Brexit means Brexit after all
Brexit is inching closer to resolution. We update our decision tree to help investors assess the possible paths forward.
MPs agreed in principle with Boris Johnson’s Brexit deal on its second reading on Tuesday. The bill won a majority of 30, helped by the votes of 19 Labour ‘rebels’. This is a significant step forward: it is the first time in five votes that the Commons has formally approved a deal. It meant the bill could pass on to the ‘committee stage’, where amendments can be proposed. Only 20 minutes later, however, MPs rejected the government’s ‘programme motion’ by 14 votes. The motion proposed to give Parliament just two days to debate and make amendments to a 115-page bill with 122 pages of explanatory notes. No. 10 threatened to pull the bill altogether and call a general election, but given some MPs who voted against the timetable indicated they would be satisfied with just five or six days’ scrutiny, this seems to go against its mantra of “let’s get Brexit done”.
As it stands, the bill has been “paused” and not “pulled”. We think that’s significant. Opposition leader Jeremy Corbyn and Brexit secretary Stephen Barclay are both extending olive branches. We believe that the bill is likely to proceed to the ‘committee stage’.
The decision tree grows
As such, we’ve updated our popular Brexit Decision Tree to help assess the likely paths forward from here. Of course, there are still many unknowns, but, to paraphrase our previous notes, stopping at “we don’t know” is not good enough. Resigning ourselves to a shrug of the shoulders would mean we’re not thinking hard enough, and could make us slow to react tomorrow if the situation clears. For sure, it’s bound to play out a little differently to our simple schema, but the decision tree promotes structured thinking.
And stopping at “we don’t know” is a missed opportunity because there can be quite a lot of information in “we don’t know” if we break down the overarching conundrum into a sequence of smaller questions. When we work our way down the tree to the possible outcomes in red and calculate their conditional probability, we find that they are not all equally likely, even if we have expressed “we don’t know” mathematically at a number of nodal points. And that little extra knowledge – that some outcomes are more likely than others – is important for investors, because financial markets are nothing if not probability-weighting mechanisms.
In previous versions, we offered the tree as a tool investors could use to navigate their way through the following six to 12 months. As such, we included “delay” as a final outcome. A delay beyond 31 October still looks very likely. Yet in this version, we concern ourselves with a more final outcome.
The EU has not yet responded to the request for a delay sent by the Prime Minister in accordance with the Benn Act. The European Commission has confirmed that the “unconventional” form of the request is irrelevant to the EU. Germany’s economic affairs minister said “it goes without saying” that a further Brexit delay would be granted. Other senior figures have made similar statements, and these echo EU staffers’ comments our analyst heard while in Brussels earlier in the year. If the government “un-pauses” the bill and the Commons passes a five or six-day programme motion, the current Halloween deadline need only be missed by a week or two. The EU is likely to offer a long delay to 31 January to give plenty of leeway, however.
In the first row of our decision tree, we start by asking what will happen to Mr Johnson’s deal in Parliament. It could be voted through without amends: our arithmetic suggests the government is still short one vote, but, clearly, that means it’s too close to call.
The bill could fail to attract a majority in any form, in which case a general election will ensue. Given Labour’s frail polling, we believe that would lead to three realistic outcomes: a hung parliament, but with the majority of seats going to the Conservative and Brexit parties together; a Conservative majority; or a hung parliament with a remain-leaning majority. The first outcome would lead to a ‘no-deal’ Brexit in our opinion; the second to Mr Johnson’s deal; the third to a second referendum, in which the public would be presented with two options: a soft form of Brexit (somewhere between Theresa May’s deal and Norway) or remain.
The bill could pass, but with an amendment that keeps the UK in the EU customs union, as per Mrs May’s deal. The bill would likely lose some votes from the most ardent Brexiters in the Conservative Party, but it may pick up more votes from rebel Labour MPs and formerly expelled Conservatives.
Or, finally, it could pass with an amendment mandating a second referendum. If this were to happen, perversely, we don’t think a referendum is the likely next step. A referendum could take six months or more to organise (the question must be decided, campaign finance rules set, etc.), but a general election could occur in early January. Labour has always wanted a general election before a second referendum, so long as an accidental ‘no-deal’ Brexit wasn’t a risk along the way. If we are wrong, and a second referendum does occur before a general election, the two options are likely to be Mr Johnson’s deal or remain.
