UK: Land of Hope & Glory…but mostly Confusion

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The lyrics of Genesis’ 1986 hit “Land of Confusion” were penned over 30 years ago, with the English rock band satirising Ronald Reagan’s US presidency (see Figure 1). Specifically, they allude to the confusion fuelled by opportunist politicians in a fast-changing world beset by acute challenges. But, in my view, they portray with uncanny accuracy the UK in 2017 as Prime Minister Theresa May and her government, Parliament and the Bank of England feel their way towards Brexit.

 

At this stage it is important not to mistake confusion with its less corrosive side-kick, uncertainty. As the saying goes, the only certain things in life are death (and taxes) – as Maynard Keynes reminded us we are all dead in the long-run. Uncertainty is prevalent in everything from financial markets to the weather. Financial institutions and corporations strive to quantify uncertainty to improve returns and can reduce uncertainty, albeit at a cost, using hedging instruments. Uncertainty drives volatility in equities, bonds and currencies and can thus be indirectly measured using indices such as the CBOE’s VIX.

In the UK, economic and political uncertainty has clearly risen since the outcome of the UK referendum on EU membership on 23rd June 2016 and general election on 8th June 2017 and I would pinpoint the following ten unknowns as currently the most potent:

 

  1. Will Theresa May remain as prime minister until the end of the current parliament?
  2. Will the Conservative-DUP alliance, which enjoys a slim working majority of 13 seats in the House of Commons, successfully pass legislation through parliament?
  3. Will this marriage of convenience between the minority Conservative party and DUP last a full parliament or could early general elections once again be triggered?
  4. Will tax rates be increased to finance greater public spending and/or will the fiscal deficit rise?
  5. Will the UK definitely leave the EU in March 2019 and if yes will the terms and conditions of the UK’s divorce from the EU be favourable?
  6. Will the UK have sufficient time to negotiate a new deal with the EU or will it instead opt for a transitional arrangement?
  7. Will a new deal with the EU include membership of the Single Market and/or Customs Union or some kind of bespoke, hybrid arrangement?
  8. Will a new deal with the EU, whether permanent or temporary, be “good” or “bad” for the British economy in the near and long-term?
  9. Is the current slowdown in economic growth and inflation pick-up transitory or self-fulfilling?
  10. Will the Bank of England (BoE) Monetary Policy Council (MPC) start hiking its record-low policy rate, and if so when and how quickly?

 

However, financial markets are also having to deal with chronic confusion in the UK, which I would argue is ultimately far harder to measure and hedge against than uncertainty. Confusion feeds and amplifies uncertainty, effectively making uncertainty even more uncertain. There can be no certainty, however slim, if there is confusion. For example, one cannot start to quantify the possible impact of tax changes on fiscal revenues (uncertainty) if the government cannot even agree on whether, when and by how much it will change tax rates in the first place (confusion). Governments rarely run as smoothly as they would like to portray, but in the UK the confusion is acute, deeply rooted and shows no signs of abating.

While the symptoms of this confusion are rather obvious, as I discuss in Part I, its causes are numerous, sometimes complex and often self-reinforcing – the subject of Part II. The government, which is in power but seemingly not in control, is arguably at the epicentre of this confusion. Prime Minister Theresa May and senior cabinet members do not speak with one voice on key topics such as Brexit and fiscal policy, with policy-makers clamouring for attention and arguably influence and control. But other economic and political actors, including Parliament, businesses, industry associations, vested interests and voters are increasingly voicing their views and adding to the discord and doubts.

Uncertainty makes it difficult to forecast where Sterling will trade next month, let alone next year. But uncertainty allied to confusion makes it nigh impossible to predict Sterling’s level next week, let alone next month, or where tax and interest rates will settle. That of course does not preclude attempts to separate the wheat from the chaff and to make some sense of the baffling contradictions epitomising government positions – as I do in Part III.

 

 

Part I – Brexit and fiscal policy reveal most acute symptoms of confusion

No issue in the past 20 years has divided the UK more than Brexit, in my view, and the cacophony of opinions is deafening and debilitating. Figure 2 summarises the key players and the spectrum of views and yet probably still under-represents the granularity of thinking on the issue of the UK’s departure from the EU. At a government level, cabinet members and the Brexit negotiating team have in the past year been increasingly prone to expressing differing and sometimes contradictory views about the modalities of the Brexit process and the ultimate end-goal.

