Claudio Brocado

About the Author Claudio Brocado

Seasoned financial professional with substantial corporate finance experience followed by well over twenty years in the financial industry (sell-side as well as over sixteen years buy-side, including firms such as RCM, Putnam, Fidelity and Batterymarch). Substantial global expertise and interest, complemented by formal studies in foreign languages and strong understanding of multiple cultures and intercultural communications. Starting 2014 spending my professional time researching and investing in global financial markets (developed and emerging).

Brexit Does Not Need to Be a Disaster; Here’s Why

Recent events in a growing number of developed countries increasingly indicate that what we have witnessed so far in the US presidential election campaign is not an isolated issue. The developed world appears to be facing what I would call the first major ‘coordinated’ political crisis of the twenty-first century. Populations appear increasingly polarized, with what has traditionally been the ‘large middle’ arguably on the decline.

The great recession or global financial crisis was the likely catalyst. As the economic crisis becomes less acute, it appears that a political crisis of confidence is following in its wake. The ‘establishment’ is blamed by an ever-larger number of people in a growing number of countries. Meaningful segments of the population are calling for ‘change,’ even as what could come next could potentially be significantly worse than the status quo.

The fact that Trump became the presumptive nominee of the Republican party in the US, and the surprisingly strong results in the Democratic party primaries by Bernie Sanders, made it clear that in ‘America’s heartland’ protectionist rhetoric found a receptive audience. Free trade and even free-market capitalism as we know it are under fiercer attack in the US than at any time in recent memory.

The anti-free-trade or protectionist movement, unfortunately, is alive and well beyond the US too. As a long-term advocate of free trade, I could not be more disappointed. It is now patently clear that the ‘establishment’ has done a very poor job of explaining the long-term benefits of free trade to the public at large.

Free trade improves the welfare of all countries adopting it, in the long run

Contrary to recent political rhetoric, international trade is not a zero-sum game. All countries that adopt free trade tend to benefit in the long run. That, of course, does not mean that everybody benefits. As countries specialize in industries where they enjoy competitive and comparative advantages, these may thrive, just as other industries are likely to suffer or even disappear altogether.

Because of the geographical concentration of certain industries prior to the spreading of free trade and globalization, there can be entire regions in a particular country which see their economies devastated as a result of free trade. Governments should not only do a better job of explaining the benefits of free trade to their constituents.

Perhaps even more importantly, the ‘establishment’ can do a much better job of cushioning the negative impacts of globalization on the most affected regions and segments of society. Retraining of workers in the worst hit industries, as well as other social ‘safety net’ programs have not been sufficiently used to minimize the adverse impact from free trade on part of the population. Long-term, sustainable productivity growth can only come from improvements in the educational systems of the affected regions. Much more investment in what I call intellectual infrastructure is desperately needed.

What most bothers me about the protectionist rhetoric so common in this year’s US presidential election primaries of both parties is that the candidates are promising to have manufacturing jobs return to the US. Implicitly threatening global trade wars, the rhetoric centers around the jobs that have moved away from the US to countries with lower labor costs.

An old cliché jokes that if jobs truly moved to the countries with the lowest labor costs, a country such as Bangladesh would be getting most of the gains in global employment. The implied criticism of such a simplistic assumption is quite valid. In my opinion, the countries that are likely to perform best over the long term are those that manage well a gradual transition towards higher-value added sectors. The goal should never be for a country to have cheaper labor; instead, the long-term focus should be on better, more educated and productive qualified labor.

The low-end manufacturing jobs that initially ‘moved’ from the US to Mexico, to some extent as a result of the North American Free Trade Agreement (NAFTA), subsequently ‘went’ to China as that country joined the World Trade Organization (WTO). China has recently been losing low-value-added jobs to countries such as Vietnam.

