Thoughts through the cycle: W1 January ’21

Brexit – a breakaway goal for Britain, or signs of an ailing European defence?

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  • “Arma virumque cano” (“I sing of arms and the man”), a suitably grand start to Virgil’s Aeneid, the epic tale of Aeneas’ journey from Troy to Italy and the founding of Rome against all odds, including overcoming the distractions of the beautiful Queen Dido in Carthage. While British Prime Minister Boris Johnson is himself a noted fan of the classical allusion, his heroic quest to get Brexit done, which began with an election victory on 12th December 2019, somehow lost much of its lustre amidst lockdown and furlough (no comment on the Dido bit).
  • It is perhaps surprising with so many column inches expended on Brexit in the four and a half years since the vote that very little was made of the paradox that lay at the heart of the referendum. The plebiscite is truly an act of direct democracy, where representative bodies stand aside and allow the people to decide an issue for themselves, the idea being that questions of a certain magnitude demand it. The 2011 referendum on the alternative vote for example only saw a 42% turnout, and most recognised it for what it was, a sop to the Liberal Democrats who were then junior coalition partners to the Conservatives.
  • Yet while a referendum is a sovereign moment, the sovereignty has to be contextualised in terms of what the vote was about, and this is where the paradox lies. There is no need to question the 1974 Common Market referendum (voting to join something), but the 2016 Brexit vote was quite different – while the vote to leave was a sovereign act of the people to make the British Parliament once again supreme in terms of passing legislation, the very act of voting to leave immediately handed sovereignty about the terms of the departure to those whom Britain was leaving, in this case the European Union in the guise of the European Commission.
  • Had the 2014 Scottish devolution vote gone the other way, exactly the same problem would have arisen for exactly the same reason. While the SNP could claim the national debt was British and not Scottish and therefore wanted none of the debt obligations, ultimately that decision was one for the ‘Westminster Parliament’. The same would be true for the currency and the Bank of England’s currency reserves – had Scotland decided to peg to the pound before entry into Europe, a currency board arrangement would have demanded all reserves be in sterling and that Scotland share England’s interest rate policy. No independence there at all. A devolved Scotland in a post-Brexit Britain would have the same issues when joining the EU – one need look no further than Spanish opposition to a fast-track entry for Scotland into the EU on the basis of it giving unhealthy ideas to separatist-leaning Catalonia. Even if leaving a union is a sovereign act, the manner of the exit is decided by those whom you are leaving behind.
  • Understanding this paradox meant that the likely outcome of Brexit negotiations was always going to be binary – a deal in name only or a hard Brexit with minimal future planning. So when a deal was announced on Christmas eve which actually looked half decent from a UK point of view, one found oneself in the strange position, at least from a British perspective, of asking what went right?
  • Before looking at the UK’s prospects, it is necessary to examine the immediate market reaction. Judging by the GBP/USD cross-rate, the market’s reaction was one of profound indifference – or perhaps ‘travel-and-arrive’, in the sense that the market always knew deep down that someone would blink and therefore the no-deal catastrophe was never going to happen. Cable is stuck around $1.35 – below its 2016 pre-Brexit level, but sharply higher than the March 2020 lows.

