One year on from the vote to leave the EU, the UK has only recently started the task of negotiating the country’s ‘exit bill’ and future relationship with Europe, and much uncertainty remains about what the final deal will look like. That same uncertainty also hangs like a cloud over the economic outlook.
A variety of possible outcomes are likely to be partially priced into sterling, including some probability of a ‘hard Brexit’ in which the economy would have to trade with the EU on World Trade Organisation rules, which focuses on goods rather than services trade. For a country whose exports are over 12% of GDP, that could cause significant disruption. Indeed, sterling is still some 20% below its 2015 peak in trade-weighted terms.
That in turn has pushed up inflation to nearly 3%, uncomfortably over the Bank of England’s 2% target. And with wage growth only around 2% – despite very low unemployment rates – this is causing a real income squeeze that is leading to slower consumer spending.
There is probably hope that the economy can use the depreciation of the pound to rebalance away from consumer spending and towards more trade and domestic production, but this is a process that has in some cases taken years to achieve. The UK manufacturing sector is unlikely to have the capacity to produce previously imported goods. UK exports also have a high degree of import content, so the competitiveness boost could be limited.
Given the subdued growth outlook, and the risk of weaker long-term growth, it is unsurprising that the government’s ‘red lines’ with respect to EU negotiations are becoming notably more blurry. The main tensions are around immigration and the jurisdiction of the European Court of Justice.
Indeed, recently there seems to have been a shift in views within Theresa May’s cabinet so that the notion of a multi-year transitional arrangement after EU exit in 2019 is now widely accepted. Unsurprisingly, Chancellor Hammond is leading the charge here but remarks from others such as Michael Gove over the last few days have also suggested that even among the cabinet’s most ardent supporters of Brexit, there is a more pragmatic tone.
It seems likely to us that that a Norway-style transitional period is put in place such that the UK can retain most of its market access and have some control on immigration in exchange for accepting ECJ oversight. This could be a tough but necessary pill to swallow to avoid a disruptive transition. But emphasis is shifting toward the idea that a transitional arrangement should end ahead of a general election date currently scheduled for 2022, three years after the scheduled date for the legal exit in March 2019. This new found pragmatism supports our long held view that the fears of a hard Brexit – the UK suddenly crashing out of the negotiations and moving towards an unprepared WTO framework – were overpriced.
And what about Europe? The EU’s negotiating hand has always seemed stronger than that of the UK’s, but with the economic recovery gathering momentum and the election of Emmanuel Macron in France, optimism has increased. Rather than punishing the UK to deter others from leaving, this new-found confidence may allow it to cut a more favourable deal in order to prevent economic disruption.
Rahil's recent blog post outlined the market and strategy implications of the Brexit challenges ahead. On this topic, not much has changed in recent weeks: UK assets (and sterling in particular) will remain vulnerable to "the slings and arrows of outrageous fortune". For us, that implies international diversification and thinking carefully about how to handle foreign currency exposure.