Three options on the ballot paper, including ‘no-deal’ Brexit, seems out of the question in Westminster (although we struggle to see why: set the rules so that remain could only win if it has an absolute majority, and if the two Brexit options combined get a majority we exit as per whichever option gets the larger share.) If remain wins, we will almost certainly have a general election, as it would be difficult for the Conservative Party to maintain any claim on a working majority. For parsimony, we have left this out of our decision tree, but it has implications for financial assets – the pound would likely struggle under a Corbyn-led government, despite Brexit being cancelled.
Multiplying our way down to the bottom through the various branch-line probabilities, Mr Johnson’s deal is still the most likely outcome (41%), but closely followed by a customs union Brexit (into which we fold – again, for parsimony – the 9% possibility of a very soft Brexit endorsed by a remain coalition after a second referendum). No Brexit and ‘no-deal’ Brexit both have a one-in-eight chance.
The economic effect so far
We think another short delay won’t alter consumption patterns or the flow of business investment. A long delay is another matter, however.
It’s worth a recap on the recent past. Since the referendum, the UK economy has performed as poorly as the Office for Budget Responsibility, the National Institute for Economic and Social Research, and the Bank of England each predicted just after the result. Their level of pessimism was widely derided at the time, and indeed the immediate shock in the first 12 months was nowhere near as severe as they had suggested. But the damage to business confidence has played out with much more persistence. Business investment has grown by just 0.4% since June 2016, compared to an average of 11% in the US, Canada, Germany, France, Italy and Japan (the other G7 economies).
Of course, the UK isn’t the only country to have performed worse than predicted over this period. While the UK was the worst performing country for a few quarters around the start of 2017, other countries have performed worse since as the slowdown in global trade and manufacturing has particularly hurt export-oriented economies such as Germany and Italy. Nevertheless, an oft-used methodology for comparing the performance of an economy relative to a statistically determined benchmark of its peers (a doppelgänger economy, if you like) suggests that the Brexit “shock” has already left the UK economy 3% worse off.
The UK economy has lost momentum again recently. Forward-looking indicators of activity in the manufacturing, construction and the service sectors are all in contractionary territory – the first time all three have been since July 2016. That said, these surveys do have a track record of exaggerating weakness at times of sharply elevated uncertainty. Assessing the data more broadly, a recession doesn’t appear likely, but there is a distinct lack of growth in the data going into the fourth quarter.
In the three months to August, employment fell and wage growth ticked down. This change in direction has concerned some analysts. But the starting point was strong and continued labour market tightness should support consumer spending. Our analysis suggests year-on-year nominal wage growth will still be 3% in the first quarter of 2020, although this doesn’t take into account any impact from Brexit. Interestingly, the 129,000-person fall in employment to August was confined to part-time employment; full-time employment rose by 73,000. This is reassuring as part-time employment is quite volatile and could easily rebound. The employment market has been remarkably strong over the last two years and softer data is not likely a sign that a large fall is coming. This is confirmed by forward-looking labour surveys.
The extraordinary 14% depreciation of the pound over the last four years drove a reallocation of resources to the export sector. Yet this appears to be a misallocation: the worst productivity growth rates are occurring in tradeable sectors such as machinery and equipment, and semi-tradeable sectors such as financial services. The violent widening of the UK’s trade deficit over the most recent 12 months is also alarming, as it suggests that overseas customers may be pre-empting future barriers to trade and have already found alternative suppliers.
Economic theory holds that such misallocation results in higher rates of wage and price inflation in more domestically focused “non-tradeable” sectors, faster growth in unit labour costs (rising wages but lower labour productivity), and lower real interest rates (rates minus inflation). This is exactly what is occurring, which leads us to question whether the weakness experienced since the referendum is at risk of becoming a little more permanent. If so, it would limit the ability for the economy to rebound if a Brexit deal is struck.
Some lasting drag is likely. Once withdrawal terms are agreed, uncertainty will lift and the economy will rebound, but the extent to which it can offset the lasting drag in the medium term depends on the future trading relationship. The Johnson deal still means that large non-tariff barriers to trade, such as differing regulations or rules around how products can be made or packaged, are likely.
