Brexit progress

By Stéphane Monier Chief Investment Officer Lombard Odier Private Bank

Progress in talks for the UK to exit the EU have put the country on course for a ‘soft’ Brexit, leading us to a less negative view on sterling. Still, we note that negotiations have moved from one period of uncertainty to another, and that key questions remain on the shape of Britain’s post-EU economy.

Finally, a breakthrough

Almost a year and a half after the UK referendum, progress has finally been made on Brexit. UK Prime Minister Theresa May secured an agreement with EU negotiators in the early hours of 8 December. There was deemed to be “sufficient progress” on three key areas: the UK’s ‘divorce bill’ from the EU; the status of EU citizens and their children in the UK; and border plans between Northern Ireland and the Republic of Ireland. On the first point, Mrs May confirmed that the divorce bill will be between 35-39 billion pounds sterling (GBP), or 40-44 billion euros (EUR). The deal’s second pillar largely ensures that the three million EU citizens living in the UK, and the one million UK citizens living on the continent, will continue to enjoy existing EU residence and social security rights, and should also allow an EU national to claim permanent residence in the UK. Crucially, the third pillar makes a concession on the question of Northern Ireland which makes a “full alignment” with the EU’s internal market and customs union rules the default position, in order to avoid a hard border between Northern Ireland (part of the UK) and mainland Ireland (part of the EU). It is worth recalling the mantra that “nothing is agreed until everything is agreed”, but in effect, the deal dramatically reduces the chances of the UK crashing out of the EU in a so-called ‘hard’ Brexit. It also allows discussions to move on to a second stage, during which the UK’s future trade deal with the EU will be hammered out. On 13 December, Mrs May suffered a rebellion from pro-European members of her own party, who approved a measure giving them more control over the final terms of Brexit – indicating further momentum towards a soft Brexit.

The recent agreement is clearly good news for the UK, and lessens the risk of no future deal with its largest trading partner. It should increase business confidence and act as a disincentive to corporations considering shifting operations into continental Europe or further afield. It is worth noting that the UK equity market is currently under owned by global investors. It is heavily exposed towards banks, which would benefit from any curve steepening, and also to international companies, which would benefit from a weaker pound. We also note that the UK’s concessions lean heavily towards many of the EU’s original demands, a point that in our view reinforces the relative balance of power between the two sides.

In light of this progress, we have revised our GBP targets against both the EUR and US dollar (USD) and believe that the extent of GBP weakening in the coming year could be lower than we had previously anticipated.

Economic headwinds

Still, while the deal lifts some of the Brexit gloom, it does not address some of our broader concerns about the direction of the UK economy, and its fundamentals, including fiscal and current account deficits that are still wide by historical standards. We believe that these could continue to weigh on both sterling and the UK’s future growth prospects.

London’s position as a pre-eminent global financial centre also remains under threat from rivals, and the government’s ability to introduce tax incentives for the financial sector is restrained by that commitment to fix the twin deficits. Indeed, the UK is still pursuing fiscal austerity at a time when many European countries have loosened their iron grip on public finances. In time, the UK will likely need greater fiscal flexibility to fund both a growth-oriented tax regime and the government’s much-touted ‘industrial strategy’. This project – to boost key industries such as life sciences – will form the backbone of efforts to create a new economic identity for the UK as the current government seeks to reduce the country’s reliance on financial services, which contributed 11.5% to the UK tax take in 2015/16¹.

Delivering the UK’s new economic identity will be a weighty challenge. Chancellor of the Exchequer Philip Hammond has been struggling to improve British workers’ productivity, which remains stubbornly below the other ‘G7’ developed economies (the US, Canada, France, Germany, Italy and Japan). Mr Hammond is left trying to refill the coffers from a tepid economy. We believe UK gross domestic product (GDP) growth will continue to underperform in the year ahead, and forecast 2018 growth of 1.3%. This is slightly below both the market consensus, and our forecasts of 2.5% and 2.2% expansion in the eurozone and US respectively.

Meanwhile, we note there is little room for manoeuvre at the Bank of England, which in November raised interest rates to 0.5% from its long-term, post-GFC low of 0.25%. We see this as a “one-and-done” hike. The UK’s economic outlook is still too vulnerable for the bank to enter a period of concerted normalisation, despite a modest uptick in inflation. The latest data showed UK consumer price inflation had risen to 3.1% in November, against 3.0% in both September and October, but we believe it could be contained in coming months, as wage growth remains sluggish and the effects of last year’s GBP weakening fall out of annual comparison figures.

Political risk

Political risk is another reason for us to pursue caution in our UK outlook. One lesson from the GFC is that poorly balanced post-crisis recovery can lead to wealth and income inequalities that deliver political shocks. The US and the UK are the prime examples. Britain’s decade-long pursuit of austerity has shaped a narrative and generated support for the UK’s opposition Labour Party, led by socialist Jeremy Corbyn. Data from the Organisation for Economic Cooperation and Development (OECD) shows that the UK had a higher level of income inequality than most European countries as of 2014².

Mrs May fumbled a snap election in 2017 and still looks deeply vulnerable, particularly when faced with the ups and downs of Brexit talks – a situation reinforced by the rebel vote from members of her own party on 13 December. Still, it is hard to imagine that the ruling Conservative Party could push through a leadership change without sparking a fresh popular vote. That would be a hugely risky move. Recent polling has been mixed, but often gives Mr Corbyn a healthy lead. A Labour government would entail risks to sterling and the health of the financial sector. Public spending and borrowing would very likely increase sharply, while Mr Corbyn’s approach to Brexit is also unclear.

Where now for Brexit?

In truth, there is little that is clear about the progress of Brexit. On 15 December, the European Council will be given the green light to start the second phase of talks, but beyond that, visibility is poor. The EU’s Brexit negotiator Michel Barnier wants the UK’s withdrawal agreement finished by October 2018, so that everything is in place for the UK to formally exit on 29 March 2019. Part of the next 10 months’ talks will be given over to a proposed two-year transition arrangement to start from that date. It is a very tight timeframe to negotiate such a dramatic change in the UK’s economic and political future.

The recent agreement should have been the straightforward part of the negotiations. Talks on a future trade deal, and a host of other elements, will be considerably more complex. This gives us some pause in pursuing a more optimistic view on the UK’s future prospects. Still, what is clear from the reaction to the recent positive progress is that moves towards a relatively benign ‘soft’ Brexit would have a positive effect on sterling and on the country’s economic outlook. We will be watching closely to see if the cooperative tone survives the intense negotiations ahead, and if efforts to reshape the UK economy can develop meaningfully in this fragile environment.

¹ Source: ‘Total Tax Contribution of UK Financial Services’ report, City of London and PricewaterhouseCoopers, December 2016
² Source: OECD website, income inequality data 2014 (most recent data available)