Author: Stéphane Monier, Chief Investment Officer, Lombard Odier Private Bank
More than three years after voting to leave the European Union, December’s UK general election delivered the biggest Conservative majority government since 1987, clearing the parliamentary hurdles for the country to leave the European Union on 31 January. That does not mean the uncertainties surrounding Brexit are settled.
The newest political complication came last week when finance minister Sajid Javid resigned after a row with Prime Minister Boris Johnson. The new Chancellor of the Exchequer, Rishi Sunak, will now share the same advisory team as Mr Johnson, increasing the prime minister’s oversight of the country’s finances. Markets interpreted the row as a signal that the government may be preparing a more fiscally ambitious agenda to kick-start a stagnating economy. The move comes as the country begins a high-speed rail infrastructure project linking London to the north of England, at an estimated cost of more than 100 billion pounds (USD 130 billion).
The UK economy needs a catalyst. The Bank of England’s outlook, released in January, forecasts growth in gross domestic product of 0.2% for the first three months of 2020, on a quarterly basis, compared with 0.0% in the final quarter of last year. Our annualised forecast, broadly in line with the BoE’s expectations for the 2020 full year, is for GDP growth of 1.4% and inflation of 1.8%.
The central bank said its forecasts assume “that there is an immediate but orderly move to a deep free trade agreement with the EU on 1 January 2021.” Investors should not take this working assumption for granted, given the negotiating complexities ahead, and year-end deadline for trade talks with the EU.
Britannia Waives the Rules
The EU and UK are preparing to start negotiations on future trade relations in March. The Prime Minister has said that the UK is not planning to follow EU rules on subsidies, competition, social standards or the environment, and has already ruled out requesting an extension to the December 31 deadline. The UK’s rush to sign a deal with the EU suggests that it wants to rapidly turn to securing agreements with other trade partners. These will bring their own challenges.
In reality, the year-end deadline is closer. To extend the talks, the UK would have to file a request before 1 July, according to the process agreed last year. The danger is that, rather than the ‘deep’ trade agreement assumed by the BoE, the short deadline means an unambitious ‘bare bones’ agreement is likely. For this reason, we do not rule out a U-turn by Mr Johnson’s government.
The European Commission, the EU’s executive, is looking for a close trading relationship, but fears that the UK may grab an unfair commercial advantage by reaching zero-tariff or zero-quota arrangements with other countries. The Commission also points out that, under the terms of last year’s political declaration, the UK has already promised to maintain EU standards on a range of subjects.
“Without a level playing field on environment, labour, taxation and state aid,” said European Commission president Ursula von der Leyen, “you cannot have the highest quality access to the world’s largest single market.”
Given the short, ten-month negotiating timetable, only a limited agreement may be possible. The EU’s trade agreement with Canada, sometimes cited by Mr Johnson as a model, took more than five years to negotiate and will only be fully implemented over several more.
A short timetable is not compatible with the need to negotiate economically significant, or politically sensitive, subjects, according to the European Commission. Any EU/UK agreement must cover the significant financial services sector. In 2018, the UK’s financial industry accounted for 6.9% of the country’s total output making it the world’s biggest net exporter of financial services.
The UK/EU joint political declaration already recognises that financial services should include mutual recognition or ‘equivalence’ in regulations. As a member of the EU, the UK helped to draft and then implement the bloc’s financial regulations.
Any equivalence arrangement will not go as far as the existing rules that allow EU and UK firms to operate throughout the region using a ‘passporting’ system. That allows a UK firm to operate throughout the EU, including registering a mutual fund or hedge fund in one member state and then selling it in others.
Even equivalence is not a panacea: it is only possible in financial services sectors already covered by ‘third-country provisions.’ Activities including lending, insurance distribution or payments have no such provision. And even where the provisions exist, they are subject to conditions that vary between each sector.
“They should not kid themselves about this,” Michel Barnier, the EU’s chief negotiator, said of the UK this month. “There will not be general, open-ended, ongoing equivalence in financial services.”
As Switzerland discovered, even an equivalence label may be withdrawn with little warning. When six year-old negotiations to consolidate existing Swiss-EU agreements stalled last year, the EU’s executive let the equivalence permit that allows European investment firms to trade stocks on Swiss platforms expire. The stakes for the UK financial industry are much broader.
Muddy waters In the future discussion around post-Brexit relations, fishing and finance are being tied together. As in any negotiation, by tying together the most complex topics, there is more room for compromise. While the fisheries sector is economically significantly smaller than finance, it is highly political. The UK fishing industry contributed just 0.12% of UK economic output in 2016, according to a UK government report. Brexit’s proponents campaigned with promises that EU secession would give British fishermen control of Britain’s coastal waters.
“You may have to make concessions in areas like fishing in order to get concessions from us in areas like financial services,” Irish Prime Minister Leo Varadkar said last month. As the talks progress this year, it should become clear where the British government’s priorities lie.
Despite these complex trade-offs, the likelihood of the EU and UK failing to reach some sort of agreement now looks lower than before December’s general election. Still, we believe that the possibility of another cliff-edge, year-end, no-deal scenario will keep enough pressure on sterling to cap any rallies in the UK’s currency. In the near term, we expect GBPUSD to trade in a narrow range between 1.28 and 1.32.
The Bank of England’s deputy governor, Andrew Bailey, will take over from Mark Carney on 17 March and chair his first Monetary Policy Committee on 26 March. Ahead of that meeting, markets are pricing a one-in-four chance of a cut in interest rates, according to Bloomberg data. The BoE based its January decision to leave rates on hold on a stabilising economic environment both at home and abroad. While we are not forecasting any policy rate change this year, any renewed outbreak of Brexit-related uncertainty would be likely to push the BoE towards easing.
UK ten-year sovereign yields recently traded close to historic lows at 0.63%, reflecting investors’ concerns about the economy’s growth and caution over the Brexit negotiations. That brings the yield differential between 2-year and 10-year maturities close to flat, a level not seen since 2005-2007 and 1997-1999. Mr Sunak’s appointment also put pressure on 10-year Gilts, which rose 10 basis points over the past week to 0.65%. We expect the overall impact from any fiscal stimulus on the yield curve to be marginal. We believe that global and Brexit-related factors will continue to dominate the UK bond market.
UK equities have benefited from some reduction in uncertainty since the election and we see earnings growth reaching high single digits in 2020. The FTSE 100 has declined 1.4% this year, in part because of its exposure to cyclical stocks and the impact of the coronavirus. Nevertheless, we expect that over the year, British domestic companies will gain, in particular if the UK budget delivers a fiscal boost in March.
The British public voted for Brexit in June 2016. As Mr Johnson promised in December last year, Brexit was ‘done’ as of 31 January 2020, but its uncertainties will continue to cloud the UK’s economic horizon for the foreseeable future.