U.K. Pre-Brexit: Solid. Three Scenarios

Around the Curve

U.K. Pre-Brexit: Solid. Three Scenarios

“Brexitville” has been busy lately. Before discussing the state of play, here's a look at the U.K. economy, which continues to display remarkable resilience despite the uncertainty.



Recent financial market headlines have been focused primarily on trade disputes—particularly with China—the Federal Reserve’s policy framework, and the related stress in emerging markets. This has meant that 2016’s big market-moving story, Brexit, has been relegated in importance for now. Meanwhile, quite a lot has been happening in “Brexitville” over the past couple of months, so we think it’s time for an update. But before we discuss the state of play in Brexit, let’s take a look at the U.K. economy, which continues to display remarkable resilience despite the uncertainty.

Much like the rest of the European region, gross domestic product (GDP) growth slowed modestly in late 2017 and early 2018, although the most recent reading has shown an uptick. Furthermore, with inflation pressures moderating, it looks like the Bank of England may be done with its hiking cycle for now.

 

Source: Bloomberg  Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

The economic surprise index is positive again, which tells us that data is coming in better than analyst expectations:

 

Source: Bloomberg  Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

The labor market still looks strong; unemployment is at its lowest level in 40 years:

 

Source: Bloomberg  Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Meanwhile, Bloomberg’s Brexit Barometer—a composite index that tracks inflation, economic activity, employment and uncertainty—remains positive. A positive reading suggests economic wellbeing is above average:

 

Source: Bloomberg  Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

So with the decent economic news out of the way let’s get back to the dog’s breakfast. For the uninitiated, we British use the saying “it’s a dog’s breakfast” to describe a situation that is a complete mess.

As a brief reminder, following the June 2016 vote to leave the European Union (EU), the U.K. formally triggered Article 50 of the Lisbon treaty in March 2017, setting in motion the 2-year countdown to March 2019, when the U.K. leaves the EU. To say that the parties stumbled through the first year accomplishing little would be an understatement. However, the pace has picked up in 2018, and last month, the U.K. put forth its formal proposal for its future relationship with the EU. This proposal followed an apparently bruising Cabinet meeting at Chequers—the weekend home of the prime minister—where Theresa May somehow managed to get the various factions of her Conservative Party somewhat in alignment on the proposal. This wasn’t without collateral damage, however, with several Cabinet members and front-bench members of Parliament (MPs) resigning. Almost immediately, the EU rejected several elements of the proposal, characterizing the U.K.’s approach as cherry-picking.

For now, the sides continue to meet on an almost continuous basis, the goal being to have an agreement in place by October 2018 in order to give U.K. lawmakers time to ratify the legislation. Simplistically, there are three outcomes: deal, no deal, no Brexit.

 

Deal

Despite being almost 75% into the 2-year window, it is somewhat alarming that the framework of a deal still remains elusive. The EU has continued to demand “respect” for the single market and its four principles: free movement of goods, services, capital, and people. These, of course, remain in conflict with the objectives of Brexit and thus we find the parties iterating through different ideas that require compromise by one or both parties, such as the Chequers proposal. Since we cannot point to a coherent framework for a deal at this time, we have to talk about the rising risk of “no deal” and “no Brexit,” which used to be regarded as tail risks.

According to Fitch earlier this month, the ratings agency doesn’t regard any particular deal scenario as having a high probability, so it no longer has a base case. To paraphrase Fitch’s, the likelihood of an acrimonious, no deal Brexit is material and growing.

No Deal

This is what used to be called a “hard” Brexit. Last week, the U.K. government published its first contingency plans that discuss how businesses and individuals should prepare for a no deal outcome where the U.K. crashes out of the EU in March 2019. The range of topics covered is fascinating. Some of the topics are obvious—such as how to apply customs rules to goods being imported from the EU—while others are far less obvious, like the rules surrounding the transportation of organ and tissue donations since EU regulation would no longer apply. The U.K. government will continue to draft and publish these contingency plans as long as no deal remains in place.

No Brexit

Meanwhile, the clamor for a second referendum continues to build. A recent poll shows a new high of 76% of those polled being unhappy with the state of negotiations. Furthermore, as the chart below shows, the number of people viewing Brexit as a mistake is on the rise again:

 

Source: WhatUKThinks.org/EU, run by NatCen Social Research  Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Furthermore, more than 100 constituencies that backed Brexit in 2016 now appear to have swung to the “remain” camp. However, the governing Conservative Party has demonstrated no interest in conducting a second referendum. Frankly, given the tight timeframe, it’s doubtful that such an event could be executed prior to March 2019 anyway.

So what does this all mean? Based on the performance of the economy, it seems either the U.K. can withstand any form of Brexit without collapsing or maybe businesses and consumers are betting that a deal gets done. One of my colleagues likened the situation to Y2K, when the “sky is falling” crowd forecasted complete chaos as the clock ticked into a new millennium. Yet the outcome of Y2K was not nearly as draconian as predicted. Perhaps the U.K. economy will be just fine despite the headlines. Nevertheless, we will be watching closely in the months leading up to March 2019.

 


Definitions:

The Citigroup Economic Surprise Indices are objective and quantitative measures of economic news defined as weighted historical standard deviations of data surprises. A positive reading suggests that economic releases have on balance been beating consensus. 

The Bloomberg Brexit Barometer/Bliss Index tracks economic well-being/health in the United Kingdom.  A positive reading suggests wellbeing is above average, while a negative reading suggests it is below. 

The Year 2000 problem, also known as the Y2K problem, the Millennium bug, the Y2K bug, or Y2K, is a class of computer bugsrelated to the formatting and storage of calendar data for dates beginning in the year 2000. Companies and organizations worldwide checked, fixed, and upgraded their computer systems to address the anticipated problem.

Very few computer failures were reported when the clocks rolled over into 2000.

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