Description

Brexit Trade

Brexit was the world’s biggest ‘special situations’. I believe that there are about to be further twists. I have stated on VIC that this is a trade on GBP (ie the currency) but as will be seen in the discussion below there are a number of ways in currencies, equities, indices and fixed income to play this idea.

Introduction:

On the 23^rd June 2016 the UK held a referendum in which the majority voted to leave the European Union. The consensus in London financial and political circles is that there is a 95-99% probability that the government will make a formal notification by 31 March 2016 under ‘article 50’ to start a ‘two year clock’ for the UK to leave the EU. [The Prime Minister, Theresa May having declared at the Conservative Party conference that that was her intention.]

For reasons I discuss in this writeup I suggest that there may be a significant possibility (perhaps as high as 30%) that the UK government timetable will be altered. Though this may appear to be ‘betting’ on a one off event I think there are significant opportunities to make money on the event as it is being overlooked or dismissed by many and though the probability is not high the market impact could be substantial. (Later in this writeup I discuss a number of ways this idea might be expressed.)

I think discussing this ‘event’ in a value orientated forum is appropriate as the detail of my hypothesis is based on the most fundamental value orientated principle – reading the filings! Furthermore if I am right this is potentially the world’s biggest ‘special situation’.

[At the end of this writeup there is a list of references / links]

IANAL:

Before I go further I need to highlight that _I am not a lawyer_ (=IANAL). I have had discussions with lawyers and others but I recommend anyone seriously interested in this situation should also seek their own legal inputs!

Tory vs Conservative

The Conservative party (the party in power) is often referred to as the Tory Party. I use both terms interchangeably below.

Key events:

Following the Brexit vote a number of individuals (=plaintiffs) sought a court review whether the UK government (=the defendant) is entitled to start the article 50 notification process (under the 2009 Lisbon Treaty of the European Union) without first obtaining a Parliamentary mandate. The court case was heard by the High Court in London on the 13, 17 and 18^th Oct 2016. Having read through the court transcripts and those part of the accompanying documentations that are publicly available I have come to the view that there is a very significant chance (possibly higher than 50% - I explain why later in the writeup) that the High Court will declare that the UK government cannot initiate notification under article 50 without a Parliamentary Bill. I anticipate the High Court judgment to be issued by the end of November and possibly within the next 10 days.

Both the plaintiffs and the defendants have already stated that the losing side will seek a review from the Supreme Court. The Supreme Court has cleared its timetable in December so there will be a further hearing then. If I am right about the High Court judgment then my feeling is (for reasons discussed below) the Supreme Court will also require the UK government to seek a Parliamentary Bill before commencing the Article 50 notification.

The general view is that the UK government is not keen to seek Parliamentary approval as the belief is that it will lead to difficulties in both the lower house (The House of Commons) where a number of Tory MPs (ie the party which is in government) believe that the UK should stay in the EU and in the upper house (The House of Lords) where the pro-Europe sentiment is even higher. The government has already appeared to threaten to flood the House of Lords with new Lords to exert its will. However this assumes that the government prevails in the lower house and this is not entirely clear. If my above assumptions regarding the High Court and the Supreme Court are correct I think the Houses of Parliament will consider the issue in either late December or (more likely) January. This could lead to significant difficulties and in the extreme lead to blocking Brexit and / or a fresh general election.

Article 50:

Article 50 under the Lisbon Treaty allows members of the European Union to withdraw from the EU. There are two key points of relevance to the UK – (1) the decision to withdraw must be ‘in accordance with its [ie the member state’s] own constitutional requirements’; (2) whether the process is irreversible

The constitutional requirements term creates difficulties in the UK because there is no written constitution – rather there are a set of precedents, conventions and traditions. The relevance of this will become clear below.

Article 50 is silent on whether the process is reversible. The general consensus is that it is irreversible – ie once a country initiates the article 50 notification it will leave the EU within 2 years (or such extended period as is agreed by the European council) ie it cannot change its mind. This is highly relevant to the court case in the High Court and (as I discuss below) might actually lead to a further judicial review.

The High Court Judges:

Before I go into the details of the court case I think it is worth pointing out that the three judges who heard the court case were some of the most senior judges in the UK – specifically they were The Lord Chief Justice, the Master of the Rolls and Lord Justice Sales. Furthermore they are acutely aware of the public interest in the matter (the court overflowed and there was live video feeds to two further courts) and that their judgment is going to be reviewed by the Supreme Court and indeed by academics for decades to come. It will also set precedent for future cases regarding the balance between the executive and the legislature.