Low-value-added manufacturing jobs will never return to the US; nor should they, in my view. To the extent that such production does make its way back to this country, it will be performed by robots, not by American workers lacking the necessary skills. Short-term oriented political moves such as mandating $15 an hour minimum wages in New York and California are likely to do more long-term harm than good.

I strongly believe in the virtue of rising wages over time. However, such rising incomes cannot just be legislated. Productivity growth facilitated by improving educational levels and long-term oriented corporate cultures will inevitably lead to growing employee compensation over the long haul, in my view. The concerns about people not being able to make a ‘living wage’ on the currently-legislated minimum level, in the short run, should be handled through fiscal measures such as an expansion of the earned income tax credit in the US.

The US needs to focus on its competitive advantages for its own job growth. As actual money follows economic value added, better paying jobs will be created in an American economy in which the workforce is better trained and thus more productive. The US should focus its efforts on better educating the workers of the future information economy.

America will not revisit what some call its ‘best days’ by trying to again become a global low-cost manufacturing economy. Even policy makers in countries such as India and China already understand this applies even to their own less-developed economies.

The US will remain the major hub for innovation and high technology, key ingredients of the information economy, for decades to come, in my view. This country is great (by many measures, greater than ever) and its best days lie still ahead, but it also has more to lose than to win from a global trade war. I remain optimistic that reason will prevail in the end.

Brexit – an example of where misleading rhetoric did win the day…

There are arguably more differences than similarities between the rhetoric and context leading up to last week’s ‘Brexit’ referendum in which a small majority of British voters who went to the polls surprisingly indeed voted for Great Britain to eventually leave the European Union (EU).

Since there is much coverage on some similarities between the Brexit vote and the 2016 elections in the US, I will initially focus on the stark differences. I normally like to shun extremes, and repeatedly advocate that there are no absolutes, and that issues are not black or white, but differing shades of gray.

While the UK did get quite polarized around the Brexit vote, and unfortunately an unacceptably high portion of the rhetoric did center around immigration, I strongly believe that Brexit is quite different from what Trump is proposing for the US.

The Republican party’s presumptive nominee, regrettably, does strongly appear to be one of the few individuals to whom issues are black or white. I can honestly find no solid arguments in favor of a Trump presidency in terms of the likely social and economic repercussions in the US and beyond.

The rhetoric has been almost entirely populist and polarizing. Moreover, contrary to many expectations (including my own), the candidate refuses to pivot to the apparent needs of the general election, sticking instead with what worked so well during the GOP primaries.

As far as Britain leaving the European Union, on the other hand, I can easily find advantages as well as disadvantages. I do want to reemphasize that Iwas indeed negatively surprised by the outcome of last week’s referendum. I honestly believe that both the UK and the rest of the EU would be stronger with Britain in the union.

As I stated earlier, there are probably more differences than similarities in what is taking place in various countries, but I will now focus on some of the common elements of several of the political developments across a growing number of countries. Nations of what used to be called the ‘first world’ (and even parts of the Eastern European ‘second world’) are seeing a backlash to globalization.

At this point, I will reiterate my own bias that I continue to strongly believe in free-market capitalism and the net long-term benefits that accrue to all countries that adopt free trade and are open to immigration. While I pride myself of having an open mind, nothing that has been said or done in the last few months causes me to doubt these strong-held views.

That said, I increasingly understand why some segments of the population (and even entire regions) of a large number of developed countries are upset with the status quo. The long-term benefits of trade and immigration must be better explained by the ‘establishment’ to those negatively impacted. Social ‘safety net’ and retraining programs are also a key priority.

In a growing number of countries, we are witnessing a backlash against immigration and free trade that the ‘Washington consensus’ arguably spearheaded around the globe in the last few decades. At the risk of over-generalizing, here are some of the common threads I see across multiple geographies.

