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Logjam in Brussels

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Currency markets showed some volatility at the beginning of last week as North Korea sent a missile over Japan. The pariah state was adding to geopolitical fears on Sunday as the announcement came that Pyongyang had successfully tested a hydrogen bomb. Whether or not Kim Jong-un’s team can sufficiently miniaturise such a device to fit into a nuclear missile remains to be seen.

Markets remain somewhat on edge over events on the Korean peninsula, with the JPY, CHF and gold all beneficiaries of the uncertainty. However, it is interesting that market reaction has been relatively contained so far. Certainly, the market’s assessment of the probability of a serious outcome over North Korea remains low.

Sterling was under pressure for most of last week, trading as low as 1.0743 against the euro as Brexit negotiations appeared grid-locked on account of the ‘divorce bill’. However, there were rumblings to the effect that European exporters are becoming unnerved by the apparent lack of progress and may start putting pressure on their national governments to encourage Michel Barnier and his team to show the very flexibility and imagination for which David Davis is calling. The point is that negotiation has to involve compromise, and the EU’s intransigence over settling the Brexit bill before moving on to other items is beginning to look unreasonable.

The great fear after Theresa May’s catastrophic election result has been that the British negotiating team will be hamstrung since the EU will know what can ultimately be passed by parliament and what cannot. That said, the EU negotiating team may be even more constrained. Barnier knows that he must secure a settlement that is acceptable to the widely differing interests of 27 member states. Given the multi-year timetables of previous EU trade deals, he also knows that this is impossible within the March 2019 deadline. He is, therefore, sticking out for a decent divorce bill, followed by the inevitable several years of transitional arrangements – by which time the already 66-year-old chief negotiator may well judge that the whole mess will be someone else’s problem. Unfortunately, this does not help German car manufacturers and other European exporters, who will become increasingly hot under the collar if Barnier continues on his current course. Given the influence of industrial lobbyists in the major member states, we are set to see a new dimension to the Brexit talks as European business takes an ever keener interest.

Of course, the UK business community is not without its own concerns about the Brexit negotiations. The next round will be the penultimate one before the European Council meets on 19 October to decide whether “sufficient progress” has been made on the terms of the UK/EU divorce. Only a ‘yes’ vote will permit subsequent rounds to involve discussion of the UK’s future relationship with the EU27, including any potential trade deal with the bloc. If Britain is to retain the international role that it so painstakingly built up throughout the twentieth century – both as a global hub for talent and as a bridge between the US and the rest of Europe – then such a deal is crucial. There may be limited appeal to working with a country that chooses to isolate itself from its closest partners – and this is what, for now, is weighing on sterling.

One could, therefore, be forgiven for thinking that there would be a sense of urgency on the part of the UK’s negotiating team to reach an agreement over the withdrawal terms. To date, however, talks have proceeded at a pretty sclerotic pace, largely as a result of Davis’ understandable reluctance to discuss an explicit figure for the UK’s outstanding financial obligations to the rest of the EU. A Sunday Telegraph article last month gave a glimmer of hope that some progress had been made, reporting that the Government had approved a divorce payment of up to €40 billion (£36 billion) which compared favourably with the EU’s initial figure of €100 billion (£92 billion). Brussels officials are not known for their ability to contain leaks but on this matter they had doubtless been read the Riot Act, which is why their total silence, together with denials from every member of the UK Government that the media has managed to corner on the topic, suggests that progress has not been as forthcoming as one might have hoped.

Certainly, at first glance, the magnitude of the withdrawal payment gives the appearance that it is worth haggling over. Yet it pales in comparison with the size of the UK’s annual exports in goods and services to the EU, which in 2016 totalled £240 billion, or 44% of the country’s total exports. It would not take much of a dent to this figure, which could certainly be provided by an inability to trade efficiently with the bloc that forms our largest single overseas market before any savings on the divorce bill were completely wiped out. Davis’ analogy for the process being followed by the UK delegation – that of going through a hotel bill line by line before deciding how much they are willing to pay – will have done nothing to improve the image held abroad of the British sense of entitlement.

Yesterday we saw the UK construction PMI for August which fell from July’s 51.9 to 51.1, against expectations of 52.0. Manufacturing PMI, announced last Friday, rose to 56.9 – up from 55.3 in July and much above the expected 55.0 – boosted by the weaker pound. This morning saw the crucial services number which came in at 53.2, below expectations of 53.5 which were, in turn, lower than July’s reading of 53.8. This morning we have also seen PMI data for the eurozone, with the composite figure, at 55.7, down a notch versus expectations but still showing robust good health. Little wonder that the euro trades so strongly. After Mario Draghi failed to give much away at Jackson Hole, all eyes will be on him at the press conference following the ECB council meeting on Thursday. It would be a surprise if he were to announce a change to either interest rates or the asset purchase programme. The market expects to have to wait for the October meeting for any announcement on tapering. This is particularly the case given the euro’s current strength. That being so, unless there are dovish surprises from the Fed, the current euro rally looks very mature.

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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