A few months into the Brexit negotiations, and the frenetic shadowboxing continues on both sides. Gridlock was entirely predictable, and markets seem to have stopped caring for now. The reactions to successive press conferences have been minimal.
The first meaningful deadline will be the EU leaders meeting this month (October), when the leaders of the 27 non-UK EU countries will determine whether sufficient progress has been made on phase 1 exit issues: the status of the UK’s impending Northern Ireland border with the EU, the rights of UK and EU citizens living in one another’s jurisdictions and the now-infamous Brexit bill.
The EU has insisted that these issues must be addressed before any others can be, and it has laid out its timetable. However, it is very possible that the deadline will be missed and expectations will shift towards a similar meeting in December. Agreement will require greater pressure on both sides than will be brought to bear by the time of this month’s meeting. Indeed, the idea that phase 1 issues will be sufficiently addressed in time to allow a cooperative trade deal to be struck by March 2019 remains a distinctly fanciful one.
It has always appeared likely that the entire two years of the Article 50 process will be consumed with divorce negotiations and that, with a disruptive change in trading relations looming, both sides will agree a further two-year transition period in order to negotiate a final economic and trading relationship.
Although progress on the divorce has been slow, there has been a rapid coalescence of UK political opinion around the need for a transition period. That represents real progress for markets. Brexit may be hard; but cool heads will prevail. Short-term market disruption will be minimised, and real change is probably still years away. As a result, Brexit fears are, temporarily, being pushed aside by markets.
But what about the macroeconomic impact of the referendum itself, and the uncertainty and financial market volatility that followed? True, the shock and uncertainty caused investment to soften. But while that slowed the economy, it did not kill it. A surge of consumption more than took up the slack, until prices in the shops started to rise faster than incomes.
The main macroeconomic impact of the referendum, import-generated inflation (as opposed to headline CPI inflation), is beginning to diminish. Every month during which the economy muddles through, instead of lapsing into recession, is another in which the shock fades and the underlying strength of the UK economy, buoyed by robust, broad-based global economic expansion, becomes the main narrative.
Bank rates upwardly mobile
With the immediate macroeconomic impact of the Brexit vote fading and issues of sufficient concern to roil markets a few quarters away, there may be a window for the Bank of England to raise interest rates early next year. Labour market performance has been impressive despite the Brexit concerns, and underlying credit dynamics have been robust in some areas, including unsecured credit issued to the consumer.
The Bank of England has already taken action to address financial stability concerns. Its Financial Policy Committee has increased the amount of capital that banks have to hold against their book of lending. Of greater interest to investors however, is whether the Monetary Policy Committee will decide to reverse the post-referendum interest rate cut in the near future. Although not likely, it is certainly possible that it could choose to do so in the coming year or so.
Several factors need to come together to bring this about. Further growth in the economy, continued falls in the unemployment rate and an acceleration in the growth of average earnings, as well as buoyant credit at home and similarly upbeat trade and commodity prices abroad would, in my opinion, all be required to provoke a change of policy. If all these conditions are in place, the Bank of England may well choose to raise its policy rate in the first quarter of next year.
Markets currently only attach a one-in-three probability to such an event, so if it occurs, sterling would likely strengthen and short-maturity gilts would sell off. To be clear, this is not the most likely scenario, but it is most certainly a possible outcome. This would not, however, signal the start of a sustained move higher in interest rates.
On the contrary, a rate hike early next year would probably be a one-off move for that year. Once spring arrives in 2018 and the count-down to the potential exit from the EU drops below one year, it may be difficult for the Bank of England to justify any change in policy, given the potential, however small, for the severe disruption to supply chains and business models that an acrimonious cliff-edge Brexit would bring about.
Leaving aside the changes Brexit will bring, the UK remains well equipped among developed countries to deal with the challenges that will confront the world in coming decades. Unlike the US, the UK has a political system that allows governments to adapt to emerging challenges in a reasonably dynamic manner.
Consider the two countries’ responses to the pressures on public finances created by ageing populations. In both countries, medium-term budget projections show retirement programmes hurtling towards insolvency. The solutions are obvious: higher public spending, lower benefits, a higher retirement age, or some combination of all three. The US has been debating such fixes for years, but no action is in sight. In the UK, the coalition government raised the retirement age in 2011 with little fanfare or debate, and without the protests such a decision would have provoked in the US.
Our system has among the fewest ‘veto points’ of any democracy. If you have a majority in the House of Commons, you can almost do what you want. That has a downside, but when changes need to be made, as they do in today’s fast-moving world, it is a net-positive.
Fit for purpose
By leaving the EU, the UK will regain some flexibility over certain areas of public policy. How it uses that flexibility will determine the country’s fate. There will be both successes and mistakes. However, over the decades, it is reasonable to believe that the UK’s political system will get enough right to support the economy and domestic equity markets.
Unlike the euro, the pound is backed by a fiscally cohesive political unit, unified banking regulations and a common language that facilitates labour mobility. Brexit could, of course, act as a catalyst to propel the eurozone towards greater cohesiveness and reform. Already Germany’s chancellor Angela Merkel and France’s president Emmanuel Macron are beginning the push towards the creation of a eurozone finance minister and budget.
That would be a positive for the eurozone, the region and the global economy. But even with these steps, it will be decades before the euro is trusted by investors in the same way single-country currencies are. There will be pangs of market concern and moments of stress as the eurozone develops. In contrast, the pound does not have such burdens, and UK equities will not have to overcome those concerns, as continental equities will.
Unlike Japan, although our population growth may slow, this trend is unlikely to result in the working age population actually shrinking in absolute terms. Despite recent rhetoric and elevated public concern, we remain a country broadly tolerant of immigration. As we regain control of immigration policy, we should think carefully about its composition, without moving aggressively to reduce its size, in order to facilitate the highest quality growth in our economy. I believe this will happen and that sufficient immigration will occur to support growth, profits and equities in the decades to come.
Set against such a backdrop, UK equities remain a decent bet for the future compared with other options, but the exceptional uncertainty that investors will face over the next few years should council investors against taking large sector or style bets in their portfolios.
For now, and indeed probably deep into the 2020s, it makes sense to choose funds that distinguish between the best-run and worst-run companies in each sector, while replicating the characteristics of firm size, market style and sector composition of the benchmark.
It’s tempting to look at the global exposure inside the UK equity market and conclude that an international bias is justified in the asset class. However, although sterling may well suffer short-term sell-offs as evidence of dysfunctionality in the Brexit negotiations continues to surface, by our calculation, it remains well below fair value and is likely to appreciate gradually in the decade after the negotiations are concluded. Any sustained appreciation would actually cause portfolios with foreign exposure to lag. For now, sticking close to the benchmark remains our base strategy for UK equities.
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