UK inching towards Brexit

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British Prime Minister Theresa May will make a speech on Tuesday 17th January in which she will set out in greater details her plans for the UK’s exit from the EU.

There have been few signs that she is willing to tone down her mantra of the UK regaining control over immigration in exchange for a bespoke trading deal with the EU which may exclude access to the Single Market.

If Theresa May sticks to her guns next week I would expect Sterling to weaken further.

A sell-off in Sterling could be partly curbed if Prime Minister May agrees more explicitly to a transition agreement whereby the UK still retains some of the benefits of EU membership even after the UK has officially left the EU.

If MPs perceive Theresa May’s speech as insufficiently detailed or it is not backed up with a detailed and formal government white paper, parliament may decide to delay or even scupper the process by which Article 50 is triggered.

This would at the margin increase the perceived odds of the UK remaining in the EU and may provide some relief for Sterling.

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.

The apparent resilience of British economic growth since the June referendum has given weight to the arguments that the economy can easily weather the UK’s exit from the EU and that the British government is in a strong negotiating position.

However, the risk now is perhaps that too much confidence is being placed in the British economy’s ability to weather a number of possible forthcoming challenges.

 

Theresa May to detail her Brexit plans on Tuesday

The government has confirmed that British Prime Minister Theresa May will make a speech on Tuesday 17th January in which she will set out in greater details her plans for the UK’s exit from the European Union (no specific time has been given). At the risk of stating the obvious, financial markets will be looking in detail at the content of her speech, including her stance on immigration into the UK and access to the Single Market, the timeline for the UK’s likely exit from the EU and scope for a transition agreement.

 

Control over immigration likely to prevail over access to Single Market

Theresa May has, since her appointment as prime minister in July, repeatedly put control over immigration at the top of her priority list in a “bespoke” deal for the UK and hinted that the UK would probably leave the Single Market and Customs Union (even if she has fallen short of explicitly making that point). EU leaders, along with the European Commission and European Council, have made it very clear that if the UK curbed immigration of EU nationals into the UK (either outright or by setting pre-conditions) this would violate one of the Single Market’s guiding four principles – the free movement of labour – which would in turn exclude the possibility of the UK remaining in the Single Market.

On every occasion where Theresa May has re-affirmed her view that the UK will seek to regain control over immigration into the UK and potentially leave the Single Market, Sterling has weakened. The concern is that a loss of access and/or more expensive access to the Single Market will ultimately weigh on UK trade and in turn economic growth.

There have been few signs that Prime Minister May is willing to tone down her mantra of the UK regaining control over immigration in exchange for a bespoke trading deal with the EU. Cabinet members which have taken a somewhat softer line, including Secretary of State for International Trade Liam Fox, have seemingly been sidelined. If Theresa May indeed sticks to her guns next week I would expect Sterling to weaken further. The Sterling Nominal Effective Exchange Rate (NEER) – which measures Sterling against the currencies of the UK’s main trading partners – has weakened about 3.7% in the past month according to my estimates (see Figure 1). However, it remains about 4% stronger than the multi-year low recorded three months ago following Sterling’s “flash crash”.

Olivier Desbarres Mayhem fig 1 and 2

Prime Minister May could soften the blow with explicit agreement to transitional agreement

There will also be much focus on the timeline of the UK’s likely exit from the EU. Prime Minister May has steadfastly stuck to her plan to trigger Article 50 by end-March, which would imply the UK’s membership to the EU formally ceasing within two years (i.e. by March 2019). The UK may successfully negotiate the terms and conditions of its exit from the EU within this two-year framework (including whether the UK would continue to contribute to the EU budget).

However, members of parliament across the political divide and UK-based companies have expressed concern that the more complex agreement on the UK’s new trading arrangements with the EU will take far longer to reach (as long as a decade according to the former British Ambassador to the EU Sir Ivan Rogers). If no agreement is reached within this two-year framework, the UK would revert to World Trade Organization (WTO) rules unless all 28 EU member states unanimously agreed to extend the timeline.

There has therefore been much talk about a possible transitional phase but it has so far seemingly received only at best lukewarm support from Theresa May. A sell-off in Sterling could be partly curbed if Prime Minister May agrees more explicitly to a transition agreement whereby the UK still retains some of the benefits of EU membership even after the UK has officially left the EU. Of course other EU member states would need to green light such an agreement which would also likely require the UK to show some willingness to compromise. However, this is probably a debate for later in the game.

 

Devil is in the detail…and degree of detail

Prime Minister May has so far only provided a very broad outline of her vision of the UK’s future relationship with the EU, with her well-worn slogans – including “Brexit means Brexit” and “a red, white and blue Brexit” falling well short of a detailed road-map for the UK. But voters, businesses, parliament, EU leaders and foreign trading partners are pressing the government to elaborate on its tactics and strategies for Brexit (see The A-Team had a plan, the British government has a nebulous goal, 13 December 2016).

There was break-through of sorts on 7th December, with the 650 members of the House of Commons (MPs) voting overwhelmingly to allow the government to trigger Article 50 by end-March in exchange for publishing the details of its Brexit plan. More specifically, MPs would vote in favour of a law allowing the government to trigger Article 50, assuming as most legal experts do that the Supreme Court upholds the High Court’s ruling that the government does not have the authority to trigger Article 50 (see Figure 3).

