Churchouse Letter
April 2016             by Peter Churchouse

To Leave Or Not To Leave

On June 23rd a vote takes place that has the potential to cause huge upheaval... but uncertainty = opportunity...

Three months from now, the U.K. could no longer be in the EU. The potential ramifications are absolutely huge.
There's a lot of fear in the market, and that's given us a potentially profitable opportunity... but it's not in stocks or the bond market... it's far easier than that...

I remember as a child in New Zealand standing on the side of the road next to our broken-down old Vauxhall car. My mother and I were making a 60-mile trip across a small range of hills from our hometown of Tauranga to Rotorua, the provincial capital of the Bay of Plenty.

It was the late 1950s. The car was a pre-World War II 1937-vintage, or thereabouts. Painted jet black, it was spacious with generous leather seats and a walnut dash. It had served us well, but now our hitherto-trusty steed had given up the ghost half way up a steep hill.

I can't remember how we got out of the predicament. Most likely, through the kindness of some passerby I suspect. Even in those days, it was an old car.

Growing up, our family never had a new car. But this wasn’t unusual in New Zealand at the time. We could not have had one even if we had wanted one. Government regulations made it impossible. It is hard to imagine this kind of thing now, but that was the case back then.

The rule was that only individuals or companies that directly earned foreign exchange were allowed to buy a new car, which then had to be imported using foreign currency.

The only individuals who could buy a new car were farmers! They produced meat, milk and wool that were exported and earned the country valuable foreign exchange.

At that time, both Australia and New Zealand boasted a per capita GDP in the top seven or eight in the world. It didn’t feel like that to us. But it is true.

How could two tiny agricultural economies tucked away at the bottom of the earth be at the top of the economic league tables?

Simple. Both countries are former British colonies. As such, both countries possessed what was called “most favoured nation status”. Meaning Britain imported as much as possible from its former colonies rather than elsewhere.

This preferred status underpinned their economies while providing the U.K. with a steady flow of cheap high-quality meat, wool and dairy products to feed its growing postwar population.

Australia also had the added advantage of being able to dig all manner of minerals out of its vast landscape for use by the former British motherland.

This trade earned Australia and New Zealand valuable overseas earnings. But these countries had little domestic manufacturing base. Therefore, they had to import just about all their non-agricultural needs.

Demand for such imports (cars, household white goods, steel, aluminium, cement – you name it) was generally higher than the earnings from agricultural exports. Hence the rationing of foreign capital!

So no, you couldn’t just buy that new Austin, Morris or Vauxhall car imported from Britain, the U.S., or wherever. You had to directly earn foreign exchange to pay for it first.

In return, the colonial motherland would undertake to relieve you of pretty much all the agricultural products you could produce. By the mid-1950’s pastoral farming products constituted over 90% of New Zealand’s exports, 65% of which was going to Britain.

This cosy relationship was the backbone of post-war growth in both countries, even more so for New Zealand than Australia.

But dark clouds were clustering on the economic horizon.

Beginning of the End

By the late 1960s, Britain was getting ready to join the European Economic Community (EEC), or the common market as it was known back then.

Formed under the 1957 Treaty of Rome, the EEC was designed to create greater economic freedom and integration amongst its original six member countries (which did not include the U.K.).

Britain applied to join the club in 1961, but was vetoed by then French president Charles De Gaulle.

In 1967, Britain re-submitted its application and, with De Gaulle now out of the way, France’s veto was removed. Negotiations were long and tortuous (little has changed on that front), but eventually the U.K. joined the EEC in January 1973.

A key sticking point in the negotiations was the European Common Agricultural Policy (CAP). This stipulated that Britain could not continue to bestow most favoured nation status on its former colonies.

By 1955 Britain had already stopped giving New Zealand ‘guaranteed’ prices for its exports, so whilst Britain remained their largest export market, prices were falling.

The entire economic prospects of Australia and New Zealand were looking increasingly grim.

The quasi-guaranteed ability to sell pretty much all its agricultural produce to a single market, Britain, would finally vanish in a puff of legislative smoke.

And in 1973 all trade agreements (except one) between New Zealand and Britain came to an end.

Britain was forced to abandon its low-cost producers down under in favour of higher-cost producers who were being subsidised under the CAP. They also had to contribute to those subsidies of French, Dutch and other EEC farmers.

The British realised this would make their own economy susceptible to higher inflation, but figured the costs of higher inflation were worth bearing to enjoy other economic benefits that closer integration would bring.

And so, for Britain, the great European experiment began. It’s been a rollercoaster ride with lots of twists and turns over the years. The most stomach clenching part of the ride was the debate on whether to join the Euro.

In the end, Britain chose not to join the Euro currency adventure. Definitely a good call, as it turns out.

But there’s a new bump in the tracks, which threatens to topple the carriage and bring the entire roller coaster crashing down. I’m talking about Britain’s potential withdrawal from the European Union (EU), or “Brexit” as it’s come to be known.

