THE DAY AFTER BREXIT June 2016

Transcription

1 THE DAY AFTER BREXIT June 2016 COLUMBIATHREADNEEDLE.COM

2 The day after Brexit Mark Burgess CIO EMEA and Global Head of Equities Picture the scene: The votes have come in showing that the British have not believed the strapline that Britain is stronger in Europe and the debate of whether Brexit is to be or not to be is moot. Today is the first day of the next two years that will determine just how Great an independent Britain really is. This is not an article arguing whether or not Brexit should occur, rather a discussion of what is likely to be the financial and market impacts if Brexit were to happen, over the next two years and beyond. What will the UK relationship with Europe look like? This is the key question that will create a great deal of uncertainty and could arguably result in a great deal of damage. This uncertainty stems from the conflicting demands the UK has from a relationship with the EU and the cost the EU would charge in exchange. 2

3 FIGURE 1 TYPES OF ACCESS TO EU In Subject to EU Regs Subject to EU Tariff policy Accept Free Movement Financial Contribution Design EU Rules Eurozone Member Eurozone X X X X X X EU Member (UK, Sweden) X X X X X European Economic Area (Norway, Iceland) X X X X European Free Trade Assoc (Switzerland) X X X Single Monetary Policy Out Customs Union (Turkey, Andorra) Free Trade Area (Albania, Serbia) X X X Most Favoured Nation RoW Source: Columbia Threadneedle Investments, Credit Suisse/IPSOS Mori January 2016 So what are the options? Figure 1 shows how things look for other EU members including where the UK was as a member of the EU. This is a good starting point for discussing the various options available to the UK. The most likely suspects would be a model similar to that of Switzerland, Turkey or Iceland. The problem with these though is that they are only fit for purpose for smaller countries and it is unlikely that an existing model will fit with all the complexities of the British economy and markets. An option like that of Canada has also been discussed but is likely to take longer to design and agree than the two years granted by Article 50. The UK would favour an agreement that: nmaintains easy access to the EU markets for UK businesses nhas some control over the movement of people (addressing the current immigration concerns) nallows deregulation, and nhas an ability to vote in EU decisions. Our estimates suggest that Sterling which had already dropped 5-6% before the vote has room to drop up to 12% further now as well as there being an uptick in volatility. The model that would best fit this would be a version of the Swiss model with more say over rules and better access to the EU market for financial services. However, this is a hefty wish list that has yet to be granted in any EU relationship and is unlikely to be without some considerable concessions on our part. Undoubtedly those still in the EU will not be eager to let the UK have their cake and eat it as this could set a precedent for others to follow suit. Therefore it is inevitable that at some point politicians will have to manage a trade-off between what is in the best interest of the economy and what we are willing to cede in terms of political power. Negotiations are likely to be long and arduous and there will be many iterations before an agreement is formed. The longer this takes the more uncertainty starts to impact the economy and so the fate of the UK lies in the hands of the politicians to reach a swift agreement that all parties accept a task few would envy. 3

