Stress testing British exceptionalism

The government dropped its approach with a lockdown starting 23 March, in the wake of warnings that herd immunity would not work and the country’s hospital system could not cope with millions of cases. On 28 May, several weeks after the lockdowns started lifting in Italy, Spain and France, the UK put in place a “track-and-trace” (and then self-isolate) system. The measures include a controversial 14-day quarantine for new arrivals into the country that would further damage an aviation industry which contributes some GBP52 billion to the economy.

Economic emergency

The UK’s economy contracted by 2% in the first three months of the year, the steepest since the Great Financial Crisis, although that data only captured the last week of March and the first week of lockdown. Nevertheless, a 5.8% fall in Gross Domestic Product for March was close to the decline for the slowdown experienced over the entire 2008-09 recession. Data for the second quarter, once the lockdown got going, will show a far deeper deceleration. The Bank of England (BoE) is forecasting a 25% decline in GDP for the second quarter and a 14% fall for the full calendar year.

The length of the lockdown is also slowing the UK’s economic capacity to bounce back. Among main developed and developing nations, the UK ranks as one of the most deeply impacted (see figure 1).

The second figure tracks the slow resumption in UK economic activity by examining supply and demand dynamics. We evaluate supply activity by analysing high-frequency data such as electricity use and pollution, which are around 85% and 60% of their pre-pandemic three-year averages. On the demand side, we can assess the evolution of business and consumer activity by tracking retail and work mobility thanks to geolocated Google user data. These demand indicators are at respectively around 30% and 50% of their pre-crisis averages. As the UK starts to leave lockdown, all four indicators have risen from their crisis lows.

It is far from clear how the UK government will finance measures compensating employees and their employers for the lack of work. The government has now threatened to begin phasing out some programmes.

Very low interest rates certainly help pay the bills and the Bank of England appears to be preparing markets for a possible policy-shift to negative rates, or at least for the idea that the floor is no longer 0%.

Bank of England Governor Andrew Bailey has declined to rule out negative rates. Professor Silvana Tenreyro, an external member of the Bank’s Monetary Policy Committee, said on 18 May other European countries’ experiences show "negative rates have had a positive effect in the sense of having a fairly powerful transmission to real activity."

This is, however, still an open debate among BoE officials, and a cut to negative rates is not our central scenario. Monetary conditions are accommodative in the UK, with real rates already in negative territory. In addition, a gradual recovery in global activity in the second half of the year seems to be BoE’s officials’ base case. Still, should negative rates become a reality in the UK, which cannot be completely ruled out over coming quarters, we expect that investors will see a limited negative impact on sterling. Markets are already pricing-in a reduction in the base rate to around -10 basis points by the end of 2020.

The post-pandemic pound

For sterling, Brexit matters more than monetary policy. We expect the UK to reach an agreement with the EU over the terms of its future relationship, starting in 2021, or at least avoid a no-deal Brexit at end of this year. Under this scenario, our expectations for sterling over the mid-to-long term remain constructive. In trade-weighted terms, the pound is undervalued by 12% against the US dollar, 7% against the euro, 5% against the Swiss franc and between 10% to 15% against major emerging currencies.

However, a “no-deal Brexit”, where the UK defaults to World Trade Organisation rules, would lead to a significant decline in sterling valuations. GBPUSD could fall towards 1.10 or below, and EURGBP would likely rise towards parity.

A Dom-estic quarrel

When Boris Johnson won December’s general election, his ‘to do’ list looked ambitious but doable, given the size of his parliamentary majority. Six months later, he has u-turned in his health crisis management, passed through intensive care with Covid-19 and his government is racking up the biggest spending in generations.

In the meantime, the Conservative party is having its own domestic quarrel. More than 60 Conservative parliamentarians have attacked the prime minister’s support for Dominic Cummings, his senior advisor. Mr Cummings has failed over nearly two weeks to justify journeys in April flouting the ‘stay at home’ policy for which he was partly responsible as a member of the government’s scientific advisory body. The hypocrisy has not been lost on many voters. The surprising thing is not that Mr Johnson has defended his advisor, but that he continues to do so despite the scale of the outcry, both from his own party and the public. A YouGov poll showed that the Conservative’s lead over Labour shrank by 9% in one week.

In addition, the government’s opposition looks more challenging. Sir Keir Starmer, the Labour Party’s new leader and an ex-barrister, is more capable of leading a credible threat to the Conservatives than his predecessor. Still, Sir Keir has not yet had to create policies that will surely expose the range of ideological divisions with his party.

Pressing matters

The UK has more than Covid-19 and its fall-out to manage. In the current recessionary environment, the complications of Brexit look like a burden too far. Ironically, despite being the European country worst affected by Covid-19 with almost 40,000 deaths, Brexit makes the UK ineligible for some of the EUR500 billion financial support being discussed by the EU.

After the pandemic, negotiations about the transition to a new economic reality outside the EU’s customs structures, effective 1 January 2021, will matter even more. Any additional regulatory load on British companies, already struggling with the impact of the pandemic, may be life threatening.

Time is running out. The UK has a 1 July deadline to request an extension to this transition phase. An extension would be politically awkward for Mr Johnson and involve some continued contributions to the EU budgets while making it more difficult to conclude new trade deals. Though a last-minute request would be in keeping with past practice, the government insists that it will not make the request, despite calls for it to do so by the European Commission, the EU’s executive.

The UK is at an historic crossroads. The country must find its place in the post-Brexit, post-Covid world while preserving its unity. Its future and opportunities will largely depend on whether Mr Johnson’s government manages to conclude high-quality deals with its trading partners and put the country firmly back on the path of economic growth.

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