An aside on constitutional law:

In theory there are three arms of government – the legislature (ie Parliament) that legislates new bills, the executive (ie the ministers and Prime Minister) that executes the laws of the land and the judiciary (ie the courts). [Actually one can argue that there is a fourth arm – the administrative arm ie the civil service.]

Because of the history of the UK the executive actually executes in the name of the Crown. Though all agree that Parliament is ‘supreme’ in the UK there are some residual powers that residue with the Crown. The executive deploys those powers under the ‘Royal Prerogative’. The perimeter of the Royal Prerogative is not clearly defined and any decisions taken in that matter are usually considered to be subject to review by Parliament.

An important point to note is that the executive may not frustrate Parliament by not implementing or by implementing rules, regulations or undertaking actions which led to the loss of rights or the falling aside of laws instigated by Parliament. Should the executive wish to change the laws they are meant to do so by seeking Parliamentary authority (including a change in the legislation).

Why the High Court is likely to require a Parliamentary Bill:

1.     The Referendum Act

The EU referendum was held in the UK under legislation passed by Parliament under the European Union Referendum Act 2015. However this bill has a peculiarity – it did not specify what action the government was to undertake if the population voted in favour of Brexit.

The government position is that it was ‘obvious’ that such a referendum vote would activate article 50. However the case is not entirely clear cut as (i) the UK is a parliamentary democracy and referendums do not have legal standing in the ‘unwritten’ constitution (ii) there is a House of Lords report suggesting that Parliament should review the results of the referendum (iii) transcripts from the Houses of Parliament and press commentary at the time of the passing of the bill are ambiguous as to whether Parliament anticipated a review of the results by itself (iv) previous referendums in the UK have been more clear on what the executive would do following each outcome of that specific referendum

2.     The Royal Prerogative

The government also relies on its right under the Royal Prerogative to negotiate international treaties to allow it to commence the article 50 notification process. In essence, when Parliament became ‘supreme’ in the UK the monarch was allowed to continue to operate in the international sphere.

However there are a number of issues related to this:

(i)                  Historically the executive has negotiated international treaties and then Parliament either ratifies them, modifies them or rejects them. However in the case of article 50 once the notification starts Parliament will have no opportunity to reject it (if article 50 is irreversible – see below). This led to some interest amongst the judges.

(ii)                The executive has considerable leeway in negotiations that touch only the international sphere (based on the Royal prerogative) but Parliament is considered to be the ultimate arbitrator for anything that impacts domestic law. The withdrawal from the EU, though at one level is an international issue, it also has considerable impact on UK domestic rights and laws.

3.      The irreversibility of Article 50

There is some academic discussion about whether a notification under article 50 is in fact irreversible or not. The court was invited by both sides to assume that it is actually irreversible for practical purposes. However the court decided that it was absolutely essential for it to consider this issue (see page 192-193 of the transcript of 13 Oct 2016 - https://www.judiciary.gov.uk/wp-content/uploads/2016/10/20161013-all-day.pdf ).

In the case of the government, the submission was that even if technically or theoretically it might be reversible that as a practical and policy measure the government would consider it irreversible.

I cannot emphasise how important this matter is – as if it is reversible then Parliament can consider the impact of Brexit in two years’ time, once the article 50 notification has been implemented and the government has a new treaty with the EU. If however it is irreversible (or in practice irreversible – as it _might_ require the consent of all other EU members) then I think the High Court will decide that Parliament must decide before filing the notification.

There is a small but distinct chance that the UK courts might seek verification from the European Court of Justice as to whether article 50 is indeed irreversible. This is a low but not zero probability event.

4.       Domestic Rights

The government has promised with a pending ‘Great Repeal Bill’ to incorporate existing European laws and rights into UK domestic law. Because of the way that European law becomes domestic law UK citizens are also considered ‘European Citizens’ and as a result have various rights including the freedom of movement.

However in court the lead counsel for the plaintiffs pointed out that there were some rights which are not in the gift of Parliament or the government to restore eg the right to free movement as it comes from the UK being part of the EU. Similarly (and somewhat amusingly) the right to vote for Members of the European Parliament.

The government argument was that it will be able to execute UK laws to restore many rights that will be lost and the rest are minor or might be restored as a result of treaty negotiation.

However the domestic rights issue is considerably more complicated than this simple summary – for instance the government argued that some of the ‘rights’ are actually not granted by the UK government but by foreign governments (eg France allows EU citizens including UK citizens to settle there so it is actually not a right granted by the UK government per se). Of course this denies that the rights are ultimately due to the membership of the EU which was the result of Parliamentary action.

My view is that the judges will take a dim view on the executive providing assurances that they _might_ be able to replace some rights (there were comments in the court that replacement is not the same as the original rights) by acts of Parliament or as a result of treaty negotiations. I also think they will take a dim view of the executive dismissing rights granted as a result of Parliamentary actions.

