This note focuses on Brexit and the UK economy. The key message is that we, as managers of Netwealth portfolios, continue to closely assess this area, and likely consequences. Naturally, no-one has a crystal ball, particularly when it comes to the political, economic and financial interactions that are possible, but we can assess the risks, opportunities and likely consequences in a logical way. For clients, our Head of Portfolio Management, Iain Barnes, has written a piece to accompany, on the market implications of Brexit.
Since the June 2016 Referendum, markets have not behaved as the consensus would have expected based on a Leave vote being recorded. The FTSE has rallied strongly, up 29.5%, sharing in a relatively buoyant environment for global equities. Meanwhile, 10-year gilt yields are 0.2% higher, rising from 1.37% on the day of the Referendum to 1.57%, while comparable US yields are up 1.31% to 3.06%, reflecting the tightening in US policy rates.1 This also highlights that there are many factors – not just linked to the UK or to Brexit - impacting market performance. And that is likely to be as true in the future, as in the recent past. So as much as one should be prepared fully for Brexit, it will not be the only influence on markets, and on how to manage portfolios.
Sterling, meanwhile, has fallen sharply, much as the consensus expected, and indeed as we thought it would. In fact, before the Referendum, we felt sterling was overvalued and was likely to weaken at some stage, whatever the outcome. Naturally, we thought it would fall more abruptly with a Leave vote, as it did. Sterling is 12% weaker versus the dollar and 11.2% lower on its trade weighted index. The last two years have highlighted the importance of currency moves as a shock absorber, in economic outcomes, as well as having a large bearing on portfolio performance, given the international exposure of our higher risk sterling portfolios. Note that in addition to sterling, we also have euro and dollar denominated portfolios.
Thus, the lessons from the last two years are that we need to be mindful that the consensus may not always be right, that there are other key factors driving portfolios aside from Brexit, the importance of movements in the currency and, as we outline below, of the policy response.
During the last two years the immediate market impact of the latest news on Brexit policy has tended to be seen in sterling’s performance, with a secondary impact on gilts and equities. The approach in the financial markets has been almost binary.
Developments that suggest any deal between the UK and rest of the EU will keep the UK close to existing arrangements – a so-called ‘soft Brexit’ – have been seen as positive for sterling, and in turn this has influenced how equities and gilts have performed. In contrast, developments seen as making a clean break from the EU have been negative for sterling.
While this binary approach will likely be the immediate way that markets react in the future, the complexity of the different options, as highlighted immediately below, points to the need for a more nuanced approach.
For the UK to make a full success of leaving the EU there are three areas to focus on:
- the future relationship with the EU;
- the UK’s relationship with the rest of the world;
- and the domestic agenda, including economic and financial policy.
All three are important and are interlinked. Market attention, naturally, takes all three into account, but the bulk of focus has tended to be on the future relationship with the EU. There are still a variety of possible outcomes for this. These could have a material short-term impact on the performance of portfolios, as well as impacting the longer-term outlook.
Currently the UK is set to leave the EU at the end of March 2019, with a transition period to the beginning of 2021. The current expectation is for the UK to agree a Withdrawal Agreement this year before a future trade relationship. It has been speculated that about 80% of this Agreement is already agreed. Its three main components are: an agreement on citizens’ rights; a divorce settlement; and a backstop agreement on the border between the Republic of Ireland and Northern Ireland, to ensure no physical hard border. At the beginning of the two-year process, the divorce payment was seen as the key stumbling block, but this has been agreed at £39 billion. Since last December, it has been the Irish backstop that has assumed central importance. While the border appears to be the key political issue, for the markets it is the trade relationship.
The Government’s aim is for the trade relationship to be agreed before the UK leaves next March, and their desire is for this to happen possibly this year, and for it to come into effect at the end of the transition period, thus allowing The City and business a couple of years to plan. Any trade deal needs to be agreed with the EU and also needs to be agreed by the UK Parliament. Three trade outcomes are widely seen as likely:
1) An agreement is reached on either the Prime Minister’s (PM) Chequers deal or, more likely, a variation of it, as it evolves into something more politically acceptable to the EU, possibly towards a Norway-style relationship.
2) There is a shift away from Chequers towards a free trade agreement – currently referred to as ‘Canada plus’ or ‘Super Canada’- with the hope of extending this in time to a comprehensive agreement, covering services.
3) There is a ‘no-deal’, or what is sometimes called a WTO deal, referring to the World Trade Organisation (WTO) rules which currently dictate how the UK trades with most countries, and which would in the event of a no-deal dictate our future trade with the EU. Trading under WTO terms should be straightforward, providing all the preparatory work has been done, and which in some cases will include mutual recognition and other arrangements. The UK would have to decide upon its future tariff structure. Firms that trade with the Single Market now would face an increase in costs under this scenario. In terms of the no-deal, one needs to define this clearly to understand the portfolio implications.