There is a sense of nostalgia for the ‘good old’ days among people who recall a time when there was more job and pension security. Economic growth rates appeared structurally higher, and post-secondary education (let alone a second wage earner in the household) was not an absolute requirement for a solid middle-class standard of living. Populations were more ethnically homogeneous, and foreign travel was far less common than today so that interaction with ‘foreign’ cultures was more of a rarity.

It is not uncommon for some of the people who feel this nostalgia (and perhaps in some cases their less-educated youth) to be more open than the population at large to a populist message voiced by a ‘new’ brand of non-establishment political leader. Unfortunately, such populist leaders often resort to ‘far-right’ political rhetoric when it comes to social matters.

At what arguably is the polar opposite end of the spectrum, at least when it comes to social issues, a surprisingly large percent of young people (what is nowadays called the millennial generation) is a lot more open to socialism than other segments of the population.

Today’s youth did not grow up with the ‘threat’ represented by the Soviet Union, and most millennials in the developed world lack a direct connection to more recent socialist experiments such as Venezuela’s. Therefore, the youthful idealism that in previous generations has also tended to make ‘twenty-somethings’ more ‘liberal’ than their parents, appears to be much more pronounced than in the past.

In other words, today’s youth in several developed countries does not believe in the power of free markets as much as other segments of the population. While in general more open to immigration, they don’t necessarily believe in the free trade aspect of globalization to the same extent. Again, I normally do not like to generalize this much, but my goal is to articulate some of the common threads I increasingly perceive across developed countries.

Then there is the vast center or middle of the political spectrum, where the majority of the electorate resides even now. Fortunately, in my opinion, elections in the near term will still be decided by these moderate voters. However, the population at large will appear increasingly polarized. This is due largely to the uneven and weak recovery experienced across the developed economies since the great recession, with the benefits of the weak economic uptick accruing mostly to the already rich.

Economic performance since the global financial crisis has been lackluster in much of the developed world. This has been the case regardless of whether the specific countries have been led in recent years by right-of (or left-of) center governments. It is also the case where there have been structural reforms in recent years, and regardless of how their respective currencies have performed. What does appear to have led to marginally better economic performance, other than more favorable demographics, has been relatively low levels of corporate and personal debt at the time of the global financial crisis.

Still, the more tepid and uneven the economic recovery of the last few years, the more polarized the population of a particular developed country appears to be. And the deeper the polarization, the stronger the disdain for the status quo and the louder the popular calls for change. Nonetheless, I hope that the population at large remains moderate, understands that, while some aspects of our free market systems do need fixing; the framework is fundamentally sound, and we should not risk breaking what only needs repair.

Finally, our new political leaders should realize that the abuse of rhetoric is already contributing to an atmosphere where extremism may thrive. Even if the loud populists do not intend for their most fervent followers to engage in violence, harsh rhetoric is polluting the social environment and creating the risk that violent confrontation (and worse) materializes.

True leaders live up to their responsibility to nudge their followers towards peaceful expression of their support. Patriots should never engage in violence against other patriots, just because their political views and visions for the future of the same country differ.

Perfectly patriotic individuals may disagree with their counterparts on the basis of their different political beliefs. Disagreements should be voiced in open and respectful dialog. Our different opinions should be expressed at the ballot box and/or through efforts to convince others of our views to the best of our peaceful abilities.

but there is indeed much to life after Brexit

While I do not want to minimize the implications of the Brexit vote, I do want to focus now on the net positives for long-term equity investors. As those of you who also follow me on Twitter @brocado already know, one of my pet peeves about much of the market commentary post-Brexit vote is that reporters and analysts downplayed the magnitude of the drop in British equities on Friday.

True, the FTSE 100 fell less than other major markets, particularly the indices of some key European bourses. However, market indices are quoted in the domestic currency, so the FTSE 100’s drop in GBP (British pound) understated the true loss of wealth to global investors as the GBP plunged in value against other major currencies. Thus, to be meaningful, comparisons across market indices have to be performed in a common currency. Moreover, the more domestically oriented and broader FTSE 250 experienced a much steeper plunge (even in GBP) than the ‘multinational’ FTSE 100.

