Today’s UK focus is on The Treasury’s near term thinking
24 May 2016 by Gerard Lyons
In our investment approach we take a long term strategic view. As part of our monthly investment committee we consider cyclical factors and how these impact our longer term thinking, and if they do, how we should incorporate these, so as to add value. One example of this is the forthcoming UK Referendum. The outcome of this event is, naturally, hard to call. Today the HM Treasury (HMT) unveiled its latest thinking regarding the short term impact of a Brexit vote. The HMT looked at three channels: the transition effect, the uncertainty effect and the financial conditions effect. This led them to produce a central ‘shock scenario’, and a more pessimistic ‘severe shock scenario’.
A couple of years ago I considered a similar approach, focusing then on the impact on the London economy both of Brexit and remaining in the EU. In that analysis the two best scenarios were to remain in an truly fully unreformed EU or to embrace global free trade Brexit. A distant third was to remain in an unreformed EU, whil the worst was an insular, inward looking Brexit. In this Referendum the choice on offer is to effectively choose between an unreformed EU, versus a global Brexit. In contrast, I would say that the HMT scenarios today were focused exclusively on an inward looking insular Brexit. The implication is that it is not just about being in or out of the EU, it also depends upon what policies are pursued.
There are a number of important things for investors to take in account from the HMT analysis. They see the economy being 3.6% weaker than otherwise in their shock scenario. What is perhaps missing is some perspective, as the central forecast from the March Budget was for the economy to grow about 4.4% over the next two years, so the Treasury shock scenario would thus have the economy growing about 4.4% minus 3.6% to give 0.8%. This is still very weak, but not as bad as the headlines. Under their severe shock they see the economy as being 6% weaker than the base case.
I have argued that the economy would likely experience a shock – but I think the HMT is too pessimistic. Moreover, I think the economy would rebound far more strongly than the HMT, benefitting from a global approach to free trade. The HMT had three channels through which their shock hit. One was the “uncertainty effect” which I can understand. Indeed the danger is that by talking up the risks of a recession, the Chancellor makes one more likely. There might well be a rise in uncertainty in a remain scenario as well, but that is not considered by the HMT. The second channel was a “financial impact”, including an increase of 0.4% in ten year yields. Of course, many factors impact financial markets, and will also be heavily influenced by what has been discounted. Contrary to the HMT analysis, financial market behaviour need not be negative for the economy. A weaker pound would likely be good news, particularly in a low inflation environment, while interest rates will stay low. Indeed it is only in recent years that a weaker pound was seen as being a positive for the economy – to boost exports. The third channel is “the transition effect” where people are expected to adjust their spending lower as they would expect to be permanently worse off. While theoretically this is possible, the likely impact is not guaranteed, particularly as if Leave has won it is likely to be because people think it is positive for the longer term outlook. In which case, contrary to the HMT analysis today, people will not have believed the Treasury’s long-term cautious view and may thus not cut spending as assumed.
But what if the HMT is right? Although the HMT analysis focused on the impact of Brexit, one could say that if they were correct then it would reflect how weak and fragile the economy is. In which case it would be likely to be hit hard under a Remain scenario as well, as it would be vulnerable to any future setbacks in Greece or elsewhere in the euro area. That is, the weak economy reflected in the HMT analysis would be an economy that was vulnerable regardless of the Referendum outcome.
The outlook depends upon the interaction between the economic fundamentals, confidence and policy. One of the current challenges in the UK - reflected in recent comments from two members of the Monetary Policy Committee - is whether the slowdown now evident in the UK is be due to other economic factors, not just the imminent referendum. Confidence is always hard to predict and factor into forecasts. Policy, meanwhile, still has room for manoeuvre, with sterling likely to weaken and rates even fall further if there is Brexit, while with Remain, sterling may be stronger initially, but rates will still be low.