Britain’s withdrawal from the EU would spell trouble for global markets, countries, businesses and individuals, just as Britain’s entry into Europe proved for many of its former colonies back in 1973.

As for New Zealand? By the time Britain joined the EEC, just 26.8% of New Zealand exports went to Britain, down from 65% in the 1950’s.

In 1953 the country had the 3rd highest standard of living in the world. By 1978, it had dropped to 22nd place…

Fall From Grace

By the time my wife Gabrielle and I first set foot in the U.K. in 1975, straight out of Africa, the U.K. had been in the EU for a couple of years.

To put it bluntly, the U.K. was a complete shambles.

The year after we arrived, Britain had to be bailed out by the IMF! This is the sort of thing you associate with wayward banana republics in the third world, not the hitherto leader of the free world.

We had enjoyed the British legacy left behind during our travels across Africa. For most of the countries we travelled through, the British pound was the “go to” currency. When you bought local currency on the black markets, you paid in pounds, not U.S. dollars.

Yet here we were, London in the mid-70s, witnessing this great country that had been at the forefront of the world for a couple of hundred years, in total turmoil.

The Prime Minister, Harold Wilson, was not even running the country. He may have been the PM, but it was Arthur Scargill, the boss of the miners’ union, and his cronies who really called the shots.

Inflation was running amok at over 25%. Britain now had to pay those very high, subsidy-protected prices for French farm produce. The cheap stuff from the Commonwealth was being squeezed out.

Back then we knew from the outset that would be the result of EU membership.

All those sheep, beef, wheat, dairy and banana producers from the former colonies were going to suffer. And the British public would be hit by the inflation caused by the mandatory purchasing of European produce at European prices that were way higher than the prices paid for produce from the Commonwealth.

The path ahead was relatively clear and predictable, if not very savoury…

But Brexit?

We’ve spent a lot of time here at office pouring over research, polls and economic data.

This is one of those occasions where you really have to cut through a lot of political noise.

There’s so much opinionated racket deliberately obscuring factual, rational analysis that it is difficult to bring reliable hard numbers to the table, whatever side of the Brexit fence you are sitting.

You can explore some of the better Brexit musings, rants and data on the following sites:,,,

The simple reality is that any discussion of Brexit involves a huge amount of speculation over radical unknowns.

Fates and Furies

The EU isn’t just some club where you hand back your membership card and walk away.

Once a country decides to leave, it’s the 27 remaining EU members that get to decide the terms. Not only that, but the withdrawing member state (in this case the U.K.) is not even allowed to participate in those discussions.

So states Article 50 of the Treaty of Lisbon, the international agreement that forms the constitutional basis of the EU. It addresses the thus far unprecedented steps taken if a member state decides to withdraw from the union.

We just don’t know what the terms of any exit agreement would be.

What we do know is that Britain can propose whatever it wants with regards to its exit, but no one has to listen. Britain will not even be in the negotiating room when those terms are discussed and eventually agreed upon by the remaining EU members.

We may all have our views on the likely approach taken by the key players – France, Germany, Holland, Spain, Italy, Portugal – but there is no way of knowing what the details of any agreement will be.

Do you honestly think that the major EU countries are going to do the U.K. any favours? Not likely. Especially given the volatility and loss of confidence the mere mention of a Brexit is causing across Europe.

EU firms would put their governments under tremendous pressure to penalise the U.K.

We can also be pretty sure that any negotiations would take a long time. This is not going to be a six month event.

Bear in mind that any trade deal with the EU requires approval of all 27 remaining countries along with the European Parliament.

And what about the 53 free-trade pacts the EU has signed with other countries around the world?

Does anyone believe that Britain will simply be able to replace those with their own?

The U.S., India and China are all currently negotiating new trade deals with the EU. Britain would not be included were it to leave.

The U.K. would be out in the cold for who-knows-how-long.

What Do I Think?

Simply put, I think Brexit would be devastating for the U.K. economy in the short-term. It would be a dagger blow to the European Union in general. And it would be a profound geopolitical shock which would reverberate in ways we can’t possibly imagine yet.

Corporate uncertainty has already escalated with the referendum deadline looming.

In the fourth quarter of last year (2015) business investment fell 2%... this is what “wait-and-see” looks like. Brexit would only prolong and deepen this hesitation.

Every quarter, Deloitte surveys Chief Financial Officers (CFO) from major U.K. companies. In its most recent one (conducted in mid-March), some 120 CFOs participated, including 20 FTSE 100 companies and 55 FTSE 250 companies.

Not surprisingly, the EU referendum is the dominant concern. But there’s also been a marked increase in EU membership favourability.

EU Membership Favourability Poll of CFOs comparing Q4 2015-Q1 2016.

But what’s frightening is that over 50% of these CFO’s of major British businesses say that their business has not or are not in the process of making any contingency plans for a possible Brexit!

This tells us that corporate Britain is completely unprepared for a possible Brexit.

The uncertainty alone generated by the referendum has reduced hiring, investment expectations and risk appetite.

