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Thoughts on Brexit (Entering Referendum with 12% Cash; Underweight U.K.)

In the Hamilton Capital Global Bank ETF (HBG; TSX), we went underweight U.K. banks heading toward the Brexit referendum, with just 3% of exposure; over time, we would expect this to be closer to 5-7% (see our HBG Manager Comment, “U.K. Banks: Remaining Underweight for Brexit as CDS Spreads/Polls Diverge”, June 8th). Here are some preliminary thoughts on implications of Brexit, particularly as related to HBG.

First, the short-term impact on the fundamental performance of the European banks would seem to be largely indirect, if at all. However, in absence of an abrupt slowdown in economic activity in the U.K. which weighs on other European countries, it is difficult to see how overall European bank profitability would be directly – and materially – impacted. In our view, it is also difficult to see how this causes a global recession, as the U.K. accounts for only ~4% of the global economy. Investors will be watching the economic indicators in the coming quarters for evidence. Given the severity of today’s market reaction, we would expect to allocate some of HBG’s 12% cash position in the coming weeks.

Second, the market is very focused on whether Brexit will be a catalyst for member countries to leave the eurozone. There is a special emphasis/concern for Italy, given its huge size and importance (~10% of total European GDP). While recognizing the potential negative impact to the U.K. in the form of economic uncertainty, in our view, leaving the European Union (i.e., open borders, common market) is significantly less complicated than leaving the eurozone (i.e., common currency, shared central bank/monetary policy, and significant economic integration). How Brexit impacts the fate/unity of the eurozone is too uncertain to predict, and is not likely to be known for many years.

Of note, most of HBG’s European bank holdings are located in Northern Europe, which is comprised of countries wealthier than Canada and with higher forecast GDP growth. Virtually all of our Northern European banks are domiciled in countries with independent central banks that retain control of their own domestic fiscal/monetary policy. Also, of note, the portfolio-weighted dividend yield of the fund’s European bank holdings is over 5.0%, which provides a level of defensiveness.

Third, this type of unexpected macro event highlights the importance of central bank flexibility. The portfolio-weighted average central bank rate of HBG is over ~100 bps, materially higher than that of the U.S., eurozone, or Canada. All things being equal, the fund’s country mix allows for some reduction in central bank rates to stimulate growth and/or mitigate any potential slowdown in global GDP.

On Brexit and the future of the U.K., what does history tell us?

The long-term impact on the U.K. will be determined by whether this change in association results in the country adopting more pro-growth policies outside the European Union – i.e., related to tax, labour, regulation, free movement of capital, among other things. If it does, history strongly suggests that the U.K. would benefit in the form of higher longer-term GDP, notwithstanding the current short-term dislocation/uncertainty. History also strongly suggests that the U.K., as one of the world’s oldest democracies and most capitalistic economies, is more likely than Europe to adopt pro-growth policies in the medium-term.

Also, as one of the world’s largest economies, the U.K, would be in a good position to pursue its own trade agreements outside of Europe. In addition, its importance to Europe would suggest that some trade arrangements will ultimately be agreed upon within the next several years. It is worth noting that there are other European countries that are not part of the E.U. but have separate arrangements, so there is precedent.

The REMAIN camp could not reconcile a fundamental contradiction in its argument/message. How is it that the U.K. could be significantly better off by not joining the eurozone, but leaving the European Union would have dramatic negative consequences? Further weakening the credibility of the REMAIN camp was that essentially the same arguments and gloomy predictions were made by economists/politicians in the 1990’s with respect to the U.K. not joining the eurozone. It is obvious, with hindsight, that not only were these predictions spectacularly wrong, but that, in fact, NOT joining the eurozone was hugely beneficial. It is reasonable to conclude that this likely weakened the credibility of the REMAIN predictions of dire consequences (especially to older voters).

It is worth noting that despite being beside the largest and most powerful economy in the world, Canada thrived without free trade with the United States from 1867 until 1988 (and indeed, there is currently not even free trade between the Canadian provinces). Having said that, in an effort to discourage member countries from contemplating leaving the eurozone, it is possible the E.U. opts to “punish” the U.K. by making cross border trade more difficult, which weighs on GDP in the short-term (possibly even causing a recession). The substantial decline in the pound could, of course, serve as a shock absorber.

Less likely, but also possible in the short-term, is that a reasonable accommodation is made that is in the economic interests of all affected countries. We will await the declaration of Article 50, which will start the two year countdown.

Note: Comments, charts and opinions offered in this commentary are produced by Hamilton Capital and are for information purposes only. They should not be considered as advice to purchase or to sell mentioned securities. Any information offered is believed to be accurate, but is not guaranteed.

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