Algebris Investments’ The Silver Bullet

The Silver Bullet Introducing the Brexit Walrus

ALGEBRIS INVESTMENTS

“The time has come,” the Walrus said,

“To talk of many things:
Of shoes — and ships — and sealing-wax —
Of cabbages — and kings —
And why the sea is boiling hot —
And whether pigs have wings.”

The Walrus and the Carpenter, by L. Carroll

We now have a Divided Kingdom outside the European Union. Brexit will be a hard
one, which will hit the UK economy and hurt most those who voted for it.

After an eight-year recovery built on rising asset prices and debt but stagnant wages, the
poor and the old will see their incomes and savings dwindle. The canary in the coal mine is
the Pound, which already dropped from over 1.50 to 1.25 against the Dollar. For an island
that imports half its goods and food, this means higher inflation. High street retailers are
Alberto Gallo already feeling the pinch: expect even smaller portions and less fruit and vegetables on the
Portfolio Manager, shelves.
Algebris Macro Credit Fund
Head of Macro Strategies
agallo@algebris.com But Brexit uncertainty could also scare off investment and push jobs away, as shown by
some firms already relocating elsewhere. This means Britain's ultimate store of wealth,
Tao Pan property, could turn into a trap. With a fall in investment and demand from foreigners and
Macro Analyst interest rates already at the bottom, London's market has already cooled off.
tpan@algebris.com

There is little the government will be able to do this time around: schemes like the Help-to-
Aditya Aney
Buy will have to give in to the reality of a 5% budget deficit and the need for lower spending.
Macro Analyst
aaney@algebris.com Higher taxes may be on the way too. While the last budget from Number 10 ignored Brexit,
some local councils are already feeling the pinch and threatening to raise taxes.
Pablo Morenes
Macro Analyst Brexit will cost Britain £140bn, 7.5% of GDP or the equivalent of £300m a week over eight
pmorenes@algebris.com years, according to our calculations based on direct costs such as job losses from the
finance sector, as well as inflation eroding incomes and savings (The Silver Bullet | The High
Cost of a Hard Brexit).
Algebris (UK) Limited
7 Clifford Street
London W1S 2FT But for a country deeply divided by economic and social rifts, leaving Europe was never
Tel: +44 (0)20 7851 1740
about the economy. It was about finding unity. Polarising public opinion against the EU and
www.algebris.com immigration and away from domestic issues was an easy political win. Yet Brexit will not fix
the shortfalls of the Anglo-American growth engine, which ran on credit and rising asset
prices over the past decades, disregarding rising inequality, a lack of inclusive access to
education and declining social mobility. Britain's richest and privately-educated seven
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 Algebris Investments’ The Silver Bullet