The Confederation of British Industries (CBI) has just released a report by PricewaterhouseCoopers showing that, even with successful trade negotiations signed, U.K. living standards, GDP and employment would all significantly deteriorate with a Brexit. (You can read the full report here if you wish).

It’s also worth noting that other major global governments have weighed in on Brexit. In October of last year Chinese President Xi Jinping told the British Prime Minister;

“China hopes to see a prosperous Europe and a united EU, and hopes Britain, as an important member of the EU, can play an even more positive and constructive role in promoting the deepening development of China-EU ties”.

Let me tell you, it’s highly unusual for a Chinese leader to opine so openly on a foreign country’s internal affairs. And it’s not particularly encouraging either.

Or take Narendra Modi, India’s PM who said a month later;

“Yes we are going to other European countries as well, but we will continue to consider the UK as our entry point to the EU as far as possible”

Like I said earlier, there would be geopolitical ramifications far beyond the initial impact zone of the U.K. and Europe.

Where Are We Now & Where’s The Damage?

When it comes to Brexit, polling is both volatile and close. The Financial Times has done an admirable job of trying to compile multiple polls (see here for the polls).

Right now it’s a lot tighter than I originally anticipated. And there are plenty of polls that put the Leave camp ahead.

Brexit Polling Movement from September 2015-April 7 2016.

But aside from the decline in business investment mentioned earlier, where else are we currently seeing Brexit fears materialise?

You might expect to see U.K. sovereign bonds (or gilts) sell off. Government bond investors shy away from the kind of uncertainty the referendum brings.

But that hasn’t been the case at all. Yields have fallen in tandem with U.S. treasuries (see Figure 3) and the spread between the two hasn’t increased.

Thus far, Brexit fears have not lead to an increase in U.K. government bond yields.

How about the stock market? Are investors dumping U.K. stocks?

No. The FTSE All-Share Index is roughly flat for the year, trailing the S&P500 by a percentage point or two and outperforming the Eurostoxx 50 by about 8%.

Right now, ALL of the market’s Brexit fears are being reflected in the currency.

We can measure the ‘fear’ in three distinct ways:

  1. The absolute level of the sterling.
  2. The implied volatility of sterling FX options.
  3. The difference in the cost of buying downside protection (i.e. sterling put options) versus up-side protections (i.e. sterling call options).

Firstly, the sterling has weakened against both the U.S. dollar and the Euro (see Figure 4), especially since Mid-November 2015 which is when we started to see Brexit polling start to narrow.

Currency weakness has not purely been a result of Brexit speculation. There has also been some weak economic data both in terms of GDP and production. But ask anyone on a forex trading desk why sterling has sold off and brexit will be top of the list.

GBP vs USD & EUR over 1 year from March 2015 to April 2016.

The second ‘fear’ measure is implied volatility.

This is a measure of the markets expected future volatility for a currency pair derived from the currency options market. In this case we’re looking at sterling versus U.S. dollar 3-month implied volatility.

Figure 5 shows this implied volatility data going back over 15 years. The only time implied volatility has surpassed the current level was during the Global Financial Crisis and subsequent Eurozone crisis.

Higher volatility means investors are paying more in the options market to hedge (or speculate) on future currency movements.

GBP Volatility Skew 2003-2016

But the final piece of ‘fear’ data we need to look at is skew. This is simply a measure of the difference in volatility between buying a GBP call (i.e. the right to buy sterling… bullish) versus a GBP put (i.e. the right to sell sterling… bearish).

When this value is positive, it means buying a call is more expensive than buying a put. When the value is negative, it means buying the put is more expensive.

As you can see from Figure 6, skew is now at its lowest point in over a decade. This tells us that investors are aggressively bidding up insurance on a weak sterling by buying puts.

When you look at these three gauges, it’s clear there’s a lot of ‘fear’ when it comes to sterling right now.

GBP Volatility Skew from October 2003-April 2016.

How Will the Vote Go?

It’s touch-and-go. And it’s a lot closer than I would have thought.

Unfortunately, we have to heavily discount the polling numbers.

You might recall last year’s U.K. national elections had opinion polls suggesting the Conservative and Labour parties being neck-and-neck (34% of the vote each) with no single poll putting the Conservatives more than 1% ahead.

Yet the Conservatives won 38% of the vote versus Labour’s 31%... a huge difference.

Also, historically referendum voting intention polls have changed a lot in the run up to the vote and early polls are not necessarily a good guide to the eventual result.

It’s expected U.S. President Barack Obama will use his visit to London this month to urge continued membership of the EU, joining his Chinese and Indian counterparts. Unlike the others, he retains a very high approval rating within the U.K. so I would expect his opinion (carefully and respectfully worded) to have some impact.

My sense is that as polls have tightened, it’s only now that we are starting to see the Remain camp become more vocal.

I expect that EVERY DAY from here on in, we will see the Remain voices becoming louder and clearer.

It will be warnings from major business leaders… open letters from large companies themselves… joint statements from industry bodies etc…

As Brexit has shifted from a long-shot to a reality, I believe that fear and uncertainty will win over the British voters.

So What’s the Trade?

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