Source: Bloomberg, 29th December 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • The various European governments have given their assent to the deal, as well as the British Parliament. The arch-brexiteers of the Conservative party’s European Research Group (ERG) complained more about the length of time given for review of the main document (all 1,246 pages of it) than the document itself. They should count themselves lucky that the five or so days given to review the EU-UK Trade and Cooperation Agreement was substantially more than the five or so hours given to US Congress to review the 5,593 pages of the recently passed Covid-19 relief bill. ERG approval ought to be seen as confirmation that the deal does not condemn Britain to the feared status of European vassalage, and is likely a better gauge of sentiment than the genetically programmed pro-European teeth gnashing of the Financial Times or anti-Boris chest beating of the Guardian.
  • So why wasn’t the deal all that bad? Both sides eventually compromised on fish, and while it seemed absurd to many that so peripheral an issue might end up being a deal breaker, it was nonetheless a reflection of the issue at the very core of Brexit, that of sovereignty. It is also worth noting that a good deal for Britain on fish (as well as farming) may well form a key development for the defence of the union should the drum-beat for ‘Indyref2’ grow louder north of the border. Arbitration over the level playing field on trade will now be exercised independently of the European Court of Justice, which is a huge win for the UK and ensures parliamentary sovereignty. The divisive ‘ratchet’ of tariff-based punishment proposed as a tool for the EU to keep the UK in check is now a two-way mechanism. This again appears to be a major concession from the European side.
  • There is of course uncertainty, and despite a fairly-comprehensive trade deal being negotiated in record time, there are still important issues to be resolved. Foremost amongst these is financial services, a major export for the UK to Europe. The European Commission has indicated that London’s status will be established in 2021, likely by March, and it is hoped that it will mean the UK’s capital will be allowed to maintain its international ranking so long as it ends up being treated in a similar way to New York or Tokyo as financial centres in a ‘third country’.
  • From a ‘common sense’ point of view, the parlous state of Europe’s economy and of its banks perhaps suggests the ECB as the chief regulator will be unlikely to want any major disruptions in the short or medium term. The predicted exodus of bankers to Europe simply hasn’t happened, and there are many practical reasons to believe it still won’t. In any case, for those in Europe worried about a fall in regulatory standards, one need look no further than former FCA chief (and now Governor of the Bank of England) Andrew Bailey’s recent feeble apology for the UK regulator’s failure to act to prevent a £237m loss for retail investors over the London Capital & Finance scam. Can UK financial regulation really get any more lax?
  • While Prime Minister Johnson is promising a bright, new dawn for the UK, Brexit is of course a risky venture launched at a risky time. While those on the remain side have been urging an extension to negotiations due to the pandemic, it is worth noting that if you keep on stalling and delaying, eventually you’ll end up negotiating during an economic downturn, and many of the delays have resulted from the remain side’s procrastination. In any case, reality is reality, and as such, the prognosis for the pound ought to be a key focus for markets going forward.
  • So far, the pound has shrugged on the deal announcement, and with the dollar at its weakest in years (and with record bearish bets against it from a market-positioning perspective), one wonders whether there is really much more upside in cable from here. While a no-deal collapse has been ruled out, mapping the downside for sterling ought to be something most investors have a handle on.
  • Because markets love inferring future price action from the past, a starting point for cable has been to look at what happened in 2016. After the vote, cable initially fell over 13% from $1.48 to ~ $1.30. What is often forgotten is that the second move lower to $1.20 (see red arrow) occurred after the Bank of England’s largely unnecessary base-rate cut (by 0.25% to 0.25%) and the re-initiation of quantitative easing (QE) to the tune of £60bn government bonds and £10bn corporate bonds. At the time, this was Mark Carney’s only actual act as governor of the bank since he took office in 2013. A full 40 days had passed since the vote, and by then, it was clear that Brexit was so shocking that it was going to take a long time to resolve. The need either for a rate cut or QE was, in the circumstances, deeply questionable. The pound paid the price.

Source: Bloomberg, 29th December 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • Fast forward to 2020, and Andrew Bailey is the new governor, and he went on record at last month’s House of Commons select committee meeting as saying the long-term risk to the economy from Brexit was greater than that of Covid-19 (yes, worse than the thing which led to a £394bn deficit, or 20% of GDP, and took the national debt over £2tn). Perhaps that is what he has to say. Nonetheless, he is right to highlight the risk, and doubtless the Bank of England will try to accommodate where it can through monetary policy. Although Mr Bailey is at pains to deny the BoE is engaging in monetary financing of the UK primary deficit, there is a peculiar symmetry between the deficit and the increases in BoE QE this year. Probs just a coincidence, right Andy?
  • Sterling actually had quite a good recovery from the March 2020 lows where it touched $1.15 against the dollar. Much of this has however been to do with US dollar weakness – US QE and fiscal stimulus was the most supercharged of the lot, and the dollar has paid the price. The UK’s current account deficit (CAD) in Q2 2020 tightened to -0.6% of GDP (although adjusted for non-monetary gold movements the real figure is -2.5%) vs. a -4.3% at the end of 2019. The UK Balance of Payments at half-year 2020 was -2.2%. Although this is smaller than it was, and while this is good for the pound all else equal, there is uncertainty about future foreign direct investment (FDI) into the UK due to the changed relationship with Europe. Much FDI money entered the UK (with its easier regulatory environment and employment laws) for onward passage into the EU. This may not be the case going forward, risking further BoP imbalances developing.
  • During the Brexit negotiation period, Mark Carney characterised Britain’s trade balance predicament as one relying on the ‘kindness of strangers’. What this means is that the UK borrows from abroad to finance itself, both at a household and corporate level. Any perceived disruption to the UK economy could raise borrowing costs, which may in turn affect the domestic economy, particularly the housing market with its heavy reliance on floating-rate mortgage funding. If the pound does fall, inflation will likely pick up very quickly (especially on food), further raising the cost of borrowing. These short-term issues have in the past led to balance-of-payments crises, but that all seems a bit 1960s and 1970s as far as the market is currently concerned. Money markets are pricing in a further cut to base rates in H2 2021. The BoE is want to pontificate at every opportunity on the benefits of negative rates. They are even talking about a new central bank digital currency, one of the so-called benefits of which would be allowing the BoE to set interest rates far more negatively than would be prudent for the ordinary, commercial banking system. All of this is due to the huge stock of debt and the worry that deflation is coming as a product of this. Sterling weakness is not often mentioned as a problem in this context.
  • If your main worry is deflation, then weakening your currency is a good way of generating inflation. This is the currency war 101 – the beggar-thy-neighbour policy of the 1930s. If you want to inflate away the nominal value of your national debt though, a weakening pound due to the uncertainty of a post-Brexit transition would not be unwelcome. Great from the perspective of the government, less good from the point of view of the rich (inflation destroys capital) and the poor (as the cost of living will likely shoot up). Remember though this is a 2020 story, and this is a year when in many ways fiscal and monetary powers around the world have fused and government has poked its nose into parts of our daily lives which were unthinkable even a year ago. Rarely does such government activism end without high inflation.
  • While the pound may risk a fall, the ascent of the euro is a mirror of that problem. The UK imports just under £100bn of goods and services from the EU each year, and a fall in the pound would add to the deflationary shock to Europe making their exports more expensive. As it is, the euro is trading near the all-time highs on a trade-weighted basis, as the graph below from the ECB shows.