percent makes up for two thirds of judges, around half of journalists and members of
Higher inequality, stronger populism
parliament, according to a government report. Meanwhile, the Child Poverty Action
Populists / Populist party support
Group estimates that 3.9m children live in poverty. The UK ranks second in the developed
50%
world for inequality, after the US.
US
40%
AT
IT Brexit will not change that, nor will it make Britain more united: the English patient was sick
30%
FR long before his divorce from Europe. With an economy focused on finance and services and
20% DK ES highly dependent on foreign investment, the idea of creating a "truly global Britain" isolated
UK
from his closest trading partner is economic la-la-land.
10% DE
FI GR
OECD Gini Coefficient The reality instead will be a hard Brexit: Britain’s bargaining position is weak. Europe's
0%
25% 30% 35% 40% incentive is to give the UK a bad deal to set an example for other countries, yet not too bad
Source: Algebris (UK) Limited, OECD, to backfire. Britain's incentive is to take it. Brexit Secretary David Davis recently admitted to
Wikipedia.
Populists/populist parties: Front National
not knowing the cost of a no-deal. His thinly-veiled threats to walk away from negotiations
(France); M5S (Italy); Freedom Party of bear little credibility: Britain depends on the EU for half of its exports, while the EU exports to
Austria; Donald Trump; Podemos (Spain);
Danish People’s Party; UKIP (UK); Finns Britain only one sixth. For Britain, this means any deal would be better than none at all.
Party; AfD (Germany); Golden Dawn
(Greece)
The irony is that running away from a European Union they thought was about to fall apart,
Brexiteers have instead made it stronger. Electorates in France and the Netherlands are
rejecting populism and politicians in Brussels and Berlin have switched gears towards
reforms and pro-EU spending measures.
Income ratio of
Gini
10% richest/
Index Theresa May, self-appointed leader in this historic negotiation, has so far revealed little
10% poorest
Finland 0.26 5.5 about her strategy. We do not know whether beyond this secrecy lies a feasible plan. But
one thing is sure: the Prime Minister has already weakened Britain's negotiating position.
Austria 0.28 6.8
Netherlands 0.28 6.7 First, she wrong-footed the start by threatening to walk away and to make the UK a
Germany 0.29 6.8 Singapore-style tax haven. Second, she has made unrealisable promises. Keeping
substantial access to the single market and having strict immigration controls are mutually
France 0.29 6.9
exclusive for the EU: achieving both is highly unrealistic. Third, the Prime Minister has not
Ireland 0.31 7.8 been honest about the true cost of Brexit. Theresa May said repeatedly that Britain could
Italy 0.33 11.4 walk away without a deal and be fine. Instead, a painless exit without a cliff-like effect on
Portugal 0.34 10.7
trade is only possible with a transitional arrangement. To obtain that, the UK will likely have
to pay the €60bn it owes from its past years of membership, as well as a membership fee for
Spain 0.35 12.7 access to the single market.
UK 0.36 10.6
US 0.40 18.5 Like the oysters fooled by the Walrus and Carpenter, Brexiters have bought into the illusion
of shaping a fairer and more independent country. Soon they will realise that the Carpenter's
Source: Algebris (UK) Limited, OECD
promises are just empty words. They will have no one to blame but themselves.

EU: a good deal is politically costly Brexit Game Theory: A Bad Deal Is Better Than No Deal
The EU’s payoff vs leniency of the
deal
Payoff for the EU PM May officially triggered the Article 50 exit clause on March 29 th and set out the UK’s
Political payoff negotiating principles in a letter to the EU. In our view, the four major points in negotiations
will be:

1. The “divorce bill”: how much the UK still needs to pay the EU after leaving it
Economic 2. Free Trade Agreement (FTA) with the EU
payoff
3. Immigration policy
4. Transitional Agreement
From a game theory perspective, we think the Brexit negotiations are likely to lead to a bad
Good Average Bad deal for the UK, which it eventually has to accept.
Source: Algebris (UK) Limited.

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 Algebris Investments’ The Silver Bullet

On the one hand, the EU is incentivised to offer a bad deal to the UK to set a tough
precedence for other countries: the political costs of appearing too lenient will outweigh the
benefits from maintaining benign trade relations with the UK.

On the other hand, the UK is economically more dependent on the EU, where 44% of its
UK needs EU, not vice-versa exports go to and 48% of foreign investment comes from. This is not to mention the potential
50% 44%
damage from a loss of passporting rights to the services sector, which makes up for around
UK to EU 79% of the UK GDP. Hence we think the UK may try to act tough at the start of negotiations,
40%
EU to UK but eventually will have to compromise to avoid bigger economic fallouts.
30%
20%
17% As we illustrate below, the equilibrium scenario based on both sides’ incentive
11%
10%
structures will be the EU offering a bad deal which the UK accepts.
3%
0%
% Total %
The EU is incentivised to offer a bad deal, and the UK is incentivised to take it
exports Employment
linked to trade EU strategy
Offer a good deal Offer a bad deal
Source: Algebris (UK) Limited, European
Commission Export Helpdesk, ONS, Civitas
Accept the 1 -2 -1 -1
deal UK EU UK EU
UK strategy
Reject the -6 -3 -5 -2
deal UK EU UK EU
Source: Algebris (UK) Limited. Blue = Optimal Choice for the UK or the EU in each scenario; Red = Optimal Choice for the UK or the
EU in each scenario. Regardless of how the UK responds, the EU’s optimal strategy is to offer a bad deal, as the political costs of a
good deal would outweigh the economic benefits (a payoff of -2 for a good deal vs -1 for a bad deal if the UK accepts the deal, and -3
vs -2 if the UK rejects the deal). The UK’s optimal strategy in both cases will be to accept the deal, as the costs of a no deal is bigger
than a bad deal (a payoff of -5 for not accepting a bad deal vs -1 for accepting it, and -6 for not accepting a good deal vs 1 for
accepting it). The game equilibrium is the UK accepting a bad deal, highlighted by the green circle; the worst outcome is the UK
rejecting a good deal, highlighted by the red circle.