As always, for investors with the time and passion for stock picking I recommend a more granular bottom-up analysis. Before deciding to sell any British stock you may own, you should understand many details, including the proportion of the relevant company’s revenues and profits that come from markets outside the UK, among many others. There will be many individual winners as well as losers from what eventually emerges as the new environment. What the British referendum on EU membership did accomplish, nonetheless, was a sharp increase in uncertainty, obviously complicating any detailed bottom-up equity analysis.

For the time being, I would like to offer just a few thoughts, based on the long experience developed with countries with sharp currency devaluations. The GBP is now bouncing around multi-decade lows, and one of the likely rather permanent repercussions of last week’s referendum will be a weaker currency than Britain would otherwise have had. I have historically been a ‘staunch anti-devaluationist’ who does not believe in currency manipulation as a path to a country’s long-term prosperity.

That said, at the individual company level, there are always winners as well as losers from a country’s currency plunging. Obviously, stocks of firms with relatively high foreign revenues stemming from countries with stronger currencies and a preponderance of costs and expenses in the domestic devalued currency tend to benefit, everything else being equal. Thus, without going into further detail at this stage, focusing on the stocks of British companies that generate sustainable revenues from markets with stronger currencies would make sense.

The immediate aftermath of the Brexit vote has raised more questions than answers. Obviously without trying to present an all-inclusive list, there are many doubts surrounding how the British referendum will impact the integrity of the UK, with a possible second referendum for Scotland to leave it and the return of the religious feud in Northern Ireland, the durability of the ‘European project,’ the common currency of which Britain was never part, the likely timing of the British government invoking Article 50, and there is increasing talk of ‘Brexit Light’ and/or how long it will take for all of Britain to really leave the EU.

There are many more qualified sources for readers to learn a lot more about the possible ramifications, and it is to be sure very much a moving target. That said, I would like to talk a bit about my own reaction and general preliminary conclusions. The magnitude of the surprise appears to have been caused by a failure of the more moderate middle (the center of the political spectrum) to show up at the polls to the expected extent.

The youth, which according to most surveys, was much more inclined to remain in the EU, ended up being underrepresented at the actual ballot box too. Moreover, reports of a surge in Google searches in Britain on what the EU even is after the vote took place are shocking and disappointing. I have never been a fan of referenda, particularly on issues of such significance. Even in this day and age, when actual expertise seems to increasingly be deemed a liability, I continue to believe that real experts need to make some complex decisions that require substantial relevant knowledge.

While I am a strong believer in democracy, I think the average citizen should elect representatives, who in turn should rely on meaningful research and consultation with experts before making important decisions. In my humble view, referenda reflect people’s current opinions (more often than not based on short-term information) and not the overall knowledge of the population at large.

Also, contrary to attempts to link what happened with the Brexit vote to the US presidential elections a bit too much, prominent UK politicians (many of them true economic and fiscal conservatives) who voted in favor of leaving the EU opposed staying because they want more free trade, not less. I was personally pleased to see Boris Johnson, the former mayor of London and arguably the face of the ‘leave’ campaign against the EU, announce today that he will not be running to try to replace David Cameron as Britain’s prime minister.

Thus, my base case scenario, even if the UK does end up completely leaving the EU, is that Britain will not abandon its support of free trade. The strong historical ties to the US may open the door for a free trade agreement between the two major English-speaking countries.

While it will arguably be more difficult for the UK to negotiate bilateral trade agreements with other major economic powers (versus benefiting from the critical mass of the EU), I increasingly believe that Britain will definitely give it a strong try. At the margin, the UK’s economic ties to the rest of Europe will undoubtedly weaken, but the net long-term impact on the British economy is impossible to ascertain, in my view, and will largely depend on Britain’s success at its attempts to strengthen trade relations with countries outside of Europe.