Source: European Central Bank, 31st December 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • Eurozone year-on-year CPI inflation has fallen from 2.3% in late 2018 and now stands at -0.3%. The falling dollar has in part been to blame for the rise in the euro, but a sharp move lower in the pound would exacerbate this problem. With Brits unable to travel as freely to the continent as before, the already-struggling tourist economies of Italy and Spain may well get another hit, even as the high euro makes their exports prohibitively expensive, further enfeebling any economic recovery. A real debt-deflationary crisis, especially one involving bank solvency, is a distinct possibility. No less than the Bank of International Settlement (BIS) warned in its latest quarterly review that a liquidity crisis may well give way to a solvency crisis in 2021, and one wonders whether southern Europe was on their mind when they were writing that.
  • From the point of view of the European Commission though, a closer union is a price which is worth paying, and sadly it is going to be the so-called Club Med countries which struggle the most. One wonders if this will change as France’s fiscal outlook deteriorates (debt to GDP is now forecast to hit 122% in 2021, far ahead of Germany’s). While nothing is ever clear in diplomacy, President Macron does appear to have played a decisive role early in December to ensure few concessions were made from the European negotiating side, especially on fishing rights. As ever in Europe, domestic political interests often seem to trump the greater good, and France has a history of doing this more than most.
  • While it would be going too far to say the EC made an eleventh-hour volte-face over Brexit, it is clear that France (sorry President Macron) didn’t get its/his way, and this is a development of some note. Part of the European narrative is one of relentless progress (towards a European superstate if you don’t like Europe or an integrated and efficient democratic federal structure if you do). Brexit was always going to be a litmus test of this, and despite putting personal and domestic interest firsts, Monsieur Macron in many ways embodied this through a willingness to risk a no-deal outcome which would dissuade other countries from leaving.
  • It seems though that the deal that has emerged was not an exercise in punishing an errant UK and therefore not necessarily one pour décourager les autres (especially Italy), and this says something very important about Europe and how it views itself. One senses a tacit admission of vulnerability here, and the market would be wise in the next year or two to focus as much on the continent as it does on the British Isles.
  • Like most things in 2020, Brexit tastes a little sour. While the return of Parliamentary sovereignty and the hopes of the UK striking out on its own in a more entrepreneurial manner are prospects for the future, the immediate situation looks pretty grim, in part because it was already grim due to the pandemic and the effect on the economy of rolling lockdowns that still seem to be the government’s only answer to the problem. There may yet be a few winners – perhaps England’s cat population will rejoice at all the extra fish. That remains to be seen. In the meantime, monitoring the pound and the euro will be key activities in gauging the health of the post-Brexit world. If one is looking for a silver lining, then post-Brexit uncertainty may give Britain a head-start in the currency war. That’s not something Governor Bailey at the Bank of England would ever say though.

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Thoughts through the cycle: W2 January ’21

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