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Brexit: The elephant in the room

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The blood-soaked battlefields of Europe were commemorated last week, with the 100th anniversary of the start of the battle of Passchendaele being marked with a memorial service in the town of Ypres, or ‘Wipers’ as it was affectionately known by the Tommies of the First World War. (The British have never been particularly good at mastering the subtleties of European languages, especially those emanating from Belgium). The casualties on the British and German sides are disputed, however it is estimated that both lost in the region of 250,000 men over the period of the battle, also known as the 3rd battle of Ypres. 
 
Theresa May took a break from her holiday in the Swiss Alps to attend the memorial service and would do well to reflect on the futile and destructive nature of European conflict. She famously declared that her decision to call a UK election was made whilst walking in the Welsh hills, so time away from the pressure of Westminster is clearly conducive to reflective contemplation. In her absence there is no official deputy, and Philip Hammond has taken the opportunity to push his agenda for a softer Brexit or a NoBrexit as it is beginning to be referred to. The Chancellor has made it clear that he believes that the UK economy will be damaged without a transitional period. He has proposed that the UK negotiate a simple ‘off the shelf’ transitional agreement which will maintain the UK’s current relationship with Europe for a further 2 years after Brexit. Protecting the UK economy will be important to ensuring that the UK maintains its sovereign credit rating and does not find the cost of borrowing spiralling.
 
Sir Alan Sugar has recently declared his view that those peddling untruths designed to boost the Leave vote, such as the £350m a day it was claimed would be available for the NHS, should be sent to prison. The majority of politicians, however, continue to cite democracy, saying that ‘the voters have spoken’. Perhaps their myopia needs to be pointed out, as those voters certainly did not give the Conservative government’s hard Brexit stance a ringing endorsement in the more recent general election. This is illustrated in the recently-released findings by the British Election Study which reported that the number one issue on voters’ minds was Brexit. All this may be true, but the appetite for action is low and the campaign groups disjointed. Alistair Campbell is trying to use all his once-famous powers as a spin doctor to mobilise a like-minded group of EU supporters to stop Brexit, however his missives on twitter seem to be echoing in a vacuum of apathy. As the dog days of summer continue this position is unlikely to change.
 
As the results of the European elections fall into place, contrary to expectation earlier in the year, the collective economy begins to gain some momentum. As a result, the UK faces a strong negotiator in this complex extrication exercise, while the damage to its own economic wellbeing continues. In his speech on Thursday, in which he announced he would be keeping the bank base rate at record lows, Mark Carney highlighted that the uncertainty of Brexit is beginning to weigh on the economy. He downgraded his growth forecast to 1.7% for 2017 and 1.6% for 2018. He stated that he expects to see an overshoot in the target 2% rate of inflation as a result of the continued weakness of the pound. The committee voted 6-2 to maintain rates at 0.25%, putting immediate downward pressure on sterling as the market unwound its interest rate expectations following the previous 5-3 split; however, they have moved to tighten credit by reducing the availability of cheap funding. The Term Funding Scheme (TFS), which allows certain banks and building societies to borrow BoE reserves in exchange for eligible collateral, will come to an end in February 2018. 
 
The question of when the BoE will raise rates will be driven by two factors: spare capacity in the economy and the inflation overrun. The main driver of the UK economy remains consumption – and in anything but the short term this is very dependent on real wage growth,   which remains negative on account of the exchange rate-related spike in inflation. Therefore, at some point, it is likely that shoppers will rein in spending. As a result, the inflation overrun will be kept to a minimum and will not require the intervention of the Bank of England to cool the economy. Indeed, it looks likely that the bank will not raise rates until the end of 2018. There are, however, a number of tools that could come into play before this happens. With QE assets still being rolled over to keep term interest rates low, the BoE could, as the Fed is currently considering, begin to taper the reinvestment of maturing bonds. This would have the impact of raising swap rates prior to the final push of raising the short-term rate.
 
While far from the only material factor currently affecting the UK economy, the manner of Brexit is now concentrating business minds. RBS have stated that in the event of a hard Brexit they will strengthen their operation in Amsterdam, making use of their Dutch banking licence to serve customers in the EU. Perhaps the acquisition of ABN Amro wasn’t such a bad idea after all! The UK government-owned bank has just reported one of its most successful quarters since the financial crisis. They will not be alone in moving operations to the continent in order to keep their business opportunities as diverse as possible. With no substantial progress or clarity about the way the UK will exit, it remains totally unclear what constitutes a good business decision.
 
Dunkirk was the last chaotic exit that the UK made from Europe, with 68,000 lives lost and all heavy equipment abandoned (20,000 motorcycles, 2,472 guns, 65,000 other vehicles; 377,000t of stores, more than 68,000t of ammunition and 147,000t of fuel). In addition, almost all of the 445 British tanks that had been sent to France with the British Expeditionary Force were also left behind. While this is popularly recognised as an incredible achievement in the face of adversity, as Churchill said, ”wars are not won by evacuations”. The UK’s EU exit fee is one of the many topics to be agreed, however initial indications (FT 19 June 17) are that it will take seven years to repay, based on the net contributions of approximately £7.75bn per year that the UK currently makes to the EU. With the critically-acclaimed film Dunkirk currently in the cinema, those responsible for the path of Brexit negotiations would be advised to spend some of their summer recess reflecting on the damaging impact of a potentially chaotic withdrawal. Small boats and Churchillian spirit may have worked seventy-seven years ago but something more nuanced will be required for Brexit if  a dark hour for the UK economy is to be avoided.
 
This week is a light one for data. The RICS house price balance for July, out on Wednesday, is expected to show a balance of +9 in July, after June’s +7, though given the well publicised weakness in the London residential sector, this may disappoint to the downside. Also on Wednesday are June industrial production (expected -0.1% y/y after May’s +0.2%) and June manufacturing production (expected +0.6% y/y after May’s +0.4%). Finally, Wednesday also sees the June trade balance for goods and services which is expected to be -£2.5 billion but unlikely to move markets unless very much adrift from expectations.

All views expressed here are the author’s own and are based on information and data available at the time of writing

 

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