The future economic effect
Today, there is less chance of an accidental, policy-induced recession. That should lift some of the fog of uncertainty. Business investment should start to accelerate. After all, as we discussed at length in our original Brexit report in 2016, there are plenty of reasons why multinational companies invest in the UK besides its trading access to the EU.
Still, with no UK-wide backstop, Johnson’s deal – our most likely scenario – leaves the risk of an eventual ‘no deal’ still on the table. Media sources suggest the promise not to exercise the option to extend the transition period beyond 2020 was the fillip for the Conservative Party’s most ardent Brexiters to back the PM. Yet even basic free trade agreements (FTAs) tend to take much longer than that to negotiate. Looking at statistics on the last 20 trade deals signed by the US, 14 took longer than 15 months before an agreement was signed, with an average of four years between the start of negotiations and the actual date of implementation!
Mrs May’s deal committed Britain to staying within the EU’s customs territory, with some regulatory alignment on agricultural and manufactured goods. This made the negotiation of an augmented FTA – which would limit more costly non-tariff barriers to trade as well as tariffs – during the subsequent transition period much more likely. Mr Johnson’s deal has the UK in its own customs territory with the right to alter trading standards. This makes negotiating even the basic FTA that Mr Johnson has set as the new benchmark – i.e. one that would still result in significant non-tariff barriers to trade – more difficult. There is still a risk, therefore, that the UK exits the transition period under a ‘no-deal’ scenario.
For sure, the probability of a ‘no-deal’ Brexit has decreased markedly, but there is lingering uncertainty. This could continue to deter investment and trade for another year. Judging this precisely is very difficult. Most economists underestimated the effects of policy uncertainty on investment and trade since the referendum, but overestimated their effects on household consumption. We assume that business investment will start to recover, but won’t return to any pre-referendum norm. We also expect the recent decline in employment will be arrested.
The Johnson government’s intention is to work towards a basic FTA, and this is the more likely alternative to an eventual ‘no deal’. This would provide clarity and lowers the risk to firms’ projected returns on investment. But we must be clear, an FTA scenario is still highly likely to lower the path of UK growth relative to a baseline of staying in the EU. Most independent economic researchers forecast that UK GDP will be between 3% and 6% smaller in seven to 10 years in this scenario. That’s because simple FTAs without regulatory alignment don’t tend to account for non-tariff barriers to trade. Western markets are dominated by complex regulatory and certification costs, quality assurance and labelling regimes, state subsidies and minimum import prices which cost businesses more than overt tariffs.
Quantifying non-tariff barriers to trade isn’t straightforward – they aren’t explicit like a tariff – but a number of studies have thrown advanced econometric techniques at the problem. The academic literature is fairly unanimous that non-tariff costs are significantly larger than tariff costs, even when we ignore non-reducible costs, such as distance and language. For these reasons, academics based at King’s College London estimate that the long-run impact of Mr Johnson’s deal on UK GDP per capita is about 2.5% (or about two and a half years of growth at the current trend rate), compared to circa 1.7% for Mrs May’s.
To be clear, our pessimism here is in no way a judgement on whether Brexit is right or wrong for the British people, in all of its many social, economic and juridical facets. It is simply a narrow expression of the empirically grounded difficulty of substituting trade with countries further away for trade with one’s nearest neighbours. These will affect the UK with or without new trade pacts, even in today’s world of overnight international shipping. And the UK is really quite far away from other potential trading partners.
Signing new FTAs with non-EU nations could help, but we need to negotiate new deals with 50 countries and our conversations with experienced trade negotiators don’t leave us optimistic about the government’s ability to do so swiftly.
The Bank of England will likely leave interest rates extremely low. At the same time, fiscal policy is set to change dramatically; the Conservative government’s fiscal rules will be ripped up. In fact, the 2019 spending review has raised this government’s spending plan to levels close to those set out by Labour in the 2017 election. And the Conservatives are promising to cut taxes as well. We still don’t have any cogent information on new tax policy, but if the new spending plans were combined with the £20 billion of income tax/national insurance contribution cuts promised by Mr Johnson on his campaign trail, we could witness one of Britain’s largest non-recessionary fiscal splurges in modern memory.
