It is in the interests of both sides to achieve a deal in both goods and services. This requires a new customs and regulatory partnership.
What is the outlook for the UK economy and UK interest rates? In his May press conference, governor of the Bank of England Mark Carney gave us only vague guidance. An array of factors are clouding the bank’s crystal ball and making it very hard to judge the future path of the economy.
Given this uncertainty, Carney’s best guess is broadly that the economy will trudge along and interest rates will need to rise only gradually over the coming years. Indeed, he suggested that the bond market – currently expecting three quarter-point rate hikes over the next three years – is probably correctly priced. That would mean that by 2020, the Bank of England base rate would be just 1.25 per cent, well below the 5 per cent seen pre-crisis.
One of the primary sources of uncertainty is of course Brexit. It is now just 10 months until the UK formally leaves the European Union. The clock is ticking and the broad terms of the future partnership need to be agreed in the coming months. But while we hear plenty about how the discussion is evolving within the UK, there is far less coverage around the evolution of the debate in the EU. In the early days following the referendum, the EU’s negotiators seemed hostile. It appeared that the UK would be punished for its decision to leave, as a firm signal to the remaining 27 members. More recently, however, the EU’s approach has been more conciliatory.
A clear case in point is the early agreement on transition. This is a period of time between March 2019, when the UK formally leaves the EU, and December 2020. In this period the relationship between the UK and EU will remain broadly the same, so businesses will have time to adjust to any change in the relationship beyond 2020. Early agreement on this transition is particularly helpful to the UK, as it reduces the risk that UK businesses affected by Brexit will relocate solely because of the risk of a ‘no deal’ outcome.
Why does the EU’s approach appear to have changed and how does this affect the prospects for a deal? I believe a number of factors have contributed to this change of tack.
First, it has become increasingly apparent that to secure the EU project of continuing to integrate its countries both economically and politically, it needs to rid the other European economies of anti-EU populist parties. The best way to do this is via a strong recovery with falling unemployment. When living standards are clearly improving, voters don’t question the status quo. Countries such as Spain – which have bounced back from the crisis most vigorously – have also seen a substantial rise in support for the EU and the single currency. In stark contrast Italy, which has barely recovered at all in the past decade, has just elected an anti-establishment, traditionally anti-EU government.
This nascent European recovery could be jeopardised by a hard Brexit deal, since the UK and EU economies are heavily intertwined. Each year, the EU sends a net €110 billion (£97 billion) of goods to the UK. The countries that would be most exposed (those with the largest net surplus as a percentage of their GDP) are the smaller northern states of Belgium and the Netherlands, the Slovak Republic, Latvia and the Czech Republic. Germany has the largest trade surplus in absolute terms, but as a percentage of its economy its surplus with the UK represents about 1.25 per cent of GDP.
These numbers don’t look overly large, but they likely underestimate the extent of the disruption to activity, at least in the short term, because more than half of the EU’s exports to the UK are intermediate inputs. In other words they are inputs to a final product. Supply chain disruptions tend to have much larger effects than are initially obvious. This was demonstrated very clearly in 2011, when the Japanese earthquake impacted supply chains and caused a marked slowdown in activity across Asia.
Second, it may also be in the EU’s interest to include services in the deal. Given the UK is a large net exporter of services, the reasoning here isn’t entirely obvious; why wouldn’t the EU use Brexit as an opportunity to expand its own financial industry, with all the lucrative jobs and tax revenues that follow?
But it is not clear that in the short term any other European city has the capacity to host such a large financial centre. And there are significant benefits from having a large financial system in one place. The City of London is a financial ecosystem where insurers, investment banks, asset managers and all the other components of the chain are in close proximity and able to connect easily and freely. That ecosystem brings substantial benefits, which in turn reduce the cost of capital to banks. If the financial services industry in the UK fragmented, with smaller parts in other European destinations such as Madrid and Dublin, this would raise the cost of capital and in turn the costs for households and businesses.
In addition, the one city that has proved most attractive to financial firms, according to the contingency plans released by the banks, is Frankfurt, as it is close to the financial regulator. But the German economy is thriving perfectly well without a large financial services industry. Its more traditional business model, of high-quality manufacturing and engineering is serving it well. Employment is at a record high and the government runs a budget surplus. Since it doesn’t need the jobs or tax revenues, why would Germany want to court a financial centre, given that it can involve substantial risks to the public purse, as seen in 2007/08?
Third, and perhaps most obvious, the UK has been a significant contributor to the EU budget. Whilst there are ambitions within the UK to reduce this contribution, the EU may be more willing to offer the benefits of access to the single market if the UK continues to make some contribution to its upkeep.
Reasons for optimism
Seen in this way, there are reasons to be optimistic that it is in the interests of both sides to achieve a deal in both goods and services. The easiest way to achieve this is to establish a new customs and regulatory partnership, which would also overcome the potential problem of a border on the island of Ireland.
In my view, a deal of this nature would have a profound effect on UK markets, because it seems there is still a significant hard Brexit risk premium in UK markets. Although sterling has risen some way against the dollar over the past year, this reflects the fact that the dollar has fallen relative to most currencies. Judge sterling against the euro or other neighbouring currencies, and the level of the exchange rate is still roughly at the level it fell to immediately after the referendum.
A Brexit deal could thus see a broad-based rise in sterling. This in turn would reduce the cost of imports and push inflation down. Meanwhile, record employment is boosting wage growth. The outlook for the UK consumer could improve dramatically into next year.
At the same time, the reduction in uncertainty could unleash a wave of business investment. This could change the outlook for Bank of England monetary policy. If growth is accelerating and unemployment already at a multi-decade low, there could be serious questions asked about whether a base rate of 0.5 per cent is appropriate.
It’s worth remembering that before the Brexit referendum, the Bank of England was expected to be the first central bank to take interest rates back to ‘normal’ levels. Indeed back in 2014, the UK central bank was expected to be raising rates well ahead of the US Federal Reserve.
That all changed on the day of the referendum, when the Bank actually shifted to lower, rather than higher, interest rates. The Fed has since steadily taken interest rates gradually higher at a pace of roughly 0.25 per cent a quarter. By the end of the year, the combination of low unemployment and strong growth is expected to spur the Fed to lift the US interest rate to 2.5 per cent.
The bank may need to catch up. Its governor pointed to three 0.25 per cent rate increases over three years. If I’m right on Brexit, I think we will see more than that.
Karen Ward is chief market strategist for the UK and Europe at JPMorgan Asset Management.