Finally, currencies under many pressures… oh, the poor peso!

There is ample coverage currently on the concerns plaguing the British pound, as well as on other factors causing currency gyrations elsewhere in the developed world. Thus, I will focus the remainder of this note on a couple of emerging markets’ longer-term issues, where there is less understanding and coverage.

Unfortunately, there is much misunderstanding (and perhaps even deliberate misinformation) regarding how the Chinese currency has actually behaved in the last couple of decades! China has admittedly been able to garner an outsized share of the market for imports in the US.

This, however, has been propelled by the country’s entry into the WTO, and not by a deliberate policy of ‘currency manipulation.’ Please consider the following facts. When the Chinese yuan or RMB, as it is also known, was actually devalued in 1994, it had an 8 ‘handle.’ In other words, it took more than 8 RMB to buy one US dollar.

It has since appreciated over the last couple of decades to about 6.6 to the dollar. It takes fewer RMB (roughly 6.6 versus more than 8) to buy one US dollar, which means that the Chinese currency has gained in value, even when compared to a relatively strong US currency in world markets.

Last August, there was much press coverage of another Chinese RMB devaluation having taken place. Still, this was a minor single-digit adjustment against the US dollar, as the Chinese government actually changed the currency ‘basket’ it uses for what it calls the daily currency ‘fixing.’

In the meantime, the Mexican peso, which devalued from a 3 handle in 1994, hovers close to 19 today! This gives you an idea of the magnitude of the revaluation the yuan has experienced relative to the currency of the other major emerging markets trading partner of the US.

While I am by no means an expert on the Chinese economy, I do know the Mexican corporate sector, as well as the country’s monetary, fiscal and currency policies quite well. Therefore, I can confidently attest to the fact that there is no deliberate manipulation of the Mexican peso to weaken it against any other currency.

The fact that the Mexican currency has indeed devalued meaningfully against the US dollar, let alone the Chinese RMB, in the last couple of decades has not been a development welcomed by most Mexican citizens and/or institutions. It is almost an issue of national shame to have such a weak currency.

What this does demonstrate, however, is that countries are really not in charge of the relative value of their currency when compared to those of countries with stronger economies, particularly when the countries in question have relatively open trade policies and their currencies float increasingly freely.

Getting back to the Middle Kingdom, the Chinese are actually trying to ‘depeg’ the RMB from the USD. The International Monetary Fund (IMF – and indeed also the US) wants China to have a more freely floating currency that truly belongs in the ‘special drawing rights’ basket to which it was recently added. In fact, the Chinese RMB inclusion in the IMF’s SDR basket was a key milestone in the march of the Chinese economy towards global recognition as a major market economy.

As I repeatedly confirm, I am a firm believer in the net long-term benefits of global free trade. Therefore, I cannot join the growing chorus advocating new trade barriers and abrogation of trade treaties. As is often the case in other areas, rather than more rules and regulations, what we truly need is better enforcement of already existing rules.

And finally back to the Mexican peso. As a particularly liquid EM currency, the MXN is used to hedge just about anything of significant market impact across the emerging markets. Now, there are financial media reports citing analyst research talking about using the Mexican peso to hedge election risk here in the US. Oh, the poor peso!

Unfortunately, this can have real macro-economic consequences south of the border. The peso is not just a financial instrument, but the currency of a country with some 120 million people! Historically, there has been a meaningful pass-through effect from currency weakness to Mexican inflation.

This pass-through rate has tended to diminish over time, in my view largely due to NAFTA and sound monetary and fiscal policies in Mexico. Nevertheless, the magnitude and relative persistence of the ongoing weakness risks reigniting inflationary pressures due to the ongoing peso plunge.

This will need to continue to be faced by Mexican policy makers with aggressive monetary and fiscal measures, lest they risk a vicious cycle of inflation causing ever more devaluation, the like of those of decades that many of us thought long gone.



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