We believe that financial markets – especially currency markets – have, for years, overestimated the probability that the UK will leave the EU without a deal. We expect October will mark a turning point, even though the process is far from over. The weighted-average effect of our probability tree-derived outcomes points to strength in UK financial assets.
On a long-run basis – the only timeframe over which we believe
currency forecasts can be made with any certainty – sterling is very undervalued, according to a number of analytical frameworks. This holds even when we hypothesise an adverse Brexit scenario. Indeed against the euro, it is undervalued almost by as much as it has ever been in the last 35 years (while the euro hasn’t existed for that long, we can calculate a theoretical exchange rate based on the fixing rate at which the old national currencies joined the euro).
We expect the pound to appreciate on a three-year-plus view, but that certainly doesn’t mean it will get there soon or that it will follow anything like a straight line. And that’s because, like Mrs May’s deal, Mr Johnson’s is still very much detail-lite. Most of the pertinent details around the trading relationship – which will affect UK productivity, and therefore the pound, the most – are still to be decided.
A survey of traders of currency futures taken on 14 October suggested only 27% of them were optimistic on sterling. There’s still a lot of pessimism to unwind. A similar proportion of equity hedge fund investors reported being confident about UK equities, according to Morgan Stanley. In dollar terms, the relative performance of the MSCI UK Index to the MSCI World is close to the all-time low reached in the dark days of 1975 – when the UK had to be bailed out by the International Monetary Fund (IMF). Based on price-to-earnings, price-to-book value, and price-to-dividend ratios, it trades at a 34% valuation discount. To be clear, we believe this is more than just Brexit. There are a number of large companies suffering major idiosyncratic problems that are skewing the index. But the bulk of this underperformance started shortly after the referendum.
Surveys of institutional fund managers indicate that international investors are underweight the UK to an unusual degree. A Brexit deal – a removal of a political risk that’s difficult to hedge – may entice those investors back to British assets.
Unwinding the upside-down
For this reason, we believe that the FTSE 100 could outperform at the same time as the pound appreciates. This would be unusual: with over 70% of revenues earned overseas, a strong pound is usually associated with the relative underperformance of the UK index. But the relationship is perhaps not as strong as some people think. The inverse relationship is not just about translating earnings from overseas, it’s also a reflection of the (non-causal) relationship between the UK index, the pound, and global appetite for risk. The pound, particularly versus the dollar, is what we call a cyclical currency – it does well when the global business cycle is accelerating and investors are taking riskier positions; the FTSE 100, in contrast, is a defensive market, it underperforms when the business cycle is accelerating because a relatively high proportion of its companies operate in sectors more immune to the economy’s ebb and flow.
This is important to understand, because if the pound rises sui generis – due to something like Brexit rather than a general change in the business cycle – the FTSE 100 could still outperform. Especially given that now would ordinarily be a good time to own the FTSE 100, as the global cycle continues to slow down (until at least New Year according to our favoured leading indicators). And even more so considering how underweight investors’ starting portfolios are.
The FTSE 250 mid-cap index usually outperforms the FTSE 100 during periods of sterling appreciation, and it certainly contains many businesses we like. But we also note that the 250 index, as a whole, has already outperformed by a lot more than the appreciation of the pound since July would imply.
Moreover, part of the reason for the historic positive correlation between the exchange rate and the 250’s relative performance comes back to that global risk appetite we spoke about. The pound tends to appreciate when global investors are optimistic about the world, and that’s also when investors tend to favour smaller, less mature, or “riskier” businesses. So, if the pound appreciates without a rise in broad risk appetite, this relationship may not hold.
Furthermore, we’ve been somewhat troubled by the fact that the market-implied equity risk premium is lower for the FTSE 250 than it is for the FTSE 100. In other words, investors are demanding less compensation for the risks associated with smaller companies than larger companies, which tend to be less risky. The UK small-cap index on the other hand has a higher positive sensitivity to the pound, and trades near a 10-year valuation low relative to the FTSE 250.
Three and a half years of Brexit has turned the UK and its people upside-down and inside out – investment markets included. As we approach a resolution, these oddities and strange contortions are set to unwind. Investors must be ready. Any deal won’t consign market volatility to the past. Only now, years after the Brexit vote, is the UK finally preparing to embark on its journey out of the EU. To paraphrase Winston Churchill: This isn’t the end, this is but the end of the beginning.