BETWEEN A ROCK & A HARD BREXIT

The Moving Finger writes; and, having writ, Moves on: nor all thy Piety nor Wit Shall lure it back to cancel half a Line, Nor all thy Tears wash out a Word of it.
— Rubaiyat of Omar Khayyam

On March 29th, Theresa May, without much aplomb, penned a 2,000 word letter to Donald Tusk the President of the EU Council and had it hand delivered to him in Brussels. The contents of the letter in no ambiguous terms informed Mr. Tusk that the UK was officially triggering Article 50, launching the process to leave the European Union. Theresa May said “An historic moment from which there can be no turning back”. Indeed. 

Donald Tusk promptly acknowledged receipt of the letter. As per Article 50 of the Lisbon Treaty, both sides have two years to negotiate a deal, and if that is not possible, the remaining 27 states have to unanimously agree to an extension, failing which Britain will be out of the Union on Mar 29, 2019. In response, Donald Tusk drafted guidelines for the divorce process to the other member states, laying emphasis on the exit cost and citizenship rights.


Reactions in the UK were polarized. Brexiteers were happy, even ecstatic. Freedom at any cost from the shackles of the European Union.  But a large segment that included pundits, market savants/analysts, trade officials, ex central bankers and ex trade officials were unanimous but despondent in their view as to what was in store for Britain. The road ahead was going to be long and arduous. And the prospect of unwinding a relationship of 44 years was a gargantuan task in terms of complexity, especially given that the UK seemed to be so ill prepared. To optimistically hope that the European Union and its 27 member states were going to roll over and - as May wishes - “avoid a cliff edge” - forging a deep and special relationship with minimum disruption in the agreement, was akin to the proverbial pipe dream. 


Two years is too short a period. To renegotiate trade, immigration, workers’ rights and environmental regulations is monumental. Throw into the mix the potential but looming Scottish referendum, Northern Ireland and its border, and last but not least – the Rock of Gibraltar - whose denizens, 96% of whom voted to stay in the EU, make it seem downright impossible. And as we all know – hope is a poor hedge, at least in the financial markets.  The United Kingdom is creaking at its very foundations. 

Theresa May in her seemingly infinite wisdom has consistently stated, “No deal is better than a bad deal”. What deal ? The divorce process and its terms had to first be negotiated. 

Donald Tusk, reflecting the EU’s views, has said that in no uncertain terms the priority was going to be to reach common ground on the terms of the exit. Member states are scheduled to agree on his draft guidelines on April 29, which incidentally falls between the two rounds of the French elections. Also in a blow to Theresa May, he ruled out the possibility of parallel discussions on trade and the single market. Looming large in the guidelines were issues about the multi-million dollar exit bill, rights of EU citizens, and Britons living abroad. 

Given this wrinkle, it would be ambitious to think that actual discussions on a trade deal could realistically begin before the Fall, when the German elections conclude. But this would leave just about a year to conclude a complex deal as time had to be left on the back end for both sides to get parliamentary approval for any deal agreed. Most trade deals supposedly take anywhere between 4 and 9 years to negotiate. The trade deal between Canada and the EU took 7 long years to negotiate - and did not include the vital services component that is integral to Britain's growth. And this was between two willing partners, unlike the EU and Britain.

The EU has also made it very clear from the outset that if a deal is not reached, and more time is required, any transition model will carry the same rules as before. That is the UK will once again fall under the remit of the ECJ, pay into the EU budget and be subject to the free movement of people. The very reason the British people wanted out. And the British government is insisting that there is no going back. Out is Out.


As for the British Economy ? Whilst the UK did not fall off the cliff edge into economic Armageddon post the referendum, there have been subtle indications lately that things are not as rosy. Although the economy finished strongly in the fourth quarter with 0.7% GDP growth, and a 1.8% growth in 2016, putting the UK second to Germany in the G7 in terms of growth, a range of indicators are pointing towards tougher times ahead. 


Household spending adjusted for inflation shrank by 0.4% in the fourth quarter, the lowest reading in three years. Inflation as measured by CPI has already crossed the BOE’s target of 2%. Food and beverages look to be hit the worst. House prices showed a dip. But consumer the engine of the UK economy seemingly remained strong, although at a cost to savings as savings rates for UK household sank to 3.3% the lowest since 1963. Clearly the UK consumer is spending whilst eroding his nest egg. 


However there is some glimmer of good news, provided by the falling pound. The current account deficit fell by more than half (12.1 billion pounds) to 2.4% of GDP from 5.3% in the previous quarter. This was because of a sharp narrowing in the deficit on trade. The total trade deficit narrowed to £4.8billion in Q4-2016 because of an increase in export of goods of £7.6billion, although £2.5billion was due to trade in erratic items such as aircraft and gold. (Source: ONS)

 Source: ONS

Source: ONS


This is not the first time the UK has had its currency depreciate, but the two most recent depreciations prior to the referendum can shed some light on the benefits of a lower pound. In 1992 after sterling’s ejection from the ERM, the currency fell 18%, export volume grew for the next 5 years at an average rate of 7.7%/year. After the financial crisis in 2008, the GBP dropped by 25%, export volumes barely grew, resulting in a large increase in the current account deficit. So between the two periods it is difficult to tell if a depreciating pound can actually grow exports meaningfully.

 Source: Kannepalli Capital

Source: Kannepalli Capital


The pound since the referendum has approximately depreciated by 18%. The pound sterling as we expected did not further depreciate post the invocation of Article 50, as most of the news was baked in.  Although it did react adversely a bit but for different reasons -  Ian McCafferty, the MPC board member went on the wires the day before the triggering to proclaim that there currently was no reason to increase interest rates and cautioned that it was better to adopt a wait and see approach. In addition, the spectre of a Scottish referendum also rattled the currency markets. These two events together negated any rise in the pound due to Kristin Forbes’ dissent in the MPC vote in the prior week.

Governor Mark Carney is scheduled to speak on Friday in London - and he also might espouse the policy of wait and see - and continue with the accommodative stance, as acrimonious negotiations loom with the EU. The Federal Reserve on the other hand could continue its process of normalizing rates if non-farm payrolls scheduled for Friday show robust employment.

Although we have a long term bearish outlook, we expect the GBP to range trade in spite of recent events and only show signs of change if and when negotiations with the EU or economic data deviate from the norm substantially.

It could be a waiting game.