Craig looks at the Brexit nightmare four months on and if there’s value investing in GBP
Markets seemed to settle remarkably quickly after the initial shock and volatility of the Brexit vote. In the four months since the vote, here’s the washup for major asset markets:
The biggest loser from the vote so far is the Pound Sterling (GBP), down 18% against both the USD and AUD.
On the other hand, the FTSE100, the leading index for the London Stock Exchange, is up 16.5%, actually reaching just 0.1% from its highest ever level earlier this month. This is largely due to the Pound (GBP) falling sharply, increasing export earnings for British companies.
Ten year UK government bonds (“gilts”) have barely changed, after seeing their yields fall by 70bps to just 0.51%pa before rising back to just 10bps lower than before the vote at 1.12%pa.
Hard Brexit vs Soft Brexit
While equity markets have been surprisingly bullish overall, volatility is very high. This has been particularly true over the past two weeks, after negotiations between the UK and EU stepped up a gear. The UK for its part has declared it will prioritise immigration curbs over renegotiation of trade relationships.
But regardless of the rhetoric, new UK PM, Teresa May, put the exit beyond doubt, saying that the two year exit process would be triggered by the end of March 2017. Not only that, she has made her position on the key negotiation points of immigration and trade very clear, stating that “We are not leaving the European Union only to give up control of immigration again”.
So to get a sense of whether the GBP is expensive or cheap and whether the UK economy will come out ahead or behind post Brexit, we need consider the likely approach taken: hard Brexit or soft Brexit.
Hard Brexit means that most ties to the EU are cut, including free migration between the EU and UK, trade agreements and the UK continuing to contribute to the EU bloc’s budget.
Soft Brexit, on the other hand, means staying within the single market as Norway is, which comes with a contribution to the bloc’s budget.
However, the problem for the viability of the soft option is that Norway (and Switzerland who has similar trade agreements) allow the free movement of European workers over their borders, whereas Teresa May has said that she will prioritise control of borders over trade.
Risks to the UK economy under Hard Brexit scenario
So on balance, it appears Hard Brexit is more likely, with the only question being – ‘how hard?’ The Canadian agreement with the EU, while not actually signed yet, gives the best benchmark. If signed on 27 October, Britain will probably look to replicate much of the Comprehensive Economic and Trade Agreement (CETA)* as quickly as possible.
CETA involves duty free trade of goods and some services, no obligations to meet EU rules on immigration, social or employment rules, and no obligation to contribute to the EU budget. But agricultural tariffs will remain in place.
The risks for the UK economy assuming this as the base case are therefore, in a rough declining order from biggest impact to least:
- Haemorrhage of banking jobs from London
London will suffer substantial job and tax losses if it fails to figure out financial passporting, figuring out how to keep the easy passage of capital between the EU and UK,. Financial Services makes up 9% of the UK economy and estimates of the losses from Brexit range from 10% to 22% of this, that is a hit to UK GDP of 0.9% to 2.2%. There is no trade agreement precedent that allows for the form of financial passporting that London needs to retain its global position as the pathway of choice between Europe and the world. On the other hand, financial passporting is a far more mutually beneficial issue; European companies would have to rewrite thousands of contracts if they were unable to access freely London’s capital markets, much of them in the vital insurance industry.
- Failure to replace EU trade membership with WTO membership
Regardless of the outcome of the trade agreement with the EU, Britain must join the World Trade Organisation (WTO) at the same time as leaving the EU. A gap between those dates will cost trade and therefore the economy. Trade agreements with countries like Australia and New Zealand can be quickly struck, but this amounts to less than 3% of the UK’s trade. Other countries will take longer to individually negotiate, so the WTO membership is a must.
- Food industry
No existing trade agreement with Europe includes the right to be part of the EU’s Common Agricultural Policy. Without a free trade agreement with the EU, the UK would fall back on WTO rules (at best) which would result in a 22% tariff being placed both on imports from the EU and exports to the EU. This would create an inflation shock that will hurt consumers and the food manufacturing industry, but also reduce competitiveness of UK farmers. With the GBP at current lows, the inflationary impact on consumers would be more than 35%, but farmers would come out only slightly worse off. Offsetting inflation, the GBP is unlikely to stay at its current lows (see more below).
- Stagflation (Inflation + Stagnation)
Higher food prices and a lower GBP will push up inflation in the UK. While central banks have been trying to push up inflation, they are actually trying to push up demand and see inflation rise in parallel. Inflation without growth is the worst case scenario. Called “stagflation”, this scenario saps business confidence as they experience rising costs but flat demand, meaning business investment suffers. Consumers experience rising costs, but low employment growth, so they also tend to spend less.
- Business confidence falls
So far so good on this front, but the recent split in the ruling Conservative party about which path to take raises the risk of investment decisions being deferred. Worst hit would be those that face uncertainty about tariffs on their exports to the EU such as the motor and steel industries.
Conclusion
The OECD has forecast UK GDP to be down 3.3% at its lowest point in 2020 before recovering again. These forecasts predated the recent Hard Brexit announcements so this impact is likely to be worse.
However, beyond the next few years of turmoil and one off inflationary, trade and investment impacts, the UK economy will benefit from being an attractive place to work and live, so long as they can avoid a recession. With control over their borders, the UK can benefit from the right to accept immigrants to boost their economy, but no more than they want to, meaning they can manage employment prospects for their people. As long as southern Europe in particular remains in its vicious cycle of high youth unemployment and population decline, the UK will be able to control its economic growth far better under Brexit than as part of the EU.
Last word on GBP
The GBP against any other currency will remain one of the most volatile currencies of the developed world, if not the emerging market world too. There could very likely be new lows tested, particularly over the next six to 12 months as the final terms of exit are negotiated and as we find out how much of a slowdown the UK economy experiences through loss of confidence and inflation.
Investors willing to take a position in the GBP need to “put it in the bottom drawer” for the next two years or more, as the GBP is expected by most economists, including myself, to make back most if not all of its 18% fall so far since Brexit. Thus a profitable prospect, but not one for the impatient or faint hearted.
*CETA at a glance
- Negotiations began in 2009 and ended in August 2014
- The deal aims to eliminate 98% of tariffs between Canada and EU
- It includes new courts for investors, harmonised regulations, sustainable development clauses and access to public sector tenders