Britain’s Challenges Are More Basic Than Brexit

The Brexit vote is coming! The Brexit vote is coming!

Much has been written and said about what might happen if U.K. voters decide to ditch the European Union tomorrow, and much of it hasn’t been reassuring. The U.K.’s economy will slow. U.K. companies will be poorer. Jobs will be lost. George Soros thinks the pound will plunge — even more than it did when he made $1 billion betting against it back in 1992.

That sounds bad. But before investors freak out about a Brexit-induced meltdown in the U.K., they would be wise to consider the current state of play.

Regardless of whether the U.K. recommits to or abandons the EU, it’s worth noting that the U.K. already is struggling with some fundamental market and economic weaknesses. The MSCI United Kingdom Index returned a handsome 10.5 percent annually from its inception in 1970 to June 2014 (including dividends). But the Index has since stumbled, returning a negative 8.9 percent annually from July 2014 through May of this year.

The Index’s two-year decline is a symptom of corporate anemia in the U.K. The average return on common equity for the companies in the Index has plunged from 17.2 percent in June 2014 to just 4.2 percent today. One-year trailing earnings-per-share for the Index are only 40 percent of the ten-year trailing average EPS — a sign that corporate earnings are in deep distress in the U.K.

The pound hasn’t held up any better than earnings. The pound peaked in June 2014 and has declined 14 percent against the dollar since then. It’s also 16 percent cheaper than its average exchange rate against the dollar since 1971.

Aren’t these weaknesses already evidence of what Brexit opponents say a post-Brexit U.K. might look like? And since the current troubles began over two years ago, they can’t credibly be blamed on Brexit.

The more likely culprit in this scenario is the business cycle, and it’s a useful reminder that while membership in the EU undoubtedly has major benefits, larger and more mundane economic forces will ultimately have a far greater impact on the U.K.’s economy over the medium term than its decision to love or leave the EU.

It’s also possible to overstate what EU membership has meant to the U.K. economy. Britain joined the European Community — the predecessor of the EU — in 1973. According to the International Monetary Fund, real GDP growth has averaged 2.2 percent annually in the U.K. since 1980 (the first year for which data is available), and real GDP per capita growth has averaged 1.9 percent annually over the same period. Both numbers are in line with historical growth rates for comparably mature economies, and it’s quite possible that the U.K.’s economy could have grown at those rates without EU membership.

Just look at comparably mature economies outside the EU. For example, real GDP growth has averaged 2.6 percent annually in the U.S. and 3.2 percent annually in Australia since 1980. And real GDP per capita growth has averaged 1.7 percent annually in the U.S. and 1.8 percent annually in Australia over the same period.

Granted, thousands of years of history point to the unimpeachable truth that trade helps economies expand and creates wealth (while often leaving battered lives, communities or professions along the way). The EU experiment has thus far only given us decades of economic data to analyze. There’s also no way of knowing whether and to what extent the U.K. would have fared worse had it not joined the EU. By the same token, it’s possible that the U.K. might have done even better had it not joined the EU.

By the way, a rejection of the EU isn’t necessarily a rejection of trade. Both the U.S. and Australia maintain relations with the EU and elsewhere that are in some respects similar to the economic cooperation enjoyed by EU member countries — and there’s no indication that similar relations can’t be (or won’t be) reached between the U.K. and the EU if the U.K. exits.

None of this is to say, of course, that U.K. stocks or the pound won’t decline further in the uncertain days or weeks or even months following a Brexit. But whatever happens, there’s more room for things to get better in the U.K. in the coming years than to get worse.

So take a breath. Your worst Brexit fears may have already been realized.

Source: Bloomberg Gadfly,