Brexit - Near term and longer term views

We very much doubt that the financial markets remotely expected the BREXIT vote to deliver a ‘leave outcome’ (and we also very much doubt that many people that voted for it actually expected it to occur).

Wednesday, July 6th 2016, 12:59PM

by Andrew Hunt

The London-based financial institutions were probably too affected by the sentiment in London and therefore unaware of the strength of feeling outside of the M25 London orbital road. Watching the referendum outcomes by constituency, it is very apparent that while London voted almost 60:40 to remain, the proportions were essentially reversed in much of the rest of England and Wales. Scotland voted to remain and with the SNP pushing not just continued EU membership but membership of the Euro. Given the clear divergence between the voting patterns of England and Scotland, we must assume that there will continue to be increased uncertainty not just over the outlook for the European Union but also the British Union itself.

Of course, in the near term, any vote for BREXIT was always likely to cause financial market instability and we can assume that this instability will continue for at least the next six months as the politicians attempt to sort out the ‘constitutional mess’ that has been created by having an ill-considered referendum within the context of the UK’s party-dominated parliamentary system. Quite simply, the two concepts don’t fit and the result has been the unstable and quite possibly unworkable situation in which the likely voting intentions of MPs (60:40 to remain), the executive branch of government, and the electorate are very far out of line, with the result that no one really knows what will happen next.

In reality, we suspect that the UK will soon be obliged to hold a general election and from this elect some form of coalition government in order to decide exactly what happens next. It is quite possible that BREXIT never actually occurs under this protracted scenario but the result may take 12 months to become apparent.
In this overwhelmingly uncertain environment, we can expect that foreign investors, who already own US$1.6 trillion-worth of UK-listed equities (virtually an all-time high) and a further US$2.5 trillion of UK domiciled bonds, will defer from acquiring further assets. Given that the UK has close to a US$150 billion current account deficit that needs continual funding by capital inflows, any ‘strike’ or reversal by foreign investors will continue to impact the external value of GBP significantly and potentially the level of domestic yields. Indeed, given that the UK requires an inflow of funds, this implies that in the near term the markets have to find a new way of attracting the necessary funding into the GBP, either by making the currency ‘cheap’ (as is occurring) or yields higher.

Interestingly, we find that the effect of the BREXIT vote on the Gilt markets has so far been almost counter-intuitive in that prospective real yields have in fact fallen quite significantly while (implied) equity yields have actually increased very sharply. It should be remembered that three quarters of FTSE revenues are derived from sales outside of the UK and although importers will likely lose from sterling’s slide, the net impact on corporate profits of the weaker currency should be positive in GBP terms, thereby implying a higher earnings yield for companies even at ‘pre Crisis’ equity price levels. Clearly, BREXIT has raised the equity markets’ risk premium significantly (although not we suspect for purely domestic reasons - see on), and quite possibly excessively.

The decline in Gilt (bond) yields that has occurred since the vote is in some ways rather more interesting. We can assume that there has been a flight to safety out of equities but the fact that at least some of these flows have found their way into Gilts tells us that the markets are not currently expecting higher inflation in the economy, that they could be expecting a recession, and most importantly of all that they are still prepared to speculate in GBP assets. Unfortunately, we suspect that the market’s view on the outlook for inflation may well be mistaken, if not on the other two factors.

Over the last 36 months, the UK consumer price index has increased by 2%, an amount that was very much less than the Bank of England’s mandated target increase. Excluding fuel prices, the increase in the index was still only 3%, which was still only roughly half the increase that the BoE was expected to deliver. However, within the constituents of the index, we find that domestic service sector prices increased fairly steadily over the period and are currently 8% higher than they were in mid-2013, while goods prices are 3% lower. Clearly, the ‘miss’ on inflation within the economy was caused by falling goods prices, many of which were sourced from abroad. However, if sterling’s effective exchange rate is now to remain 10% lower than it was last year, then the probable impact will be to raise imported goods prices by a similar amount and we suspect that this will lead to the UK’s rate of inflation moving from its current near zero rate to closer to the Bank of England’s 2% target rate. Consequently, we can suggest that prospective real Gilt yields have indeed fallen very significantly and that this move may have to be reversed unless the economy does indeed suffer a recession.