In June, when speaking at The Times CEO Conference in London, the PM, when asked whether no-deal meant no withdrawal agreement or no trade deal, replied that no-deal meant “WTO terms”. The implication of that being that if there was a withdrawal agreement, then it might be possible to spend the transition period working out a deal. This would be the equivalent of the UK remaining in the EU on current terms through the transition.
Others might conclude that a no-deal could mean no withdrawal agreement and no transition deal, in which case exit happens immediately, next April. Also, with no-deal, there is a need to differentiate between the trade component, referred to here, and the non-trade component, covering a wide array of areas, and in the bulk of these it is about ensuring sufficient preparation and work, including where necessary agreement with other countries, has been carried out to make a no-deal viable. Because this process is, perhaps by its very nature, opaque, it is unclear how much preparation has taken place, adding to the uncertainty, and to the general feeling that there could be some short-term disruption.
In addition, in whichever approach is taken, there is a need for UK leaders to provide context and convey a vision around it, outlining what it means for areas of policy such as immigration and the message it sends to skilled workers and international investors, as well as to small firms and to international companies based in the UK. The dominant services sector, and the hugely important City and financial services sector, are central to the success of this vision. All this will be important for how the market behaves, after the initial reaction.
To add to the complexity, the UK Parliament has to have a meaningful vote on any deal that the PM has agreed with the EU. Thus, from a portfolio perspective, we need to be mindful that financial markets will be anticipating and reacting to not only the agreement between the UK and EU but also to domestic UK politics.
While the overwhelming probability is that the UK leaves at the end of March, with a 21-month transition to follow, it is possible that a different scenario could materialise and we need to be alert to such a possibility. The circumstances in which we would not leave at the end of March would likely include Parliament voting for this (which is unlikely), there is a second referendum (very unlikely), or there is a general election in the next few months (also very unlikely). Occasionally, there are suggestions that Article 50 could be extended, but that, too, is a low probability.
The above scenarios and permutations produce a complex interaction of possible outcomes. It would be wrong to position portfolios for any one particular outcome. Another approach is to assess the balance of risks, assessing the likelihood of each different possibility. The challenge here is that not only are the probabilities of each outcome themselves a judgement call, but so too is the likely market reaction.
We also take into account the likely policy response and the possible impact that this will have on portfolios. The outlook for any economy depends upon the interaction between the economic fundamentals, policy and confidence. Policy, too, has an important influence on the behaviour of markets – both in the UK and elsewhere.
In the post referendum period, for instance, the actions of the Bank of England have been important. As we expected, and agreed with, the Bank cut rates and added liquidity via quantitative easing after the Referendum, although we didn’t expect they would, or think it was necessary to buy corporate bonds. That emergency rate cut has since been reversed and the Bank has gone on to make a further hike, embarking upon a gradual process of normalisation (see the graph). This will see rates rising and the Bank’s balance sheet shrinking through quantitative tightening. We have written about this policy normalisation - where the concise summary is that rates will stay low, rise gradually and peak at a low level. This will impact all markets, but in particular will have a bearing on the shape of the yield curve, and bond yields. The current combination of yields staying low, and steady growth in nominal GDP, as we have pointed out, could allow the budget deficit to fall faster than the market expects - something we have seen over the last year.2
The longer-term impact
A key issue is how Brexit will impact trend growth in the UK. This will be an important longer-term influence in our portfolios. The chart below shows the annual rate of UK economic growth.
Leaving the EU will increase the cost of trade with the EU, which helps explain the negative economic forecasts associated with leaving. But there will be many gains, in my view, too, particularly the further ahead one projects, and of course subject to future policy actions. It is important that in leaving the UK not only reaches a deal with the EU, but that this does not constrain the UK’s future room for manoeuvre on domestic and trade policy. To maximise future potential the UK needs to retain this flexibility and take policies to make the UK competitive while also boosting investment and innovation. I have written about this extensively elsewhere.3
The ongoing issue, even before the Referendum, was the need for the economy - and the markets - to see an increase in UK productivity and future trend growth.
In terms of the economic impact, the economy in the last two years has performed closely to our pre-Referendum expectation in the event of a vote to Leave. Before the referendum our expectation was a ‘Nike Swoosh’, reflecting the shape of that firm’s famous brand symbol, whereby growth would be weaker than it would otherwise have been during the Article 50 period, but not falling into recession. This is how it has turned out. Back in 2016 we were also more positive than the consensus about global growth.
It is hard to gauge fully the impact of the uncertainty of the last two years. On the positive side, sterling's weakness has boosted the competitiveness of exports and the continued fall in unemployment has supported consumer confidence, despite the squeeze in real incomes. On the downside, meanwhile, the temporary rise in inflation triggered partially by sterling’s fall has dented spending power, in an environment where wage growth has been modest. This is similar to what happened post the financial crisis when sterling fell sharply too. Then, after the rise in imported inflation had worked its way through the economy, domestic inflation remained low. Note inflation is now 2.7%, above the 2% target and as such wage and domestic inflation pressures need to be watched closely.
