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Full force of Brexit shock yet to feed through

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The astonishingly peaceful hills of Le Marche in central Italy are a good vantage point from which to reflect on life, politics and the markets. News that most of Italy’s banks had passed the EU stress tests was splashed across an inside double spread of a regional newspaper and Brexit seemed a million, rather than a thousand, miles away.

Apart from the odd tractor, wifi and mobile phones, the general rhythm of life appears to have changed little in decades, or even longer. It is difficult to imagine that ‘il Sorpasso’ – the moment when Italy’s economy overtook Britain’s in 1987 – made much of an impression here. However, the fact that the Italian economy is no bigger than it was in 2000 most certainly has. Unemployment appears high; the tables outside bars, which, ten or twenty years ago, would have been occupied only by elderly men, now enjoy a younger clientele. It is in the supermarket though, where Italy’s stagnation and ongoing flirtation with deflation manifests itself so vividly. Signs declaring, ‘this is not a promotion but a permanent price reduction’ abound. Despite sterling’s recent Brexit-induced depreciation, eating out is vastly cheaper than in even the most provincial of English towns.

For years, we have warned that the experiment of the euro, in denying the historically weaker European countries the ability to devalue their way out of trouble, would mean that the only available alternative would be general deflation to restore the competitive advantage that used to be achieved through currency devaluation. The process is drawn-out and painful. More flexible labour markets would help but these are slow in coming (leading inevitably to high unemployment) and Renzi’s reforms threaten to be subsumed in a wave of electoral protest represented by M5S (the anti-EU/euro Five Star Movement). The next eurozone crisis is unlikely to be far away.

Back in the UK, the initial shock of the Leave vote six weeks ago may be receding but this is very far from being borne out in the numbers. Last week’s pretty dreadful manufacturing PMI for July of 48.2 was beaten for pessimism by the more important services number of 47.4 and construction’s 45.9 which was above the market’s expectation of a collapse to 44.0. On the back of these numbers, it was no surprise (after wrong-footing the markets previously) that the MPC voted 8/1 in favour of cutting Base Rate to 0.25%. This was backed up with a £60 billion increase in the QE programme to £435 billion and a new commitment to create up to £10 billion of new money for corporate bond purchases. If the appalling PMI numbers are even close to reflecting the fate of the economy in the near term, it is unlikely that these moves will have much of an offsetting impact. After all, the 10 year gilt yield, while making a new low of 0.627% last Friday, only fell about 15 basis points on Thursday’s announcement. New Chancellor Philip Hammond may find himself embarking on a most un-Tory, deficit-widening infrastructure programme.
There may even be tax cuts funded by an end to the controversial but vote-winning ‘triple lock’ on state pensions, which always looked untenable in the long term, given the unavoidable truth of Britain’s demographics. Hammond’s best chance of freeing himself from the fiscal shackle of the triple lock will be this November, while he can still blame it on the recently sacked Osborne and the virtually extinct Lib Dems.

What is not clear, though, is that ending the triple lock will do much for the economy. If people can no longer look forward to a generously increasing state pension, they will have to save more for retirement themselves – and that is becoming ruinously expensive. Reports last week that some companies are offering up to 35 times the annual benefit of defined benefit pensions, in order to buy themselves out of their obligations, raised eyebrows in some quarters. However, depending on circumstances, the best annuities can cost considerably more than 35 times the annual income level (otherwise companies would not be so keen to buy them out). Indeed, at such high multiples, the size of the pot required to generate a decent income for those without a defined benefit pension means that people will have to divert increasing amounts of current expenditure into saving, thus reducing aggregate demand. Given the extremely low savings ratio, it is clear that this is not happening yet. Furthermore, most people’s understanding of pensions is so limited that this increased saving may never materialise. One does wonder whether Osborne removed the requirement to buy annuities because he suspected they were poised to become so astoundingly expensive.

Tomorrow sees the UK industrial production and manufacturing output (expected +1.6% and +1.3% year on year); the trade balance for June is also out tomorrow and is expected to be somewhat worse, but it will be July’s figure that more fully reflects the increased cost of imports post Brexit. Thursday sees the Royal Institue of Chartered Surveors house price balance, where the balance of surveyors seeing price rises over those seeing falls is expected to have fallen from 16% to 6% in July.

Finally, on Friday, construction output for June is expected to show a year on year decline of 2.1%. However, it will be next month’s data which will give a better idea of whether the dire PMI numbers are being borne out and whether the Bank of England’s worries of reduced demand – and even contraction in July – as expressed in last week’s Inflation Report, will turn out to be justified.

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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