Depreciation brings inflation

Negotiating the Divorce, While Seeing the Kids
5y Inflation exp

GBP Index
3.8% (RHS, inverted) 65 The first negotiation point will be to settle the divorce bill which the UK owes for its past
3.6% years of membership. Past that, the key will be for Britain to secure a transitional agreement
70
3.4% and avoid a cliff effect on trade. However, to reach a deal and to have access to the single
3.2% 75 market, the UK may have to compromise on immigration and potentially pay a fee. Both
3.0%
80 would require PM May to take a softer stance, something which currently is politically difficult
2.8%
given the split within the Conservative party.
2.6% 85
Mar 16 Aug 16 Jan 17
The “divorce bill”: European Commission president Juncker and the EU’s Chief Negotiator
Source: Algebris (UK) Limited,
Bloomberg. Deutsche Bank GBP
for Brexit Michel Barnier have said that the UK has to pay an exit bill of around €60bn, and
Trade Weighted Index Spot. Inflation the bill would need to be agreed before beginning negotiations on an FTA or transitional
rate is 5-yr,5-yr forward.
agreement. The UK’s Brexit secretary David Davis so far ruled out paying for a hefty bill, as
it would be politically challenging given that Brexiteers campaigned on a promise of “saving
£350mn per week from Brussels”. In her letter to European Council President Tusk, PM May
implicitly suggested that a Brexit bill would not be paid before a trade agreement, although
Gilt yields look rich
she agreed to “determine a fair settlement of the UK’s rights and obligations as a departing
10y Gilt yield
4% 10y inflation exp. member state”. Ultimately, we think the UK and EU would agree to a bill but which would
only be paid after a trade deal is finalised: this would permit negotiations to continue, while
3% not appearing as a defeat for PM May.

2%
In our view, the complexity behind the Brexit bill calculation means there is room for the UK
1%
to negotiate vs the EU’s current estimate of €60bn. The exit bill itself mainly comes from the
UK’s budget commitments for 2019-2023 which it still needs to pay post Brexit, unfunded
0% pension liabilities for UK staff who worked in the EU’s institutions and other contingent
2013 2015 2017 liabilities. According to estimates by the Centre for European Reform, the bill could range
Source: Algebris (UK) Limited, between €24.5bn and €73bn, depending on the calculation methods and what will be
Bloomberg
covered.
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 Algebris Investments’ The Silver Bullet

Free Trade Agreement (FTA): PM May aims to achieve a “bold and ambitious Free Trade
BoE: limited dry powder Agreement” with the EU and start negotiations early, as expressed in her letter to President
Total reserves, % GDP
120% Tusk. PM May has down played the challenge of achieving an agreement by stressing that
100% sectors like the auto industry and financial services may adopt existing Single Market
80% agreements as it “makes no sense to start again from scratch when Britain and the
60%
remaining Member States have adhered to the same rules for so many years”. However the
40%
20% 6%
reality will likely be an extended period of uncertainty as both sides may agree the broad
0% terms of a trade-deal before 2019, but leave the details and ratification for a later date.
Japan

