Andrew Baron, Butterfield
Financial markets are considered good discounting mechanisms, but they don’t always get the probabilities exactly right. One of these skewed probability moments is currently playing out in markets. We believe that financial markets are pricing too rosy a scenario for Brexit, despite the increasing agreement that this is a voyage into untested and uncharted waters.
Regardless of whether Theresa May wins a greater “mandate” with her decision to call a general election prior to negotiations, the triggering of Article 50 by the U.K. was simply the beginning of a very long and difficult journey, and associated with that journey there could be an equally long road of market volatility and low growth.
There are those who still believe that the negotiation is with a singular body, the EU, but they clearly have not been paying attention to recent history; this is a negotiation with 27 sovereign states, all of whom have different political realities at home and cosseted domestic industries to protect. Take, for example, the EU’s trade negotiations with Canada on the recently signed CETA pact. Canada may be a country of vast surface area, but it has a GDP only a bit bigger than that of Spain. It took the EU and Canada five years to negotiate that bilateral trade agreement, another three to get it ratified by the EU Parliament and even then, it was nearly scuppered at the last minute by a regional legislative body in Belgium (the Walloons… and no, we are not making that up).
To think that negotiation between the U.K., the fifth largest economy in the world, and the EU, the second largest, is going to yield a disproportionate economic benefit to citizens of the smaller of the two is not credible, in our view, but we can virtually guarantee it will not be negotiated quickly.
Our point here is not to predict a doomsday scenario. We have no tangible reason to believe that exiting the EU is going to cause economic Armageddon and we certainly have not positioned our client portfolios for it. However, there is a much more mundane, much more plausible scenario in which U.K. growth is structurally impaired for a number of years. In fact, the Bank of England recently produced something called an “exploratory scenario” that takes currently observable macroeconomic trends and either continues their trajectory or only makes them slightly worse. A scenario where growth takes a massive hit from Brexit might make good headlines but has a low probability.
The Bank of England scenario is interesting to us precisely because it posits a higher probability outcome: stagnation. It highlights several features of the macro picture in the U.K. that make us think there is little wiggle room for the Brexit negotiators to get it wrong. Specifically, three things fall into view as most important to us. First, base rates are near zero and the Bank of England is already engaged in quantitative easing at a rapid pace. This lowers the flexibility of monetary policy to respond to any lower growth that comes from Brexit. Second, business investment as a percentage of U.K. GDP is near its lowest level since 1960 and did not quickly or sufficiently recover from the Global Financial Crisis, a phenomenon also seen across the other G-7 economies. Visibility on the U.K.’s ability to attract fixed investment will remain especially low over the exit negotiation period and there is little scope for investment to fall without becoming a drag on GDP.
Finally, productivity levels in the U.K. are amongst the worst in the developed world (along with Europe and the U.S., to be fair). It is difficult to see how productivity would improve under the shadow of Brexit uncertainty, so again there is sufficient scope for disappointment due to low or falling productivity.
We sincerely hope, as President of the European Council Donald Tusk said on the day of the Article 50 signing, that the U.K. and the EU can work “constructively” and become “close partners,” but we are not prepared, at present, to increase risk for clients in a country with an uncertain future, and we are positioned for increased volatility. The protracted negotiations also influence the value of the U.K. currency, and therefore it is likely that Sterling’s fortunes will be affected largely by the ebb and flow of news emanating from Brexit talks. Barring any near-term, material shocks to the U.K. economy, it could be argued that, in the very short term, the pound may enjoy a period of relative stability until a clearer picture emerges as to how these negotiations are proceeding. Since the start of 2017, Sterling has recovered some ground versus the U.S. dollar and is broadly unchanged against the euro. However, downside risks continue to dominate for the time being.
The views expressed are the opinions of the writer, and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.