I think that the judges will cut through the hubris around this issue and state that due to the significant impact on UK citizens’ rights (whether they be granted under domestic law, by international treaty or by other countries) and the impact on domestic rights that the executive activating article 50 (if it is indeed irreversible) leads to an overturn of legislation implemented by Parliament that Parliamentary scrutiny before activating article 50 is necessary. Promising a ‘Great Repeal Bill’ is not good enough as the government cannot assure that it will be passed, nor state what rights it will restore and hence, again,  it is right for Parliament to scrutinise the issue before notification under article 50.

5.      Other points.

There were numerous other points discussed in court (there are several hundred pages of transcripts) and I would refer anyone interested to read through the links I provide at the end of this writeup. One of the real left field events might be Northern Ireland where there is a separate court case underway. Additionally it is not clear what Brexit means for the devolved governments of Scotland, Wales and Northern Ireland.

However I think the above points that I have gone into detail on are likely to be the key issues for the High Court.

The Supreme Court:

Generally when a case is reviewed by a higher court it does not undertake a retrial but rather considers if the lower court was wrong in its interpretation or implementation of law or if there was a procedural mistake.

Knowing this and given the experience of the judges hearing the case in the High Court I think the probability of the Supreme Court overturning the decision of the High Court is low.

Parliament:

If both the Supreme Court and the High Court rule that there needs to be a Parliamentary Act then the government will have to submit the issue to Parliament. One of the major issues is that no one is really sure what people voted for – ie what does Brexit mean? Did they vote to leave the EU or was it leave the EU but stay within the single market and / or the customs union? (Staying within the single market and / or the customs union is not in the gift of the government despite the declarations of some campaigners). What about immigration and migration. Or did they vote for £350M per week for the NHS.

In view of this, despite the Conservative majority it is likely the government will be in for a tough ride and there is a high chance (say 40% - 50%) that the government is unable to pass a bill that it likes through both houses.

One of the big issues will be whether MPs will be allowed a free vote or whether there will be a three line whip (a Parliamentary term meaning that the ‘Whips office’ will require Conservative MPs to vote with the government). There is a tradition of MPs being allowed ‘free votes’ on matters of principle.

In this context it is important to note (and I have not seen this discussed anyway) the electoral boundaries commission has been redrawing various constituency boundaries. The result is that a number of MPs on both sides of the house are likely to find that their constituencies no longer exist at the next election. This might embolden some MPs to not care a damn about the government whip.

The traditional way for the government to resolve an impasse is to go to the country and seek a new mandate via an election. However the Fixed-term Parliaments Act of 2011 requires either a vote of no confidence in the government (which no government ever seeks) or a 2/3 majority of the House of Commons to vote for a general election. The latter point effectively allow the opposition parties to block a new general election. Furthermore given the point above regarding electoral boundaries a number of Tory MPs are likely to also be bloody minded.

I therefore think there is a chance that the government gets stuck in a Parliamentary quagmire.

‘Trades’:

1.       Currency

In some ways the currency trade is the most obvious (sterling rallies if Brexit does not happen). There are two obvious pairs to consider – GBP vs USD and GBP vs EUR. Consideration should clearly be given to the US election and the probability of rising interest rates in the US in December.

I am currently considering the use of complex or exotic currency options but that is probably beyond the remit of most investors on VIC.

2.       Commodities

Clearly commodities tend to be priced in USD. There are a number of large commodity companies listed in London eg Rio Tinto (RIO LN), BHP (BLT LN), Ango American (AAL LN), Antofagasta (ANTO LN), Glencore (GLEN LN), Royal Dutch Shell (RDSB LN / RDSA LN) and BP (BP/ LN). Falling sterling has been at least partially responsible for their share price rallies in sterling terms. Clearly if Brexit does not occur and sterling consequently rallies the UK listing of commodity stocks will be hit

3.       Indices

The FTSE100 index was initially hit by Brexit but then rallied as sterling fell and there was a recognition that a lot of FTSE100 companies actually have substantial non GBP earnings which are now worth more in GBP terms. In comparison the FTSE 250 (smaller companies – more UK centric) have performed less well. I think it would be naïve to expect an exact reversal but I do think that a move in GBP and a change in the perceived probability of Brexit will impact the relative performance of the FTSE 100 vs FTSE 250.

4.       Stock specific trades

There are clearly a number of stock specific opportunities that will arise if it looks like Brexit is off the table. Perhaps members of VIC will wish to suggest some of these in the comments.