Italy

Germany
UK
Saudi Arabia
China
Russia
South Korea
Brazil

France

Spain
Switzerland

India

Additionally, as part of the broad terms agreed to, the EU and UK will need to agree on an
institution to settle FTA disputes so as to give the EU assurances that following a trade
agreement the UK does not undermine the single market through “regulatory dumping” (FT).
Source: Algebris (UK) Limited, IMF Immigration: The Brexit-campaign focused on the costs of net migration and promised
voters fewer migrants if Britain left the EU. PM May will now need to deliver on this promise,
£: risk of losing reserve status as she highlighted in her January speech in Lancaster House. While PM May has effectively
% of global FX reserves in £* vs ruled out the possibility of implementing a point-based migration system for EU nationals,
UK GDP as % of global GDP the final deal may include a limit on net migration from the EU under a work permit scheme.
% global FX reserves
6% % global GDP Transitional agreement: UK-EU trade will need to be governed by a Transitional
5%
Agreement, between the date that the broad terms of an FTA is agreed and when the FTA
comes into effect. Rather than negotiating separate terms for this Transitional Agreement,
4%
we think during this period UK-EU trade will remain governed under EU law and the
3% European Court of Justice.
2% Could the UK make a U-turn? A turnaround on the Brexit decision is very unlikely and
1% would result in a split in the government and the Conservative party. However, the rational
96 00 04 08 12 16 strategy to avoid a bad deal or no deal would be a more friendly negotiation aimed at
Source: Algebris (UK) Limited,
IMF.*% of allocated reserves, i.e. agreeing on a transitional agreement and avoiding a cliff-like effect on trade. Doing this,
reserves with known FX composition however, requires political capital. The Prime Minister's approach so far has been a tough
one, partly to appease the hard-liners in the party. Negotiating a soft Brexit while appearing
Debt continues to rise to be hard on the EU is a difficult strategy - and in our view it would take time and more
Household debt to income, %
signs of economic weakness before the UK is able to soften its approach.
180
170
160
More Downside for UK Financial Markets and the Economy
150
140 A weaker Sterling, with higher inflation: We think Sterling will likely weaken further as the
130 illusion of a good deal fades. The Bank of England is unlikely to offer much help, both
120 because it does not have the foreign-reserve fire power to defend its currency, and as the
2005 2010 2015 2020 Bank will likely maintain an accommodative monetary stance to support growth in the face of
Source: Algebris (UK) Limited, Office
of Budgetary Responsibility (OBR) rising inflation. A potential loss of reserve currency status would further hurt Sterling, which
currently makes up 4.5% of global FX reserves. With the UK importing nearly 46% of its
energy and 50% of its food, a weaker Sterling will lead to higher import-led inflation.
UK homes: a wealth illusion
UK avg. house prices, 000 A growing public deficit: Mr Hammond’s Spring Budget effectively ignored the
225 In £ 340 consequences of Brexit, predicting a decline both in borrowing and debt to GDP by 2021.
In $ (RHS) The budget is predicated on unrealistic expectations of declining unemployment, falling
320
inflation and steady growth. The reality is that the government may need to increase fiscal
200
300 spending to support the economy, leading to a further widening of the fiscal deficit, currently
280
at -3.8% of GDP.
175
260 Lower consumer spending hurting retailers: The OBR forecasts that UK household debt
to disposable income will rise from 143% in 2016 to 153% in 2022. This will likely result in
150 240
11 12 13 14 15 16 17 households having lower disposable income, at a time of higher inflation. UK retailers are
Source: Algebris (UK) Limited, likely to be squeezed by lower revenues and higher costs due to import-led inflation.
Bloomberg

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 Algebris Investments’ The Silver Bullet

Negative real returns for savers: With the BoE likely to maintain low rates despite rising
inflation, Britons will suffer from negative real returns on their savings which are already
precariously low. According to a study by Money Advise Service, over 16m Britons have less
than a £100 in savings. Properties are unlikely to provide sufficient protection, with markets
already showing cooling signs given lower demand from foreign investors.
Conclusions: Brexit is a symptom of Britain's deeply rooted economic imbalances: a growth
UK property market is cooling
model too concentrated on finance and services and dependent on foreign goods, human
UK house prices, YoY%
and financial capital, record-high social and wealth inequality, lack of investment in
Rightmove online
15% asking prices infrastructure and education and a monetary and fiscal policy which have favoured a
Nationwide house property bubble and excess household debt. In their attempt to create a fairer and more
prices
10% equal country, Britons sought to sever ties from what they saw as a weakened partner. The
reality is that Brexit will likely make Britain weaker and, ironically, is making the EU stronger.
5%
Absent a coherent economic and negotiating strategy by the government, we believe the UK
0% economy will deteriorate further. The most vulnerable assets remain Sterling, Gilts and
11 12 13 14 15 16 17 consumer firms such as mid-market retailers. On the other hand, countercyclical like debt
-5% collectors are poised to benefit. In the Eurozone, we believe investors are overpricing political
Source: Algebris (UK) Limited, risks and underestimating the upside surprises in growth and inflation (The Silver Bullet | Don’t
Bloomberg
Fret about Frexit). We are positioned to gain from this upside in credit risk, rates and equity
sectors linked to reflation and public spending: financials, infrastructure and defence.