Prime Minister Theresa May, David Davis – the Secretary of State for Exiting the European Union who also heads up the British Brexit team – Secretary of State Boris Johnson, Chancellor Philip Hammond and Trade Minister Liam Fox have been unable to agree on the optimal path for the UK in a post-EU world, putting forward increasingly confused and confusing statements. While Chancellor Hammond wants to focus on the economic and fiscal impact of Brexit, other cabinet members have prioritised control over EU immigration while others still have emphasised the over-riding importance of sovereign independence (including from the European Court of Justice). The government’s opening gambit on the status of EU nationals living in the UK has raised far more questions than it has provided answers.

Even individual cabinet members’ views are seemingly in constant flux, shifting with the vagaries of popular sentiment and the realities of the daunting task in hand. Beyond the cabinet, the 318 Conservative MPs’ opinions on Brexit are even more eclectic and widespread, with moderate Brexiters clashing with 30 or so hardline eurosceptics and a smattering of pro-Europeans (including Kenneth Clarke).

 

Differing opinions can of course be a source of good but only if they are channelled constructively. Instead, an unsettling cycle of half-truths, empty promises, obfuscation of facts, platitudes and clichés – including Theresa May’s “no deal is better than a bad deal” and “the best possible deal for the UK” have done little to paper over the cracks of confusion at the heart of government. I argued in December that the British government simply does not have a cohesive or comprehensive Brexit plan, only nebulous goals for the UK post EU (see The A-Team had a plan, the British government has a nebulous goal, 13 December 2016). The ruling Conservative Party, which has since lost its parliamentary majority, has given me no reason in the past six months to change my mind.

 

Ripples of confusion extend well beyond government

This confusion is even greater at the parliamentary level, with few political parties showing consistency or clarity of thought in terms of Brexit.

  • The Northern Irish Democratic Unionist Party (DUP), which recently signed a formal Supply and Confidence agreement with the Conservative Party, generally favours the UK exiting the EU. However, the DUP has expressed a preference for Northern Ireland to maintain free-trade arrangements with the Republic Ireland, which could be incompatible with the UK no longer being an EU member (see UK election: Clutching defeat from the jaws of victory, 9 June 2017).
  • The Labour Party, which has 262 seats in the 650 House of Commons, has been evasive on whether the UK should stay in the Single Market and Customs Union, arguing instead that the UK should enjoy the benefits which membership to these two entities convey. Divisions within the Labour Party were exposed in recent parliamentary votes, resulting in party leader Jeremy Corbyn dismissing a number of his shadow-cabinet members.
  • Admittedly the pro-EU Liberal Democrats and nationalist United Kingdom Independence Party (UKIP) have taken clearer (and diametrically opposed) positions on the Brexit issue. But they are at best only marginal forces in British politics: the Liberal Democrats have only 12 seats while UKIP has none and only won 1.8% of the popular vote in the recent general election.

Businesses and industry associations, including the Chamber of Commerce & Industry (CBI), have been adding to the noise, pushing for the government to temporarily remain in the Single Market and Customs Union beyond March 2019 until a fully-fledged deal has been reached.

 

EU leadership seemingly united on key principles and timeline

There is an argument that these multiple layers of confusion are intentional, part of the British government’s strategy to hide its poker hand and keep the EU guessing, with the ultimate goal of securing a very advantageous deal. Yet, European leaders have shown a sense of unity and little sign of wavering since the British voted for the UK to leave the EU over a year ago.

The head of the Brexit team, Michel Barnier, and political heavyweights including German Chancellor Merkel, have steadfastly stuck to their position that membership of the Single Market is conditional on the four freedom of movements, including importantly the free movement of labour (see Figure 3). The British government has skirted around this issue ad-nauseam without spelling out how the UK could benefit from frictionless trade with the EU whilst still controlling EU immigration.

 

 

Similarly, the EU leadership was from day one unequivocal that an agreement on the terms and conditions of the UK’s divorce should precede negotiations over a new deal. After months of posturing the British government implicitly conceded that this sequencing would indeed prevail.

 

Only near-certainty is that UK will likely leave the European Union

The closest thing we have to unity of thought and near-certainty is that the UK will leave the EU by 29th March 2019 – two years after Theresa May triggered Article 50 of the Lisbon Treaty. Even pro-EU MPs seem to begrudgingly acknowledge that the referendum result, which saw 52% of the electorate vote in favour of the UK leaving the EU, needs to be respected.

However, there are still rumblings in the background of a second referendum and talk of the government performing a giant u-turn and effectively aborting the Brexit process if it becomes clear that any new deal would seriously hurt the British economy. EU leaders have blown hot and cold about the prospect of the UK changing course and remaining in the EU but a number of senior politicians, including French President Macron, have left the door open to such a possibility (it would be theoretically possible for the UK to cancel the exit process but all 27 EU member states would likely have to agree to such a scenario).

The UK is scheduled to leave the EU in 21 months, which in practical terms is a very tight timeline but in political terms is an eternity. While the probability of the UK leaving is high, in my view, it would be foolhardy to assume that it is anywhere near 100%.

