legacy issues include divisive politics, excessive debt, undercapitalised banks and challenging demographics. Several years of quantitative easing, debt restructuring (in the case of Greece) and negative interest rate policy have kept the fragile region from backsliding into recession, but forward progress has been spotty at best.

Historically, Europe’s divisive politics and socialist tendencies have often collided with movements towards freer trade and purer capitalism. The recent Brexit vote is really just another example of populist backlash against the establishment. Clearly, not all European citizens view globalisation as a positive trend. Uncontrolled immigration and open borders are blamed for causing myriad social problems ranging from escalating housing costs to increased terrorism.

Importantly, the issue of debt cannot be ignored. After decades of living beyond their means, governments everywhere need to deleverage and Europe is no exception. Excessive debt created by ongoing deficit spending on top of the need to absorb dodgy loans made to the fiscally wayward Southern countries led to the European credit implosion of 2012. Since then, European banks have been forced to improve their balance sheets and shore up capital while at the same time paying massive government fines. More recently, Italy has been the source of a whole new round of problem loans.

Although Europe faces some challenging headwinds, a few positives remain. European stocks have dramatically underperformed their US counterparts for several years now and may offer value for longer term investors who can take some volatility. On a forward price-earnings ratio basis, Europe is 16% cheaper than the S&P 500. As an added bonus, dividends on European stocks on average about 3.7% versus the US-based S&P 500’s yield of just 2.1 per cent. And finally, the falling pound and to some extent, a softer euro currency should be a boon for Western European exporters once the region has chance to work through the Brexit nuances.

Presently, we remain underweight both Europe and the UK in our global equity strategies but have been adding to positions selectively on weakness. Volatility strategies are also working in this environment. Selling puts and calls allow an informed investor to bank attractive volatility premiums during times of despair.

Both the UK and the EU face a more uncertain immediate future. According to the European Commission, the Brexit vote will result in 0.2 per cent to 0.5 per cent less growth for the euro region in 2017 and the UK will enter recession. A range of outcomes is possible, but ultimately progress will depend upon how exactly the EU decides to deal with the exit negotiations. Taking a hard line would likely add further downward pressure to trade and growth. However, if the EU makes the pathway too soft, that could encourage other members to consider leaving.

Expect the rest of the EU to stay together for now as the remaining nations are geographically situated within the continent and share extensive borders. Moreover, the largest members, unlike the UK, have adopted the euro and would be faced with the extraordinary hurdle of transitioning to another currency if they decide to leave. Europe watchers may remember that the “Grexit” showdown was at least in part thwarted by the currency issue.

At the end of the day, Europe 2.0 will look a lot like Europe 1.0: smaller but perhaps more nimble in some respects. Certainly the remaining nations will be watching the UK intently for clues concerning their own fate. An election in Spain, just a few days after the Brexit vote actually found greater support for the status quo, likely influenced by the rapidly plunging UK equity markets and British pound.

After the latest run-up in risk assets, investors should consider moving towards higher quality investments and avoid riskier situations everywhere. Volatility will likely remain elevated and that should offer more opportunities. Over $13 trillion of sovereign bonds are now trading at negative interest rates, and much of this is in Europe. Aggressive monetary policy has reached the limits of its effectiveness. No rational investor should consider buying long term euro sovereigns or investment grade bonds at negative rates which guarantee loss of principal.

Ultimately, Europe needs more intelligent leadership from both business and government. The way forward will require greater co-operation, compromise and some sacrifice from all, including quite possibly investors. Don’t be on the losing side of this trade.

Bryan Dooley, CFA, is a senior portfolio manager for LOM Asset Management Ltd. He can be contacted at bryan.dooley@lom.com.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.