"I weep for you," the Walrus said:

"I deeply sympathize."
With sobs and tears he sorted out
Those of the largest size,
Holding his pocket-handkerchief
Before his streaming eyes.

"O Oysters," said the Carpenter,

"You've had a pleasant run!
Shall we be trotting home again?'
But answer came there none--
And this was scarcely odd, because
They'd eaten every one.”

The Walrus and the Carpenter, by L. Carroll

The Silver Bullet is Algebris Investments' macro letter.

Alberto Gallo is Head of Macro Strategies at Algebris (UK) Limited, and is Portfolio Manager
for the Algebris Macro Credit Fund (UCITS), joined by macro analysts Tao Pan, Aditya Aney
and Pablo Morenes.
For more information about Algebris and its products, or to be added to our
Silver Bullet distribution list, please contact Investor Relations at algebrisIR@algebris.com or
Sarah Finley at +44 (0) 207 851 1741. Visit Algebris Insights for past Silver Bullets.
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 Algebris Investments’ The Silver Bullet

Previous articles:

The Silver Bullet | Europe’s Long Way out of QE Infinity, March 23, 2017

The Silver Bullet | Don’t Fret about Frexit, March 8, 2017

The Silver Bullet | Greece: More Melodrachma, No Default, February 20, 2017

The Silver Bullet | Don’t Give up on Europe, February 6, 2017

The Silver Bullet | 2017: When Inflation Dreams Become Nightmares, January 19, 2017

The Silver Bullet | 2017: The Movie, December 14, 2016

The Silver Bullet | Investing in the Time of Populism, November 15, 2016

The Silver Bullet | Trick or Tantrum?, October 31, 2016

The Silver Bullet | The High Price of a Hard Brexit, October 12, 2016

The Silver Bullet | Investing when the monetary tide is turning, September 20, 2016

The Silver Bullet | Central bankers: the tide is turning, September 7, 2016

The Silver Bullet | Perpetual Motion, August 12, 2016

The Silver Bullet | We are still dancing, July 14, 2016

The Silver Bullet | The Divided Kingdom, June 28, 2016

The Silver Bullet | Brexit: it’s not EU, it’s me, June 13, 2016

The Silver Bullet | Trumponomics, June 1, 2016

The Silver Bullet | Brazil: The Caipirinha Crisis is Just Starting, May 17, 2016

The Silver Bullet | China: Feeling the Stones of Japanification, May 4, 2016

The Silver Bullet | Alice and the Mad Interest Rate Party, April 19, 2016

The Silver Bullet | Helicopter Money (that’s what I want), April 12, 2016

Additional reading:

Barker, A., The €60bn Brexit Bill: How to Disentangle Britain from the EU Budget, Centre for
European Reform, February 6, 2017

The Silver Bullet | The High Price of a Hard Brexit, October 12, 2016
The Silver Bullet | The Divided Kingdom, June 28, 2016

The Silver Bullet | Brexit: it’s not EU, it’s me, June 13, 2016

Wadsworth, J., Dhingra, S., Ottavian, G., Van Reenen, J., Brexit and the impact of immigration
on the UK, LSE, May 2016

UK Perspectives 2016: Trade with the EU and beyond, Office for National Statistics, 25 May
2016

Jones, R., Innovation, research and the UK’s productivity crisis, The University of Sheffield,
April 2016

Standard & Poor’s, QE and Economic Inequality: The UK Experience, 10 February 2016

The motor industry: statistics and policy, House of Commons Library, October 2015
Gallo, A., Walker, R., Tyrrell-Hendry, L., Popovic, M., Grant, A., Pan, T., The Revolver |
Divided Kingdom: Britain’s future beyond the election, 14 April 2015

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 Algebris Investments’ The Silver Bullet

Financial Services: contribution to the UK economy, House of Commons Library, February

2015

Milburn, A., Elitist Britain?, Social Mobility and Child Poverty Commission, 2014

Outside and Inside, Official Norwegian Reports NOU 2012: 2 Chapter 1

Switzerland’s relationship with the EU, House of Commons Library, October 2011

Euromyths, European Commission Blog

Sources:
The source for all images is Wikimedia Commons unless indicated otherwise.

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