But the devil is in the detail – or lack thereof. This parliamentary vote was not binding and MPs did not specify which format the government’s detailed plans should take. If MPs perceive Theresa May’s speech as insufficiently detailed or it is not backed up with a detailed and formal government white paper, parliament may decide to delay or even scupper the process by which Article 50 is triggered. This would at the margin increase the perceived odds of the UK remaining in the EU and may provide some relief for Sterling.

However, I would view this as only a temporary reprieve. Ultimately, the government has a popular mandate for the UK to leave the EU and I would expect Prime Minister May to compromise in order for Parliament to grant the government the right to trigger Article 50 in the foreseeable future. While the British economy may well benefit in the long-run from no longer being an EU member, the predominant risk in my view is that the uncertainty associated with complex and potentially long-winded negotiations with the EU will weigh on UK economic growth and on Sterling near-term.

Olivier Desbarres Mayhem fig 3

UK economy resilient but yet to be tested

The apparent resilience of British economic growth since the June referendum has been a recurring theme in recent weeks and given weight to the arguments that the economy can easily weather the UK’s exit from the EU, which in turn puts the British government in a strong negotiating position. Certainly predictions of a post-referendum economic collapse have so far proven unfounded, as acknowledged by Bank of England Governor Mark Carney and a number of international organisations. However, the risk now is perhaps that too much confidence is being placed in the British economy’s ability to weather a number of possible forthcoming challenges.

For starters, GDP growth did slow in Q3 2016 to 0.56% quarter-on-quarter from 0.64% qoq in Q2 2016 and average growth of 0.6% qoq in the previous three years (see Figure 4). This slowdown occurred despite 1) a pick-up in global GDP growth (see Figure 5), 2) ultra-low UK interest rates, 3) the 15% depreciation in the Sterling NEER between November 2015 and end-June 2016 and 4) Sterling’s further 3.2% depreciation in Q3 2016 (see Figure 1).

UK growth still very dependent on household consumption

Moreover, UK growth remains imbalanced, which leaves it particularly vulnerable during the two-year negotiation phase and potentially beyond. From the demand side, household consumption remains the main driver of growth (see Figure 6). In the first three quarters of 2016, real GDP rose about 1.5%, with household expenditure accounting for nearly 90% of that growth.

Olivier Desbarres Mayhem fig 6

Consumer demand remained strong in October-November 2016, with the value and volume of retail sales up about 2.6% and 2.1%, respectively (see Figure 7) despite stagnant real wage and employment growth (see Figure 8). British companies have also reported decent retail sales in December, including over the important Christmas period.

Olivier Desbarres Mayhem fig 7 and 8

There are a number of explanations for strong consumer demand. These include the rapid growth in consumer credit buoyed by plentiful and cheap bank lending (see Figure 9) and the possibility that households have brought forward their purchases ahead of an expected rise in UK inflation. However, these drivers in themselves present a number of risks to consumer demand going forward. Specifically, a rise in imported inflation (due to Sterling’s depreciation) and pressure on real wage growth could dent households’ scope to consume while higher interest rates (in the face of higher inflation) could curb their willingness to borrow.

If household growth slows, it is not clear what will take over. Gross fixed capital formation (GFCF), commonly referred to as fixed investment, rose about 1.5% in Q1-Q3 2016 but because of its relatively small weight added only 0.2 percentage points to overall GDP growth (see Figure 6). Within GFCF, business investment growth was weak (see Figure 10) and added nothing to overall growth. Moreover, if the government does trigger Article 50 in coming months, the ensuing uncertainty about the British economy’s path could conceivably act as a headwind to future business investment in my view.

Olivier Desbarres Mayhem fig 11 and 12

Net trade still a drag on GDP growth despite more competitive Sterling

Acquisitions less disposals of valuables, which are part of gross capital formation, added about 1.2 percentage points to GDP growth but this is a very volatile item and the large positive contribution in Q1-Q3 2016 was partly mirrored by a large negative contribution from net trade in goods and services (see Figure 11).

The UK continues to run a monthly trade surplus on services of about £8bn. But it runs a larger deficit on goods which reached £36bn in September-November despite Sterling’s significant gain in competitiveness in the past 14 months (see Figure 12). If we exclude erratic items, the trade deficit on goods of £12.2bn in November alone was the second largest in the past 20 years. The net result is a still large trade deficit on goods and services (see Figure 13).

This highlights the UK economy’s dependence on imported goods and inability to substitute at short notice imported goods for domestically produced ones. At the very least it raises questions about the extent to which UK trade will benefit from a more competitive currency going forward. It also highlights the importance of a service sector which accounts for about 80% of the British economy. British exports of financial services are likely to remain robust, even if/when the government triggers Article 50 given the lack of alternatives in the near-term. But again there is a non-negligible risk that, if the UK exits the Single Market and UK-based banks, insurers and asset managers lose the right to sell their services freely across the EU (“passporting” rights), some of these companies relocate part of their operations to other EU member states, with a corresponding hit to the contribution of services to overall UK economic growth.

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.

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