 

Vague fiscal policy new battleground for confusion

More recently, the debate about the optimal path for taxation, public spending and the budget deficit has taken centre stage, driven by growing popular opposition to ongoing austerity measures. But again the only consensus amongst senior cabinet members is that there is no consensus as to whether, when and how taxes should be hiked to fund yet to be quantified or qualified public spending increases and/or whether there is scope for fiscal deficit targets to be softened

Fiscal policy u-turns have become common currency, with the government flip-flopping on policies including the 1% cap on public sector wage increases, the so-called dementia tax, national insurances tax, the triple-lock on state pension increases[1] and free school lunches. Ministers have been forced to repeatedly backtrack, playing catch up in trying (and failing) to mask shifting official positions and present a united front. Boris Johnson has in recent days publicly called for an end to the 1% cap only to be rebuffed by Theresa May and Chancellor Hammond who clearly favour tighter fiscal policy.

 

Part II – Confusion is structural, cyclical and partly self-inflicted

The underlying causes for these multiple-layers of confusion are both structural and cyclical. I would argue that 1) poor sequencing, a lack of preparation, no precedent and a tight timeframe with regards Brexit, 2) the recent general election result and shifting popular opinion and 3) the multiplicity of economic challenges have fuelled confusion and in turn exacerbated uncertainty.

 

Brexit: Poor sequencing, lack of preparation, no precedent and time running out to complete immensely complex project

For starters, then Prime Minister David Cameron stacked the odds against the government’s official position that the UK should remain in the EU by not allowing sufficient time to renegotiate a new EU deal and by holding the referendum on EU membership before the parliamentary vote – unlike Prime Minister Edward Heath’s Labour government in the 1975 referendum on EC membership (see Figure 4).

 

 

Putting aside the issue of sequencing, one obvious reason behind the confusion regarding Brexit is simply that Prime Minister David Cameron’s government had simply not planned for the eventuality of a “leave” vote at the EU referendum on 23rd June 2016. The broad-based assumption was that the deal which he had secured with the EU in early 2016 would push the balance of popular opinion comfortably in favour of “remain”. The then Chancellor Osborne had explicitly stated that the Treasury had been focussed on negotiation talks with EU leaders and had not made contingencies for a possible exit from the EU.

 

 

The ruling Conservative Party then lost nine months clearing legal hurdles, drumming up parliamentary support for Brexit and electing a new leader (Theresa May) and a further two months preparing for the 8th June 2017 general election. As UK and EU parliaments and the European Council will have to vote on any new agreement by end-2018, the British government effectively now has only 18 months to complete the most complex legal, constitutional, political, economic, financial and social project undertaken by any EU country in the past 40 years.

And of course there is no precedent for a country leaving the EU, no ready-made templates for the British government to rely on. Proponents of Brexit have referenced Norway, which is not a member of the EU but is closely associated with the EU through its membership of the European Economic Area in the context of being a European Free Trade Association member (see Figure 5). But the comparison is far from perfect. For starters, Norway is a significant net exporter of oil (and aluminium) which has funded one of the world’s largest pension funds and affords it a degree of economic flexibility which the UK does not enjoy.

This lack of preparation and precedent and a (largely self-imposed) challenging timeframe have undoubtedly compounded the sense of a government playing catch-up and the confusion which has ensued. The outcome of the hastily called general election of 8th June 2017 has only added fuel to the fire.

 

General election – Out of the frying pan, into the fire and self-inflicted confusion

Prime Minister May performed a remarkable u-turn in April by calling an early general elections, after having strenuously talked down the need to hold elections only two years into the parliamentary term. This decision back-fired with a weakened Conservative Party struggling more than ever for cohesion.

Theresa May’s motivations were four-fold: (1) Win a popular rather than party mandate, (2) Capitalise on the massive lead in the polls the ruling Conservatives enjoyed over the opposition Labour Party and thus allow her to push through her own agenda, including her preferred form of Brexit, (3) Allow the government more time to secure a new EU trade deal, and (4) Strengthen the government’s stance in negotiations with the EU (see UK election special – When two tribes go to war, 2 June 2017)

Objective (3) has to some extent been met as the current parliament will now extend to May 2022, rather than 2020, potentially giving the government a further two years to secure a final EU deal. But objective (4) was always wishful thinking and Prime Minister failed outright to secure objective (3). Most damaging, however, was the Conservative Party losing both its absolute and working majorities (see Figure 6).

