ANALYSIS: Whatever the result of this week’s Brexit vote, it is the beginning of the end of the current version of the European project. I recall writing a report for clients in 1999 that the euro common currency takes away one of the key balancing mechanisms of a floating currency and that it would likely end badly. I recall shortly thereafter, some were calling for the creation of the “amero”, the North and Central American common currency, which I then opined was a much worse idea for Canada.

These types of ideas can take decades to play out and should not be the basis of an investment decision. In the short run, they offer tradable opportunities to be sure. The uncertainty a ‘yes’ Brexit vote would add will not doubt be a negative in the short run, as many establishment elites have opined, but likely a positive in the long run in my humble opinion. Sure, trade deals would have to be renegotiated and labour mobility would be a bit tougher but no big deal from compared to removing a layer of bureaucracy (Brussels) that appears to serve no real good productive purpose and which I would vote for 100 per cent of the time.

The north of Europe simply works a bit harder and is a bit more productive than the south, for whatever cultural reason. For the typical tax payer in Germany, it’s just not tolerable that their tax dollars go towards supporting the person in Greece that on average retires a decade earlier. Obviously, there is more to it than that, but is the essence of the difference between the wealthier north and poorer south. Separation of class is largely part of what we are seeing in the U.S. with the remarkable success of Trump and Sanders. We also see a vote in Spain this week as they were not able to establish a coalition government, and we suspect the anti-EU parties to gain more momentum this time. We would not be surprised if Netherlands held an EU-leave referendum and Catalonia held a vote to separate from Spain at some point in the coming year.

As a refresher, the main goal of bringing Europe together economically in the 1960s and 70s was to avoid another European-centric World War, which it has certainly done a good job at doing, along with the creation of the United Nations in 1945. I like the idea of the EU for this goal alone, but unfortunately, the economic reality as they drew up in the planning has not worked as well as hoped.

The Maastricht Treaty was signed in 1992 and led to the creation of the euro in 1999. One of the obligations of the treaty for the members was to keep "sound fiscal policies, with debt limited to 60 per cent of GDP and annual deficits no greater than three per cent of GDP”. Greece, of course, should never have been admitted (they cheated and lied about their fiscal position…with the help of Goldman Sachs who should be legally culpable in my humble view) and the financial crisis of 2008-09 ripped the fiscal pact apart in every country. What the EU did do is add a level of bureaucracy, inefficiency, and cost (my Libertarian views for smaller government poking through).

Floating exchange rates are one of the best ways for economies to rebalance in the long run allowing those that are poorly managed to suffer without dragging others down with it. Yes, it can promote currency wars to benefit export countries, but you have to believe that products should be produced in the places with the greatest efficiencies (quality being equal) and economies under good leadership should adapt to do what they are most productive. We probably need to get back to floating exchange rates in Europe in the long run. In an ideal world, governments could manage a balanced budget, but the real world has shown that fiscally-failed economies like Japan and Greece cannot grow much with low rates and staggering debt levels. Debt levels in the world are staggering and are a significant headwind to economic progress.

Thankfully, the U.K. never gave up their floating exchange rate, though they tried during the first version of the euro (exchange rate mechanism) that failed in 1992 when George Soros broke the Bank of England. The pound broke support in the 1.47-1.48 range in January, but held the multi-decade support around 1.39-1.40. A break of this range should give an indication of what is to come. Stability above 1.48 or high volatility below 1.39.

A major market concern is what a winning Brexit vote might inspire in other nations. The French dislike the EU even more than the U.K., according to a recent Pew survey. The EU racked up a 61 per cent unfavorable rating in France versus 48 per cent in the U.K. Germany and Spain are not much better. The Netherlands wants its own referendum to follow historic Brexit vote, but that could die off if the ‘no’ vote wins a strong majority. Dutch people (90 per cent) hope the Netherlands will hold its own EU referendum amid mass discontent at Brussels bureaucrats.

Harry van Bommel, MP for Holland’s Socialist Party, told Express.co.uk:

“We cannot go on the way we are – financing Greece, trying to keep countries in the eurozone. The eurozone will break up eventually.” He added: “Because we’re in the euro, Dutch people see budget cuts, unemployment going up, and they relay that to the EU. These facts make the EU very unpopular. People distrust Europe and some people even hate Europe – it’s in an existential crisis.”

A graph in the above video shows the general negative trends in opinions on the EU in other European countries.

If we see a vote to leave, we understand that it could take as long as seven years to fully play out, but a minimum of two years to even begin to know what an exit actually means. Markets do not like uncertainty and a leave vote offers a huge amount of uncertainty for an extended time. The pundits are correct that in the short run it could really hurt growth. What they leave out is that in the long run it might actually be better to have less bureaucracy, but the establishment elites are not going to say that.

On a ‘no’ vote result, market would likely have a bit of a rally to test key resistance levels, but at the end of the day, Europe’s problems are deep and eventually it will break up, as the Dutch MP pointed out last week. We think it is going to be too close to call. The common wisdom is that the undecided vote for the status quo, but things are changing and the anti-establishment vote is increasing everywhere.

I expect to remain very defensive in my client portfolios as credit risks in China are increasing weekly. The more important question to answer from a market perspective is when is the next recession coming, not if, seven years into a recovery. Why do you think the FOMC downgraded their assessment on rates so significantly last week?

Follow Larry Online:

LinkedIn Group: ETF Capital Management

Facebook: ETF Capital Management