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Brexit – has the fog lifted?

After Theresa May’s explanation of the Brexit process and The Supreme Court ruling, the UK’s intended departure date and destination look clearer. But, in his latest Ahead of the Curve monthly, Neil Williams, Group Chief Economist at Hermes Investment Management, believes the largest uncertainty now is the length of the journey ahead. Our negotiations, he argues, could stretch well beyond the two years assumed by Article 50.

Buckling up for a long journey...
Mrs May says no other countries’ membership models will be sought, which seems to rule out Norway and Switzerland’s associate memberships. Yet, her desire to “pursue a bold and ambitious free trade agreement” with the EU suggests she could yet behind the scenes negotiate to maintain access to - but no longer full membership of - the tariff-free customs union.

Securing access might be the ‘best of both worlds’. Turkey and Canada have enjoyed customs-union access with the EU without membership. Canada’s in 2016 came after seven years of negotiation. And, needing sign-off by all EU states, it was stalled by the Belgian region of Wallonia! Chancellor Hammond’s threat that without access, much lower UK corporate tax rates will be needed to maintain FDI and competitiveness (which risks a European ‘chase to the bottom’) looks an early stick to achieving similar privileges.

Access to the customs union could be the best of both worlds...
Even this will need time. First, the deal when struck will need Parliamentary approval, and then be subject to a ‘phasing in’ period (Mr Hammond has suggested two years) to allow firms, consumers and officials to adjust to the new arrangements. A second independence referendum in pro-EU Scotland, though not precluding Brexit, could also provide an extra hurdle to completing it before the General Election scheduled for May 2020.

Second, the UK is relying on a cooperative sign-off by its 27 EU peers. The only real precedent we have is Greenland’s exit in 1985. This was a ‘soft’ exit, but it took three years. We, larger and 44 years entwined in the EU, will need longer.

We’re opening the ‘trapdoor’ in a highly-charged political year. Voters facing national elections in Germany, France, The Netherlands and probably Italy may want to approach it as protest to six years of euro-zone austerity. In the ‘peripheral’ economies, reform fatigue and populist parties are building. Therefore, incumbents may be reluctant to condone an easy UK exit that puts its economy ahead of their own.

And with large members like Germany and France so far down the EU ‘path’, the threat of exit probably applies more to the newer entrants, like Croatia and central/eastern Europe whose EU pedigree is less engrained.

Third, EU law forbids trade-deal ‘bigamy’, in terms of enacting agreements elsewhere while still an EU member. This prevents a quick compensating tie-up with the US for example. So, a challenge is to remain close to the European negotiating table to maintain the best trade and regulatory deals for services, which account for 80% of the UK’s gross value added. This makes it more ambitious than a Canada-style deal.

Governor Carney’s ‘blind eye’ would be akin to King’s when the CPI breached 5%...
Which leaves the BoE watchful that a weaker pound doesn’t pump inflation. Should protectionist forces in the US and Europe build, which seems likely, inflation will reappear. But, it will be the ‘wrong sort’ – cost-push, led by tariffs, goods and labour shortages, rather than ‘feel-good’ demand-pull. Central banks will then have to ‘turn a blind’ eye as economies stagflate.

Our simulations show at current USD/GBP and oil prices, RPI inflation this April lifting to +3%yoy, from January’s +2½%yoy. But, combinations of a weaker pound and/or higher oil could feasibly take the RPI to +4%yoy. This would be a five-and-a-half year high. In each case, the CPI breaches its +2%yoy target in April. Further GBP weakness and/or oil strength would push it up to +3%yoy.

But, should that occur, we still doubt the MPC would react, given the feared hit to growth and the housing market. This would be akin to the ‘blind eye’ governor King turned in 2011 when the CPI climbed to +5.2%yoy as the pound weakened and energy/food prices rose.

And, with the Treasury also loosening the fiscal reins, this has further implications for the pound. No major economy has in the longer-term net loosened its overall (monetary and fiscal) stance more than the UK (see chart 1). And, given the subsequent inflation premium, there’s little coincidence that those running the more expansionary policies like the US/UK have generally sustained the weaker currencies (see chart 2).

The prospect now for UK policy to stay loose, Brexit negotiations stretching beyond the two years hoped for, and USD strength as the Fed raises rates and protectionism and repatriation beckon, should leave the pound vulnerable.

So, we could be choosing one of the worst times to negotiate an exit - given the anti-establishment feeling in the US and Europe’s election calendar. And, we’ll now have to compromise if we want tariff-free trade - after all, this is our second European ‘divorce’, after the ERM in 1992. So, any tie-ups in the future - with Europe or elsewhere - will probably come ‘with strings’. A bit like EU membership then!

Chart 1. No major economy has loosened policy more than the UK
Shifts since 2000 in real rates (using CPI, 3m Libor), and cyc adj budget balances

Source: Hermes Investment Management, based on OECD projections, IMF & Bloomberg

Chart 2. Which helps explain the pound’s relative weakness
Trade-weighted exchange rates, re-based to Q1 2000 (= 100). Quarterly data

Source: Thomson Reuters Datastream

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