Sterling singing to (leaked) tune ahead of Theresa May speech

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Reports in the British press about the content of Theresa May’s planned speech tomorrow seem to confirm that the prime minister may sacrifice access to the Single Market in exchange for control over EU immigration into the UK.

Unsurprisingly perhaps, Sterling has weakened further but the currency may get some (temporary) respite if the content of Theresa May’s actual speech is somewhat more conciliatory.

In particular I would expect markets to focus on whether the UK government has moved closer to agreeing to a transitional arrangement once the UK has actually left the EU and whether any progress has been made in protecting the all-important UK services sector.

About 45% of the UK’s total exports are destined to the other 27 EU member states and about 53% of its total imports come from the EU. In comparison, only about 9% of the EU-27 exports of goods and services are destined for the UK. Similarly, only 9% of the EU-27 imports of goods and services come from the UK.

The EU thus has far more leverage over the UK than vice-versa assuming these 27 EU member states are willing and able to negotiate as one trading block, in my view. This imbalance is even greater in traded goods alone.

However, when it comes to services, the picture is somewhat more balanced and the UK may arguably have a stronger bargaining hand.

Simply put the EU buys and sells a far greater share of its services to/from the UK than it does for goods and it may be difficult for EU countries to substitute imports of financial services from the UK given London’s pre-eminence as a financial centre.

 

A fair bit of noise ahead of Prime Minister Theresa’s May speech on Brexit

British Prime Minister Theresa May is scheduled to make a speech tomorrow (17 January) in which she will outline her plans for the UK’s future relationship with the European Union once the UK has left the EU. Since she was appointed Prime Minister in July, after David Cameron’s resignation, the former Home Secretary has provided very few details of the likely terms and conditions of the UK’s exit from the EU let alone of a new deal with the UK’s largest trading partner[1].

Tomorrow’s speech is therefore an important milestone in the already tortuous path to the UK’s likely exit from the EU. But it is has been somewhat overshadowed by the ongoing saga of US President-elect Donald Trump’s relationship with Russia ahead of his inauguration on 20th January and by an interview published this morning between Donald Trump and former UK cabinet member Michael Gove now writing for the UK Times (see Figure 1). While Theresa May has yet to secure a head-to-head with Donald Trump, he said the US would aim to secure a new trade with the UK within weeks of his inauguration.

olivier desbarres theresa may fig 1

Moreover, markets are likely to turn to Bank of England (BoE) Governor Mark Carney’s lecture today at the London School of Economics (18.30 Local time) on Policy Issues affecting the Bank of England. Carney will likely stick to a background discussion of the challenges which UK monetary policy faces and will disappoint traders looking for insights on whether the BoE may tweak its policy rate and/or QE program. However, given the fraught relationship between Carney and the government, any suggestion from Carney that this relationship remains on tenterhooks could at the margin detract from Theresa May’s speech.

 

Theresa May’s speech will sound familiar, if leaks are to believed

Finally, and most importantly, the content of Theresa May’s speech was partly leaked to the press over the weekend. If the leak is accurate, Theresa May will confirm that the British government will prioritise control over immigration and full independence from the European Court of Justice and seek a bespoke trading deal with the EU which may exclude access to the Single Market and potentially the Customs Union – what has been coined a “Hard Brexit”. Sterling opened considerably weaker in trading this morning, with GBP-USD temporarily below 1.20 and GBP-EUR dropping to around 1.133. Sterling’s Nominal Effective Exchange Rate (NEER) is at a two-month low according to my estimates (see Figure 2).

olivier desbarres theresa may fig 2 and 3

This should perhaps come as no surprise. Sterling has typically weakened when the government has stated its preference for a Hard Brexit – however ill-defined – and its drop today is in line with my view that if Theresa May stuck to her guns this week Sterling would likely weaken further (see UK inching towards Brexit, 13 January 2017). It is conceivable that the content of Theresa May’s speech – or at least some of the key points – was intentionally leaked. The government seems aware that markets may react negatively to her detailed goals for the UK’s exit from the EU and may have therefore wanted to pre-empt any large move in Sterling, UK equities and gilts.

If the content of Theresa May’s actual speech proves somewhat less hard-edged, Sterling and UK equities could conceivably rebound and the government claim this as proof that UK financial markets approve of her plan. It may thus be a case of “buy the rumour and sell the fact” – in this instance sell Sterling ahead of the speech but buy it back once the speech has actually been delivered. Specifically, markets may take some comfort if Theresa May tomorrow shows a greater inclination for a transitional agreement once the UK has left the EU (in early 2019 based on the government’s preferred current timeline). A number of senior cabinet members, including Secretary of State David Davis, have suggested in recent weeks that such an arrangement may be beneficial to both parties.

While Theresa May’s speech (no time confirmed) will be centrepiece tomorrow, it will likely be sandwiched between two important UK data releases:  December CPI-inflation out at 09.30 and November labour data out on Wednesday at 09.30. UK inflation has risen only slowly in recent months with retailers seemingly willing to absorb price pressure in order maintain to maintain market share. The concern, however, is that Sterling’s collapse post-referendum will start feeding through more forcefully to imported inflation and consumer prices, which in turn will dent already modest real wage growth and ultimately household consumption – the UK’s main engine of growth (see Figure 3). A set of high inflation and/or weak wage numbers may therefore blunt any rebound in Sterling.