With regard to the likely outlook for growth in the economy over the near term, we doubt that there will be much actual change in UK export or even foreign direct investment trends (which have been very weak anyway over the last year) but any sterling-related rise in import prices that succeeds in raising the inflation rate will exert a profoundly deflationary effect on household real income growth. Over the last year, UK household disposable incomes rose by a very respectable 2.5% in nominal terms and by only very slightly less in real terms – a rate of increase that will have put the UK consumer towards the top end of the global income growth league table. However, if consumer prices are now to rise by 2% following an increase in import costs, then household real income growth will fall to an almost recession-like sub 1% unless employment growth rises further (unlikely) or wage inflation rates increase.

The scenario that therefore emerges for the UK is therefore one of modest “stagflation” in which growth weakens moderately (and the economy had already been losing some momentum) and inflation picks up. Traditionally, this is not usually a positive outcome for the bond markets and we are therefore concerned that the Gilt markets may yet suffer a reversal once the ‘knee-jerk reaction stage’ has passed.

From a longer term perspective, however, we must wonder if the BREXIT vote will mark the beginnings of a period of creative destruction for the political – economic system. Following years of globally-induced falling trade prices but rising service sector prices, the UK and may other economies have become un-balanced with an over-concentration of resources within the service / property / financial service sectors, and far too few resources left working within the traded goods and manufacturing sectors. Hence, the UK along with many other countries have experienced slower trend rates of economic growth, rising levels of divisive income inequality, overly expensive house prices, and a dis-affected younger population.

However, providing of course that the UK is not locked out of global trading markets following any successful BREXIT (and for others to do so would be vindictive and damaging to themselves), a weaker sterling and potentially higher rates of background inflation could lead to a prolonged period of re-balancing of the UK economy towards a more efficient composition that functioned better over time.

At this point, it should be noted that at some point the divergence between relative prices will have to be closed and we would argue that rising traded goods prices and higher background rates of general price inflation would seem to represent a better outcome for the UK than Japanese-style collapsing house prices and a ‘balance sheet recession’. In this author’s view, any BREXIT would give the authorities the ability to encourage a long overdue restructuring of the economy that could both lift long term growth rates and reduce income inequality, two events that I believe would be positive for the equity markets over the longer term.

However, before one becomes too positive, it should be noted that the real danger in BREXIT is that the decision taken by the UK population could be seen as being more credible than the Brussels EU elite by other voters around Europe, and that the UK’s vote to leave triggers a chain reaction that leads Portugal, Italy, Spain, Greece or even Holland to leave the Euro. In this context we are not worried if Denmark, Poland or other non-Euro members were to leave the EU but the departure of even a single Euro Member (however small) would destroy the entire Euro project. Of course, we have never been a believer in the Euro, not because Europe was not an optimum currency block or because of the ECB’s terms of reference but rather because of the simple fact that in order to have a currency, one must first have a single country – sovereignty must come before you can have a Sovereign coin. The BREXIT vote clearly makes the likelihood of a single nation of Europe less not more likely and hence it must imply that the Euro experiment has become even more ill-advised. Hence, there is a clear risk that BREXIT will usher in the Euro’s possibly final existential crisis.

If handled correctly, BREXIT offers the UK, European and even global economies a rare opportunity to address some of the longer term issues that have held back their economies and already caused a degree of political instability, albeit at the expense of their cherished single currency / super-state agenda. Just as the 1992 ERM crisis in European currency markets was destructive and uncomfortable in the short term, over the medium term it became a positive event and BREXIT offers the same opportunity to create more and wider prosperity.

We therefore expect the next few months to be volatile in markets and currencies but if the political events that could potentially stem from BREXIT lead to a sweeping away of some of the factors that have strangled long term growth rates in Europe, then society and even financial markets will have much to gain over the longer term. BREXIT could yet usher in a period of creative destruction in Europe.

Andrew Hunt International Economist London

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