Monthly UK developments April 2017


Brexit news

After an extended parliamentary debate, the bill authorising the prime minister to invoke Article 50 of the EU Treaty of Lisbon- the legal basis for leaving the European Union- finally became law last month as on March 13th the House of Commons rejected two amendments that had been proposed by the Lords and the upper house then backed down. PM Teresa May finally sent the letter invoking article 50 to the European Council on March 29th and the official 2 year countdown for the UK to leave the Union begun.

The negotiations are definitely going to be rough once they start and neither side appeared to be ready. To top it all a new uncertainty has been added to the puzzle: The snap election called for June 8th in the UK. The financial markets took the announcement as a sign that the government would be able to pursue a softer, more market-friendly version of Brexit on the basis of PM May enjoying a comfortable majority. PM May is considered to be a moderate Conservative and breaking away from the grasp of the hard-line elements within her party will give her more flexibility and she would be in a stronger position to make the necessary compromises with the EU.

But for this to happen, the Conservative Party must first secure a large enough majority to allow PM May to negotiate from a position of domestic strength and reduce the influence of fringe elements in her own party. Evidently, there are about 20 serial rebel Conservative MPs that have voted against the government on European issues and this represents only the ‘hard-core’ of the Eurosceptic vote: Sixty MPs backed a petition to leave the Single Market late last year and in 2011, eighty-one voted against the government on a motion to hold an EU referendum.

So if PM May is to be able to have some leeway in the negotiations and not be bound by these ‘’hard-core’’ Brexiteers a minimum majority of between 50-60 seats is needed.

The latest 10 poll average shows a Conservative lead of around 18 points. Under a uniform swing, this would be enough to deliver a majority of between 110-150 seats for the Conservatives, but two things we must keep in mind:

First, the confidence in British pollsters to predict elections has been undermined in the last two years, with the 2015 UK general election a good example.

Second, this election is likely to be particularly unpredictable given that both the Conservatives and Liberal Democrats are seeking to pick-up votes in unfamiliar areas and already there are polls that show that Jeremy Corbyn’s Labour Party has nearly halved the gap with the Torries from 21% to 11% since the election was announced.

So investors and politicians will be keeping an eye on polls (for lack of a better alternative) to decipher the election outcome and the prospects for a ‘’soft’’ or ‘’ hard Brexit” but at the same time in the background there is the yet unquantified Brexit bill estimated at anything between €24.5bn and €72.8bn. There are 3 main components for this cost and all are derived from the UK’s EU membership:

The first, and largest, covers the gap between payments made in the EU’s annual budget and the larger “commitments” made under its seven-year budgetary framework, approved by Britain and the 27 other EU governments. Britain’s share of what Eurocrats call the reste à liquider (or amount yet to be paid) could be around €29bn.

The second element covers investment commitments to be executed after Britain leaves the EU in 2019. Most of this is “cohesion” funding for poorer countries and even though the British government will claim that its taxpayers shouldn’t be on the hook for payments due after Brexit, the Brussels bureaucrats will counter that Britain’s approval of the current EU budget that runs till 2020 obliges it to pay up an estimated €17.4 billion

The third component is pensions for the Eurocrats for the EU’s unfunded scheme being approximately €60 billion. Even though Britain could offer to cover its own nationals, the EU would counter that all such liabilities are joint, as the Eurocrats work for the EU and not their governments.

This could turn out to be one of the fiercest debates in the negotiations as Michel Barnier who will lead the EU’s negotiation team puts the figure at €40 to €60 billion whilst the Brexiteers believe that no such liability exists since it is leaving the club. If a compromise is not reached, the UK might find itself accused in the International Court of Justice and the talks could be over before starting.

In any case, there are other important pieces of the puzzle in play: The French second round presidential elections on May 7th which will see a staunch Europhile , Manuel Macron fighting it off with Front National’s Marine Le Pen and the German elections in September which will dictate the timing when the actual negotiations begin

Exchange and Interest rates

Following last June’s Brexit referendum the Sterling has dropped by a tenth in a matter of days. Investors and speculators were fearful that parity loomed both against the Euro or even the US Dollar. It hit a trade weighted all time low back in October 2016 but despite the UK government hardening its stance since opting for a ‘’Hard Brexit’’ ( Leaving the single market and putting curbs on immigration , both of which are very likely to hurt the UK economy) the currency has recovered. Ever since October that economic data from the period after the referendum started becoming available and showed that unemployment continued its declining trajectory whilst business activity was buoyant sterling was regained its footing. It has found renewed support after March’s  Monetary Policy Committee meeting that had 1 member voting for a hike in interest rates to keep inflation in check as opposed to the 9-0 result from the previous meeting but serious headwinds are ahead. Most important is the UK’s gigantic current account deficit which at 5% of GDP is by far the highest of all the G7 countries. For the moment and despite the Brexit uncertainty the UK is considered a stable economy leading to sufficient inflows (think of buying mansions in Chelsea, buying tech firms in Cambridge or parking funds in UK banks) to keep two way flows somewhat balanced, the sterling can have some respite or even appreciate. The announcement for the snap elections had seen it rise as high as 0.83 against the €uro (1.2050) and 1.29 against the dollar.

The Euro managed an impressive relief rally after Sunday’s French elections and appears to be well supported in the 0.8150-0.8300 region which is critical for its future prospects. As long as it holds above that level I am inclined to bet with the trend and aim for 0.88-0.90

At the same time Purchasing Power Parity analysis suggests the Pound is not that cheap, particularly against the Euro. On a PPP basis (Purchasing power parity -PPP is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries) EUR/GBP, which reflects the lion’s share of the trade weighted index, is now below fair value. GBP/USD is cheap as estimated PPP fair value is at 1.42, but this largely reflects the strength of the dollar. As can be seen from the chart below Sterling has managed to re-test levels not seen since the aftermath of last June’s Brexit referendum but it has a long uphill struggle ahead with strong resistance in the 1.30-1.35 level

The Pound could also be vulnerable to a possible ECB interest rate tightening in the autumn as Sterling was the largest beneficiary of Eurozone outflows following the introduction of negative rates and QE in 2014 and 2015 respectively. If the Bank of England remains on hold, the Fed taper tantrum experience suggests some of these flows could reverse.

Inflation is Bank of England’s main concern and they will shift interest rates higher once their target of 2% is threatened in a sustained manner and should wages start picking up speed then the underlying inflationary picture would be deemed strong enough to warrant a Sterling-friendly interest rate rise. The problem is that wage growth remains static.

As can be seen the GBP 3 month LIBOR rate has been languishing below 1% since 2012 and the Brexit referendum dealt it another blow almost halving its value with no sign of a perking up.




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