No Deal Brexit should be your base case
(This is an excerpt from our flagship report we published on August 10)
With three months to go between now and the October European Council meeting, we are now at the stage where Hard Brexit is now becoming a distinct possibility. Allow me to quote from my recent Expert Series interview with the Peterson Institute Jacob Kirkegaard on his three possible Brexit scenarios.
At this point, there are three possible scenarios that could play out over the next few months in the run-up to the European Council meeting in October. This gathering has been touted as the EU’s own deadline for a UK withdrawal agreement.
Scenario 1: Norway
The first scenario is that ultimately the European Union rejects Mrs. May’s new set of proposals which, at this juncture, is likely. At that point, the EU would tell the British government, or more likely, the Parliament, that the only viable solution to avoid a hard border in Northern Ireland is for the UK to stay in the Customs Union and the European Economic Area (EEA). This route is essentially becoming like Norway which it is a member of the EEA, but not the EU, and is subject to just a third of the rules as other members. The alternative to accepting this option is no deal at all and, of course, all the dislocation that would entail. Then, the decision would be up to the British Parliament, which at that time, could be facing more much volatile financial markets.
Scenario 2: Kick the can down the road
The second scenario is the “kick the can down the road” option. This would entail that the British government and the EU arrange some sort of fudge that would allow the UK to withdraw, but also allow them to paper over the fact that there is no solution to the Northern Ireland border, no agreement on the long-term relationship of the two parties and an assumption that all of the details about the ultimate arrangement will be negotiated during the transition period which ends in 2020.
Therefore, what this scenario entails is that there is the “cliff edge” of the UK dropping out of the Single Market and the Customs Union, but at the end of the transition period, not in March 2019. Therefore, both parties buy themselves some time. This is a path that may be seen as advantageous to some in the EU thinking that if there is a prolonged period of uncertainty, there will be more downward pressure on the British economy which will ultimately make it more difficult for the UK not to accept EU demands.
Ultimately, at the end of the transition period, the UK would basically be in the same position that it would be in first scenario; namely that it would need to remain in the internal market and the Customs Union to avoid a hard border in Northern Ireland. So essentially, in the EU’s mind, this option is to prolong any agreement for a couple of years, or twenty-one months, and then at that point, the UK economy will be weaker, and the government will have less bargaining power to negotiate.
Scenario 3: No deal and crashing out
The third scenario is that there is no deal. This outcome would be detrimental to the UK economy and would only be actively pursued by a limited minority in the Conservative Party
so if it were to happen, it would be the result of unexpected consequences, misperceptions, miscalculations or a political accident. Another path to this result would be if the UK Parliament was simply unable to accept, or come to, any version of Brexit that was acceptable to the EU 27.
In that scenario, the EU 27 would basically say this is the Brexit that you wanted, and now you have it. However, it is not likely that this outcome would be the intended policy of the British government, therefore, it would happen only because of a political miscalculation or an act of incompetence.
Those are the three Brexit scenarios that could occur in the second half of 2018, with this issue really coming to the fore following the EU Council in mid-October. At that meeting, it is
very unlikely that a withdrawal agreement, or an accord that deals with the Northern Ireland issue, will be agreed upon. At that point, the EU will probably make it clear that if the UK wants to avoid a hard border, becoming Norway is the only option. At that point, the European leaders will probably sit back, and do what they did with the Greek / Periphery crises and wait for financial markets to force a solution. For them, the ideal outcome would be for the British Parliament to have a majority in favor of a Norway-type arrangement, or to support a very soft Brexit, by the beginning of 2019.
Of these three scenarios, one and two, “Norway” or “Kicking the can down the road” would see the pound rally significantly. I find it hard to see how PM May can get a majority of the UK Parliament to support a Norway style deal that is imposed on them in the way that Jacob outline.
As for the transitional deal, this seems to make a lot of sense but whether the Europeans would be prepared to do this remain unclear. This would certainly lead to a GBP rally as the status quo would be maintained. Again, according to Jacob, this appear unlikely.
We are then left with Hard Brexit.
What are the current economic realities?
While a collapse in the GBP will only happen in a scenario of true economic distress, I believe that we can make the following assumptions:
The Bank of England is now on hold. While I have flirted with saying the two interest rate increases by Mark Carney are bordering on a policy error in the guise of Jean Claude Trichet raising EU rates in July 2008, the inflation outlook left him very little alterative. While there will be those who will use the ridiculous arguments that tightening now allows him to cut later, it is clear he will need all the help he can get if Hard Brexit leads to recession.
Corporate and Consumer confidence are probably heading lower as a No Deal Brexit becomes the consensus. Business investment and Retail Sales (ex-hoarding. No, I am not joking) will almost certainly move lower. I cannot paint a scenario where UK economic activity doesn’t slow significantly in the next nine months.
Inflation should remain sticky due to the weakness in the GBP since April. There is a lag effect but prices in the UK economy are highly susceptible to the gyrations of the currency and with the GBP/USD cross rate down some 10%-plus since April, inflation pressure can re-emerge in 2019, adding to a stagflation narrative.
The UK housing market remains the key sector and while a recession can certainly occur without a collapse in the housing market, weakness in house prices would make things a whole lot worse. I am not overly bearish on UK housing. Housing markets only collapse when there is wide ranging, forced selling of property. What causes that? Well, basically it is when over indebted individuals cannot afford the servicing costs either because of unemployment or higher interest costs. While unemployment could well spike if the economy goes into recession, UK interest rates are heading lower, so debt service costs will fall for those on a variable mortgage. Also, the push towards fixed rate mortgages shields home owners from interest rate risk. Comparisons to the US in 2007 are deeply flawed.
Yes, there will be selling by the top 10% of income earners as expats leave or business owners struggle, but this isn’t enough to cause a true collapse in broad price levels. I feel that we are more likely to see a stalling of activity rather than much lower clearly prices, effectively what we are seeing today. In fact, a clearing price for more expensive property is more likely to occur if you do get a sharp deterioration in the value of the pound that will encourage foreign buying of property. We have seen this in Australia over the past 20 years as a weak currency encouraged expat demand for property. While Brexit does make the UK less desirable, London, in particular will always be a global destination. The rest of the UK may not fair as well, but London property will quickly find a floor if the GBP/USD trades, say 1.10 in 2019.
With a decision require by October, the reality of Brexit is in the here and now. While a concession by both sides – kicking the can down the road – is the only way to avoid economic disruption, the political haggling, primarily within the UK government, means that a Hard Brexit is the most likely scenario. Such an outcome would see yields and the GBP collapse and the UK head towards recession and years of economic stagnation if Jeremy Corbyn becomes the next Prime Minister.
Markets have remained focused on the prevailing economic data that has been broadly positive. However, it is difficult for me to paint a scenario where this is maintained. The thematic model portfolio added to a long UK 10-Year Gilt position last week and also to a long EURGBP position that looks poised to head to parity over the next 12 months.
Trading the GBP versus the USD is more problematic as the US cross currents are too wide and varied. GBPJPY is a compelling way to express this view and we will establish a new short if GBPJPY trades back to 1.45.