The continued uncertainty about Brexit is likely to have dented investment plans. Although in the case of these plans, this may well prove temporary. It is our contention that, whatever trade deal is agreed, the removal of uncertainty will give an uplift to investment plans during the transition period. Once business has clarity about what lies ahead they can then enact investment plans that may have been paused. The overall impact will naturally depend upon firms’ own business models and the policy adopted.
In assessing the impact of Brexit on the economy so far, a “doppelganger” methodology has been used across the City, mapping growth of other leading economies in the last two years. This is then used as a proxy for how the UK might have performed if there had been no vote to leave versus the UK’s actual performance. This is useful, but I tend to think it is better in qualitative than in precise quantitative terms, as the problem with the methodology is that the empirical correlation matrix of say GDP growth over time in different countries is inherently noisy, and thus not stable.4
Overall, using this methodology, there have been various suggestions, roughly speaking, that the economy is around 2.1% to 2.5% smaller than it might otherwise have been. We are more in line with the figure of a 1% shortfall produced by Julian Jessop of the IEA5, who has pointed out that sterling would likely have fallen anyway, that the euro area growth rebound last year was more of a catch-up, while President Trump’s tax cuts have boosted US domestic demand (the US accounts for close to one-quarter of the size of the economies in the doppelganger comparison). In June, the FT said, “an FT average of several models suggests that by the end of the first quarter of this year, the economy was 1.2 per cent smaller than it would have been without the Brexit vote.”6
There is a current tendency in economics to then extrapolate near-term projections, despite the often large margin of error on even one-year ahead forecasts, to predict the likely shortfall at some arbitrary date in the future - this is particularly so with projections of the budget deficit and future size of the economy. Far more important for our investment outlook is to gauge what is likely future sustainable growth.
From an investment perspective we not only take into consideration the near-term economic outlook, but also likely longer-term performance, too. Moreover, the economy’s trend growth clearly has a bearing on what is the sustainable rate of growth that can be achieved, before inflation and other pressures are seen. Also, this has a bearing on policy - in a number of ways. If trend growth is seen as lower then the economy’s ability to withstand inflation is seen as less, meaning it is more likely the Bank of England will have to hike. We have seen this in the Bank’s explanation of the latest rate hike. Also, trend growth has a bearing on fiscal policy. If the economy’s potential growth is lower, then more of the budget deficit is seen as being explained by structural or longer-term factors as opposed to cyclical or short-term influences, and thus this adds to the pressure for spending cuts, or tax hikes, lessening the room for fiscal manoeuvre. Some of this thinking will be evident in the Budget this October.
Source: ONS, Netwealth calculations
The above chart shows the trend in UK growth from 1975. Since the early 2000s there has been a steady downward move. The UK’s growth rate has been variable. It is also interesting to see that the 20-year average began to fall before the financial crisis. Looking ahead, it may take time for any new policies to fully take effect.
There has been a tendency, post Referendum, for greater caution or pessimism about the UK economic outlook. This may turn out to be excessive. Certainly, as we have touched on in various commentaries here and elsewhere over the last two years, the UK economy is imbalanced, and faces some significant challenges. Hence the vital need for a domestic economic agenda that addresses regional issues, boosts investment, particularly in skills and training, infrastructure, supports innovation and implements the right incentives to help small firms.
Moreover, with the vast bulk of global growth expected to come from outside Western Europe, the challenge and opportunity for the UK and rest of the EU is to position themselves in this changing and growing global economy.
From a portfolio perspective, this leads into many complex debates, not least the shape of the yield curve, the impact of the international exposure of the FTSE 100, where 66% of current earnings emanate from outsider the UK7, and the relationship between the FTSE 100 and FTSE 250, which is more skewed towards the domestic economy.
Here the message is that we will be watching the Brexit progress closely. In coming weeks, as we approach the Budget on 29th October, we will focus on the policy issues and UK economic projections.
Please remember that when investing your capital is at risk.
1The source of all market data in this piece is Bloomberg; economic data is official Government statistics. Market prices referred to here are on the day of the Referendum and the last trading day of September, 28th September 2018
2Monetary Policy Normalisation, Our Views, 3/August/2018
3See, ‘Clean Brexit’, co-authors Liam Halligan and Gerard Lyons (Biteback Publications)
4For the methodology see Ormerod, P. and Mounfield, C., 2002. The convergence of European business cycles 1978–2000. Physica A: Statistical Mechanics and its Applications, 307(3-4), pp.494-504
5See 14/09/2018, “Impact of Brexit on the UK economy grossly exaggerated”
6See Chris Giles’ piece, “What are the economic effects of Brexit so far?”
7See London’s Global Reach and the Half a Trillion Dollars Equity Prize, IEA, February 2018, by Gerard Lyons. Table 3