Brexit: markets questions still to answer

Posted on September 23, 2016

What does a weaker pound mean for the UK economy?

So far, a 15 per cent decline on a trade-weighted basis for the pound since the vote for Brexit on June 23 has brought lots of tourists into the UK and boosted FTSE 100 companies, three-quarters of which generate their revenues from abroad. It has also helped other companies less exposed to UK uncertainty and made life a lot easier for UK exporters. This has also generated better than expected economic data and, in turn, resulted in sterling stabilising.

Sterling’s fall has been “the essential safety valve which has protected the economy and financial markets from collapse”, said Alan Wilde, head of fixed income at Barings.

Brexiters recall how sterling’s exit from the European exchange rate mechanism in 1992 made the currency more competitive and helped the UK’s balance of payments, contributing to the UK’s surprise recovery.

But how long will these beneficial effects last? And can they offset the negative consequences of a sharp devaluation? The big worry for economists is that oil and other commodities, priced in US dollar terms are more expensive, and the knock-on effect of dearer imports is likely to be rising inflation if producers pass on the increase to consumers. Against a backdrop of weaker earnings power, high personal debt and low savings, higher inflation could damage confidence and tip over into businesses pulling back from investment, especially if Brexit divorce negotiations become complicated.

The market will want to know what the Bank of England makes of all of this, and the extent to which it ignores rising inflation when it determines whether to ease monetary policy further.


    What role will markets play when negotiators start to joust?

    The Center for European Reform counts six interlocking negotiations for the UK government to contemplate: legal exit from the EU, the ultimate trading relationship, an interim arrangement between the two, joining the World Trade Organisation, trade agreements with 53 countries to replace existing EU deals, and co-operation on European security and defence.

    Investors must ponder the role they will play as positions are staked out and red lines drawn from next year. The lesson of Greece — via years of deadlines, deals and bailouts — may be that market alarm is needed to force agreement on contentious issues.

    So calm now may simply reflect a lack of information. “Once the UK politicians decide they have something more than a blank sheet of paper, then markets will respond,” said George Magnus, a senior economic adviser to UBS. And when he speaks to investors he often hears the same thing: “Their question is: ‘What are we supposed to do?’ We have to carry on as if nothing is happening, until we know something is.”


    When does the UK current account start to matter?

    Not much attention was paid to the UK’s position as a persistent big net borrower to the rest of the world. That changed because of Brexit.

    The deficit of £32.6bn in the first quarter represents 7 per cent of UK gross domestic product — that is high by developed world standards. It requires financing from abroad, so it matters if Brexit causes international investors to stem the flow of capital that helps to pay down the debt.

    Of the component parts of the current account, the trade balance remains in deficit but has been relatively stable while the investment income balance has deteriorated. Payouts to foreign investors are on the rise and UK investments overseas are falling.

    The argument goes that a weaker pound further stabilises the trade deficit, albeit slightly, and improves the investment income component, since UK investors will get more from their overseas income.

    But the wider issue is about confidence. Is the UK less creditworthy because of Brexit? Britain’s high current account deficit can remain insignificant so long as the market thinks it doesn’t matter. Brexit is the kind of shock that may make the market rethink its blithe regard for the deficit, especially if investors start to lose their nerve about the UK and the currency market pushes sterling substantially lower.


    How would a fiscal response change assumptions about markets?

    For more than half a decade a single opinion has prevailed in the markets: the responsibility for boosting demand will solely fall to central banks as governments cut spending — making safe government debt scarce and pricey.

    The next Autumn Statement, planned for November 23, gives Philip Hammond, the chancellor of the exchequer, the chance to shake things up and start spending some money.

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    KNUTSFORD, UNITED KINGDOM - MARCH 17: In this photo illustration, the European Union and the Union flag sit together on March 17, 2016 in Knutsford, United Kingdom. The United Kingdom will hold a referendum on June 23, 2016 to decide whether or not to remain a member of the European Union (EU), an economic and political partnership involving 28 European countries which allows members to trade together in a single market and free movement across its borders for citizens. (Photo illustration by Christopher Furlong/Getty Images)

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    Fiscal stimulus, if it works, would send bond prices tumbling. Prices fall as yields increase, and any boost to inflation and growth should lead to investors demanding more compensation for handing their money over to the government when higher returns are available elsewhere.

    How fast and how far they fall should depend on how central banks react.

    The Bank of England will be “behind the curve”, said Trevor Greetham, head of multi-asset at Royal London, so, while switching to corporate credit or equities instead of sovereign debt allows investors to bet on growth, the fall in bond prices is unlikely to be too dramatic.

    “We may end up in a better policy mix than we were in pre-Brexit,” he said.


    When do banks have to start making decisions about London?

    Banks, exchanges and market infrastructure are among the biggest beneficiaries of the so-called passporting arrangements, which allows them to offer services to the whole bloc from one country. So far none has made concrete decisions on a moving process that could take three to five years to complete. Passports for financial service are issued per directive, so institutions will have to decide which ones they need.

    “There’s a need to get on and act and serve your clients,” said John Liver, a partner in financial services at EY in London. “But there’s a question mark whether there’s a first mover advantage. You don’t want to be isolated in a different city. There’s a lot of value in an ecosystem.”

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    A Deutsche Bank logo adorns a wall at the company's headquarters in Frankfurt, Germany June 9, 2015. REUTERS/Ralph Orlowski/File Photo

    Failure to provide a substantial replacement would do significant damage

    Many have struggled to find a city with adequate office space and transport links. A more significant problem may be a deluge of hundreds of regulatory applications to watchdogs ill-equipped to cope.

    Some have suggested that the UK could withstand a “hard Brexit”, by which the UK exits the single market and loses its passports. Moody’s, the credit rating agency, suggests that many UK-based financial companies would find the dislocation “manageable” as long as British markets rules were judged to be “equivalent” to incoming EU standards.

    Others are less optimistic and say the “equivalence” approval, part of the Mifid II legislation, is untested. “I think they are overestimating the benefit of “equivalence”, while underestimating the risk of a hard Brexit that sees the UK on the outside of the EU looking in,” said Sean Tuffy, head of regulatory affairs at Brown Brothers Harriman.

    But trying to determine the view of something as amorphous as “The City” or “the market” is a near-impossible task. For all those in favour of Leave, many pointed out that a lot of the business London conducts — from insurance to trading, risk management, tax and legal services — is for the rest of the world, and not just the EU.

    Reporting by Roger Blitz, Philip Stafford, Gavin Jackson and Dan McCrum

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