04 August 2016
A Tale of Two Brexits
by Frank O’Nomics
It is the best of markets, it is the worst of data. There is a marked divergence between the interpretation of the implications of Brexit by equity markets and the evidence provided by the more recent releases of forward looking economic data. FTSE has risen a net 4.7% since the 23rd June, despite the initial sharp fall, and even the more domestic oriented FTSE 250 has recovered almost all of its losses. The data on the other hand, when one looks beyond the numbers that describe the pre-vote situation, has been very worrying. Which of these is wrong? Are investors being drawn, yet again, into an asset price bubble, which will exacerbate the pain of a Brexit related slowdown when it bursts? Or, have those purveying post-Brexit gloom (myself included) been far too pessimistic? The easy answer to these questions is that is too early to say, but being dismissive of the debate is dangerous, as we are either ignoring a great investment opportunity or being too complacent, running the danger of significant capital losses
The initial panic over the vote to leave the EU, while significant in terms of currency and equity market moves, has to a large extent proved merely transitory and, where sustained, as in the case of sterling’s fall, can actually be argued as potentially positive. The rally in markets has not been confined to the UK, and some elements of the world outside of Europe are showing signs of enthusiasm about entering trade agreements with the UK – including the US, despite the warnings from President Obama that we would be pushed to the back of the queue. There are some justifications for our overcoming what some have termed “Brexitosis”, where many forecast an imminent recession, a flight of global investors and a collapse of sterling. Firstly, the Tory leadership issue has been resolved a lot quicker than expected and the new Cabinet has been well received by markets. The lack of the emergency Budget predicted by George Osborne has also reassured market participants not to panic, and the suspension of a balanced budget target for 2020 has countered worries of excessive and damaging austerity measures. Secondly, there are signs that international investors are showing some confidence in the UK, with deals such as the takeover of ARM by Softbank (a Japanese company) not merely an opportunistic deal generated by relative currency moves – Softbank have pledged to double its British workforce in the next 5 years and to keep the headquarters in Cambridge.
Thirdly, there is a widespread expectation that the Bank of England will produce a package of measures that will prevent a recession and it is this prospect of a further monetary stimulus that is keeping markets so buoyant. If money is going to become still cheaper, and remain so for longer, at the same time as the Bank of England looks ready to return to competing with the market to buy assets, then why wouldn’t investors want to own equities yielding upwards of 3%? Finally, domestic businesses are also showing some signs of wanting to invest (Glaxo SmithKline for example have recently pledged to invest £275 million). The UK, it seems, is still regarded as a safe, well governed and progressive environment for trade and investment, and markets are prepared to bet on the government negotiating favourable terms of trade with Europe on our exit, with additional benefits coming from a host of trade deals with nations outside the EU.
We have yet to start proper negotiations with Europe, but on the basis that EU businesses sell British consumers £68 billion more in goods and services than our companies sell back, there is a strong incentive for the EU to be accommodating. In terms of the right deal to strike, some have pointed to the Canadian-EU trade agreement, which aims to eliminate tariffs on 98% of trade (sadly this does not cover financial services). Beyond this, Liam Fox’s international trade ministry will be looking to develop trade agreements outside of the EU – with a suggestion that we might join the Trans-Pacific partnership (US, Canada, Australia, New Zealand and Singapore).
So far, so good – but what about the real economic outlook? Some might argue that the record low level of unemployment and surprisingly high second quarter GDP figures (0.6% up from 0.1% in Q1) point to a UK economy that was in pretty good shape going into the June vote. Similarly, while the reduction in the IMF growth forecast for the UK in 2017 to 1.3% due to Brexit (almost 1% less than they were forecasting in April) is worrying, it is still a stronger outcome than that expected for France and Germany. However, employment data lags the real economy by several quarters, the GDP data is only preliminary and so subject to revision, and the more forward looking economic data looks much more depressing. UK manufacturing confidence is at its lowest since 2009, despite the benefits from a weaker currency, and the CBI has said that expectations for new orders are at that weakest level since January 2012. Further, the recent purchasing managers data has sunk to a level that is associated with a recession. A level above 50 in the indices generated by the Markt/CIPS survey indicates an economy that it growing, and the reading for manufacturing and services fell from 52.4 in June to 47.7 in July. What is of particular concern is that the steepest fall was in the services sector, which accounts for 80% of the UK economy. Some of the feedback from specific business areas also looks pretty bleak. Huge redemption requests from property funds have placed a cloud over the commercial sector, which will take a long time to clear, as a number of the funds will need to sell properties to satisfy those requests. The banking sector has not been short of problems for the last 8 years, and Brexit has added more, with Lloyds Bank announcing last week that they would cut a further 3,000 jobs and are expecting a deceleration in growth. The investment industry outlook is no better, with a Chartered Financial Analyst Institute survey showing that 82% of fund managers believe that London will lose out to the benefit of cities such as Frankfurt and Dublin. As for the consumers, their confidence levels fell at the fastest pace recorded in the last 25 years in a survey conducted in the first 2 weeks of July.
To find out whether the markets or the forward-looking economic data are correct we will need a lot more information. The most critical elements of that will be details of the terms of trade that we negotiate with the EU and outside. It is all very well for politicians to say “Brexit means Brexit” – but the type of Brexit we have will be all important. The IMF growth forecasts for the UK may look stronger than for France and Germany, but they are based on us negotiating favourable exit terms, and for them to be concluded relatively quickly. A protracted Brexit process will perpetuate uncertainty and undermine current market optimism. The key will be whether we can negotiate terms that leave us a more open global economy, with trade deals that deliver concomitant benefits to competition and productivity, rather than a situation where we become an inwardly focused country that becomes ever less competitive, loosing our status as a global financial centre and what little we have left of a manufacturing industry. For now it seems hard to fight the weight of money which is providing solid support to financial markets – in the longer-term much will depend on the abilities and success of David Davies and Liam Fox.
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