5.       Fixed Income

A weakening currency, and loss of (or reduced access to) export markets together with multiple deficits is not a great place to be. A lack of confidence in the UK as a reliable partner and altering (import driven) inflation expectations have already started to hit the market. Obviously the outcome of the court case can be expressed via fixed income markets – however as this is a field I have no specific expertise in I defer to others regarding how to implement there.

Other events to consider:

1.       Italian Referendum 2016

The Italian Constitutional Referendum on 4^th Dec 2016 may lead to the fall of the government and the entry into power of a party keen to lead Italy to an exit from the EU. Because of Italy’s membership of the Euro the impact of Italy exiting Europe could potentially be worse than that of Brexit.

2.       French and German Elections 2017

Both France and Germany have general elections in 2017. The negotiating positions of both countries and their stance to Brexit may change depending on the outcome.

Is this merely a bet?

I appreciate that one might consider that this is merely a binary bet on the outcome of a court case. However the way I consider it is the probability of a move multiplied by the size of the move. On that basis I think it is possible to construct a position with a positive expectancy. Furthermore though I have discussed probabilities I have done so to reflect a measured approach to the court case. Inevitably the end outcome will (hopefully) be binary. So I have spent a considerable length of time (days) not merely following the court case by reading through the documents (hundreds of pages) at the end of this writeup. I started from the position that the UK Government would prevail in court and that the plaintiffs arguments were weak but reading through the various documents has brought me to conclude that I was wrong and that the plaintiffs have a good case that is being missed by the market.

If I am wrong:

For colleagues on VIC who are less keen to ‘bet’ on the outcome of the High Court decision it will be interesting to see what the High Court concludes. If the court comes out in favour of the UK government it is hard to envisage the UK not filing article 50 by the end of March 2017. In that case this has further consequences for the UK and the EU. I will perhaps address these at some later date in the comments / discussion.

References / links:

1.       Article 50 – what is it - http://www.europarl.europa.eu/RegData/etudes/BRIE/2016/577971/EPRS_BRI(2016)577971_EN.pdf

2.       The Court transcripts - https://www.judiciary.gov.uk/publications/santos-and-m-v-secretary-of-state-for-exiting-the-european-union-transcripts/ 

3.       The Royal Prerogative - https://en.wikipedia.org/wiki/Royal_prerogative_in_the_United_Kingdom

4.       The UK Referendum Bill - https://en.wikipedia.org/wiki/United_Kingdom_European_Union_membership_referendum,_2016

5.       The European Union Referendum Bill / Act :

a.       http://www.publications.parliament.uk/pa/bills/cbill/2015-2016/0002/16002.pdf

b.      http://www.legislation.gov.uk/ukpga/2015/36/pdfs/ukpga_20150036_en.pdf

c.       https://en.wikipedia.org/wiki/European_Union_Referendum_Act_2015

6.       Reversibility of article 50 - https://ukconstitutionallaw.org/2016/10/17/aurel-sari-biting-the-bullet-why-the-uk-is-free-to-revoke-its-withdrawal-notification-under-article-50-teu/

7.       Fixed Terms Parliament Act 2011 - https://en.wikipedia.org/wiki/Fixed-term_Parliaments_Act_2011 and http://www.legislation.gov.uk/ukpga/2011/14/enacted

8.       Italian Referendum - http://www.forbes.com/sites/johnmauldin/2016/08/31/the-italian-referendum-could-result-in-the-death-of-the-euro/#4ac7ad7611da and https://en.wikipedia.org/wiki/Italian_constitutional_referendum,_2016

9.       Constitutional Law Blog – lots of good discussion here – in particular:

a.       https://ukconstitutionallaw.org/2016/10/14/robert-craig-report-of-proceedings-miller-v-secretary-of-state-for-exiting-the-european-union/

b.      https://ukconstitutionallaw.org/2016/10/20/robert-craig-report-of-proceedings-miller-v-secretary-of-state-for-exiting-the-european-union-day-2/

c.       https://ukconstitutionallaw.org/2016/10/24/robert-craig-report-of-proceedings-miller-v-secretary-of-state-for-exiting-the-european-union-day-3/ 

10.   The following blog has links to the skeleton arguments for the parties - https://www.monckton.com/article-50-litigation-governments-skeleton-argument-published/

a.       Also see - https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/558592/Miller_v_SSExEU_-_Skeleton_Argument_of_the_Secretary_of_State_300916.pdf

b.      And https://www.bindmans.com/uploads/files/documents/Defendant_s_Detailed_Grounds_of_Resistance_for_publication.PDF

Catalyst

Pending High Court Ruling - by the end of November possibly earlier.

To be following by a Supreme Court hearing in Dec; and possibly Parliamentary review in January / Feb?