 

Service sector key to UK and potential bargaining chip

Financial markets will also likely focus tomorrow on the extent to which Theresa May is willing and able to provide a degree of continuity to the all-important UK services sector. If she succeeds on this front Sterling could recover further although any rally will be tempered by the reality of the UK having to reach an agreement with 27 EU member states with vested interest to defend.

She certainly has an incentive to try and ring-fence the services sector as it accounts for about 80% of UK GDP – by comparison manufacturing and construction account for only 15% and 5%, respectively. The UK’s exports of services, which amounted to about £240bn per annum (about 9% of GDP) in the 12 months to November, have been on a steady upward trajectory in the past six years (see Figure 4). Whereas the UK runs a sizeable trade deficits on goods, its annual trade surplus on services exceeds £90bn or 3.6% of GDP (see Figure 5). Importantly, Theresa May has conceivably more bargaining power with the rest of the EU when it comes to the services sector.

olivier desbarres theresa may fig 4 and 5

The EU is by far the UK’s largest trading partner. About 45% of the UK’s exports of goods and services are destined to the other 27 EU member states and about 53% of its imports of goods and services come from the EU (using 2014 data). In comparison, only about 9% of the EU-27 exports of goods and services are destined for the UK. Similarly, only 9% of the EU-27 imports of goods and services come from the UK (see Figure 6).

In aggregate, therefore, the EU has seemingly far more leverage over the UK than vice-versa assuming these 27 EU member states are willing and able to negotiate as one trading block. If the UK exits the Single Market and tariffs are applied to goods and services traded between the UK and EU, the cost of these goods and services will rise (all other things being equal). This loss of price-competitiveness could result in fewer goods and services being traded between the UK and the EU and/or traded at higher cost, which could in turn have a negative economic impact on both the UK and EU. However, while a small percentage change in these flows and their costs would likely have a modest absolute impact on the EU as a whole, it could have a large absolute impact on the UK.

This imbalance is even greater in traded goods. While the UK exports about half of its goods to the EU and imports 54% of its goods from the EU, the EU exports only 7% of its goods to the UK and imports only 4.5% of its goods from the UK (see Figure 7). Moreover, these percentages do not change materially for the largest EU economies – Germany, France and Italy. For example, about 7% of Germany’s exports of goods are destined for the UK and 5% of its imports of goods stem from the UK, according to the Bundesbank.

olivier desbarres theresa may fig7

However, when it comes to services, the picture is somewhat more balanced and the UK may arguably have a stronger bargaining hand. While the EU is not very dependent on exports/imports of goods to/from the UK, the EU is far more dependent on exports/imports of services to/from the UK (see Figure 8). While only 7% of the EU’s exports of goods are destined to the UK, the share of exports of services going to the UK is twice as high. Similarly, while only 5% of the EU’s imports of goods stem from the UK, 20% of its imports of services come from the UK. Simply put the EU buys and sells a far greater share of its services to/from the UK than it does for goods.

Over time, it may be possible for the UK and EU to buy their goods (more cheaply) from non-EU countries but this substitution effect may be less obvious for high value-added and specialised services. It may be difficult for EU countries to substitute imports of financial services from the UK as London is one of the pre-eminent financial centres in the world (number one or two along with New York according to the Global Financial Centres Index and International Financial Centres Development Index). While there has been anecdotal evidence of some UK-based financial services providers relocating some of their staff to other EU member states ahead of the UK’s likely departure from the EU, there has been little evidence to date that they are willing or able to relocate a significant share of their front-line staff.

EU member states may thus be wearier as a bloc of agreeing to a future trading arrangement with the UK which negatively impacts the UK’s ability to provide financial services to EU companies or which disrupts EU financial markets. Indeed, the EU’s chief negotiator Michel Barnier was quoted as telling a private meeting of MEPs that specific work needed to be done to ensure that the remaining 27 EU member states have a “special relationship” with the City of London and that financial instability be avoided.

 

Parliament will want to see detail, not just clichés

As I argued in UK inching towards Brexit (13 January 2017), there is another scenario whereby Sterling may (somewhat perversely) rebound. Members of Parliament (MPs) have requested that the government provide a detailed plan in exchange to agreeing to the government triggering Article 50 by end-March. If MPs deem that Theresa May’s speech falls short of a detailed plan, they could conceivably push for the publication of a more detailed and formal white paper.

If this is not forthcoming, MPs still have the power to delay the triggering of Article 50, assuming that the Supreme Court upholds the High Court’s ruling that the government does not have the prerogative to trigger Article 50. The Supreme Court’s decision is expected in late January and legal experts believe it will rule with the High Court. However, I would view this as only a temporary reprieve as ultimately the government has a popular mandate for the UK to leave the EU.

 

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] While this somewhat makes sense from a tactical perspective, I have also argued that the government’s reluctance to share its game plan is a by-product of the very limited time it has had to devise a detailed roadmap for what will arguably be the most complex economic, financial, social, political and legal project that any EU member state has undertaken (see The A-Team had a plan, the British government has a nebulous goal, 13 December 2016).

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