 

 

The minority Conservative Party subsequently signed a formal alliance with the DUP, which won 10 seats and in theory should help the government get key policies (including on Brexit and the budget) through parliament. But this marriage of convenience is fraught with problems and been much criticised. While calls to oust Theresa May as party leader have abated, infighting within the party has gone up a notch and senior cabinet members have been jockeying for power, exacerbating confusion over who truly is in charge.

 

Trade-offs more painful and confusion more acute as a result of slowing economic growth

There can be little doubt that economic growth in the UK has slowed this year. This does not bode well for the government’s finances but perversely has intensified popular opposition to the government’s multi-year austerity drive. Increasingly painful fiscal trade-offs have in turn seen government officials and MPs increasingly divided as to the optimal path for fiscal policy. The fall-out has been growing confusion at the heart of government as to whether, when and by how much public spending should rise and whether it should be financed by higher taxes and/or greater borrowing.

  • GDP growth was a paltry 0.2% qoq in Q1 2017 and macro indicators suggest it did not rise much in Q2 (preliminary data are due out on 26 July).
  • Slow economic growth, labour productivity now below end-2007 levels and a still reasonably large pool of available labour (unemployed, part-time workers and those not in the labour force but willing to work) are likely to continue weighing on workers’ ability to negotiate higher earnings and in turn nominal wage growth.
  • Falling real wages, pressure for banks to curb lending, stagnant property prices, a record-low household savings rate and political uncertainty continue to hold back retail sale volumes (which contracted 1.1% mom in May) and in turn household consumption and GDP growth.
  • Investment has slowed in a number of sectors. Investment in the auto sector in H1 2017 was running at about a quarter of where it was only two years ago, as companies delay or shelve investment plans.
  • Export growth has picked-up but so has import growth, resulting in a still large trade deficit (despite the 18% gain in Sterling competitiveness in the past 18 months) and little support for overall GDP growth.
  • On the supply side, industrial output has for the past 12 months continued to flat-line and the latest manufacturing PMI data are not particularly encouraging.

Adding to the confusion is the fact that for the first time in almost a decade, the BoE is seriously considering a policy rate hike (see GBP – Hawkish surprise presents selling opportunity, 15 June 2017).

 

Part III – Forecasts at the mercy of confusion (and uncertainty)

With this noisy backdrop, any forecast can be at best only tentative. However, I would conclude the following at this stage:

1) I ascribe an 80% probability of the government sticking to its current plan to exit the EU by 29th March 2019.

2) Assuming complex discussions about a new UK deal with the EU start no earlier than 2018, both parties would have only 12 months to agree on the economic, financial, political and legal intricacies of such a deal. This is arguably a very narrow timeframe, particularly for a Conservative Party short of a parliamentary majority and which has so far moved very slowly.

With this in mind, it strikes me as very unlikely that a full-scale and permanent deal with the EU will be in place by end-2018, which would leave the government with only two real options: walking away from a deal and reverting back to WTO trading rules or agreeing to a transitional deal which buys the government more time to contemplate its options. The latter is the more likely in my view and this could include some form of borderless trade with the EU for a defined period in exchange for continued contributions to the EU budget and a watered down version of the EU-immigration targets the government currently has in mind.

3) With regards to fiscal policy, the path of least resistance could be for the government to adopt a middle-of-the-road approach which includes an uptick in public spending (focused on wages rather than infrastructure), small tax increases (particularly for higher income earners) coupled with a modest fiscal deficit slippage this year and next. This would help alleviate calls for an end to austerity and not materially damage the Conservative Party’s status as the more fiscally responsible of the major parties.

The Conservative Party has been in discussions with the left-leaning Liberal Democrats about the latter supporting the government in parliamentary votes on a case-by-case basis. This suggests to me that the government has, at the very least, not fully excluded modest increases in public spending even if the scope for significant fiscal reflation remains limited.

4) The BoE’s eight-member MPC is unlikely to hike its policy rates of 0.25% at its August meeting. While I expect MPC member Andrew Haldane to join Michael Saunders and Ian McCafferty in voting in favour of a 25bp hike, I expect new member Silvana Tenreyro to vote in favour of no change which would result in a 3 versus 5 vote in favour of rates remaining on hold. Importantly, I believe that Governor Carney – who has the casting vote in the event of a 4 versus 4 tie – will again vote for no change, even if he has had a tendency to blow hot and cold.

5) Sterling may well continue to struggle for direction with the Sterling Nominal Effective Exchange Rate (NEER) remaining in its year-to-date range (see Figure 7). But unless the government can post some notable successes with regards to its Brexit negotiations, UK economic growth recovers or the MPC hikes rates in coming months, at the margin I see the risk biased to Sterling downside from current levels.

 

 

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.


 

[1] The triple lock policy ensures that the state pension rises each year by the highest of one of three measures: wage growth, inflation or 2.5%.

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