4 FIGURE 2 CPI AND EFFECTIVE EXCHANGE RATE INDEX Percent Index FX Indexes, Bank of England, Effective Exchange Rate Index, rhs Consumer Price Index, Core CPI, Total, Change Y/Y, lhs Source: Macrobond- April 2016 In the meantime it is important to consider the various financial and market impacts for the UK and globally. Sterling The most obvious place to start when looking at the impact of Brexit is sterling. Currency markets, unlike it would appear, other markets, have begun pricing in Brexit in the run up to the vote. Our estimates suggest that sterling which had already dropped 5-6% before the vote has room to drop up to 12% further now as well as there being an uptick in volatility. Of course weak sterling is not entirely bad news for the UK - in fact there are many positives to be considered. The UK s current account deficit (as discussed later) could be helped by a weaker sterling. This may indeed be crucial if Foreign Direct Investment (FDI) falters rendering the current account deficit unmanageable. However, in order to completely cover the deficit a very large drop in currency would be required and in the long term sterling is not expected to remain that weak. Thus this would 4 only be a short-term boost rather than a long term solution and the issue of FDI will need to be addressed separately. Another benefactor of a weaker sterling can be seen in the equity markets. The FTSE 100 is comprised of around 70% overseas earnings and with a weaker sterling we expect an increase in earnings, which is positive for equities. There may be opportunities in the UK domestic stocks that have been sold off aggressively which can be taken advantage of now. In particular those stocks that were in the various Brexit Baskets created by investment banks as they tried to exploit Brexit concerns. Furthermore, evidently any exposure to overseas earnings is positive for investments as they benefit from a weaker sterling. Depending on just how weak sterling becomes there are a number of possible decisions for the Bank of England to consider not least interest rates. Interest Rates The BoE will undoubtedly push out the prospect of rate hikes and may even go as far as to cut rates, as long as sterling is not in free fall. This monetary policy easing is likely to be mirrored by the EU as they are faced with uncertain market conditions and losing one the world s financial epicentres, the City of London. Further easing increases the monetary policy divergence giving the Fed food for thought can they continue on the lonely rate hike path if global growth is stunted? With the weaker sterling already discussed looking at Figure 2 it appears at long last inflation may follow suit due to higher import and oil prices. Although inflation, given the long period of low and slow in the economy, would normally be welcomed, with such high uncertainty the BoE will still be forced to keep rates low so as to support businesses. Prolonging the lower for longer easy monetary policy environment has both local and global implications for the

5 FIGURE 3 NET DIRECT INVESTMENT IN THE UK BY FOREIGN COUNTRIES 100 Net Direct Investment, GBP bn /1/1998 1/1/1999 1/1/2000 1/1/2001 1/1/2002 1/1/2003 1/1/2004 1/1/2005 1/1/2006 1/1/2007 1/1/2008 1/1/2009 1/1/2010 1/1/2011 1/1/2012 1/1/2013 World Total EU27 Europe US Source: Macrobond April 2016 We should expect the prolonged period of uncertainty, brought about by the extended renegotiations to dampen GDP growth generally, sapping confidence and undermining activity more broadly. economy. However, this is not the only factor impacting the UK s economy that should be considered with a decision to leave the EU. Economy The primary concern as we moved forward without the EU is FDI and the UK s current account deficit. The UK has one of the largest current account deficits of the advanced economies and FDI is necessary to continue to fund this. Currently FDI from Europe makes up a large proportion of net FDI in UK as shown in Figure 3. Clearly this needs to be managed when negotiating the exit to avoid losing this investment. Even a faltering in the flow of FDI will be problematic to the UK and if this were to stop altogether (though granted highly unlikely), the UK would be in real trouble. Nevertheless there is still a substantial proportion of FDI which originates from outside of the EU. One can only hope that this was not invested in the UK purely as a platform into the EU. Turning our attention to trade, just over half of UK trade was with the EU, as at the end of It is still unclear what will happen to this trade with Brexit, however it is likely to reduce as the ease with which businesses could trade diminishes. A study from the Centre for European Reform, suggested that the UK s trade with the other EU members is 55 per cent higher than one would expect, given the size of these countries economies. This could imply that the UK has formed an overreliance on trade in the EU based on an ease of trade and, in which case, this will almost certainly reduce with a departure from Europe. Employment is another example where the EU contributes significantly. The UK has seen a steady increase in the number of EU employees over time. Outside of the free movement of labour in the EU we will see a shift in the composition of the UK workforce. While creating an increase in the number of jobs available to UK citizens, the inevitable time taken to fill these roles will impact companies if the EU employees are unable to 5

6 FIGURE 4 TRADE BETWEEN MEMBER STATES OF THE EU AND BETWEEN THE EU AND THE REST OF THE WORLD 6000 Exports plus imports, bn Intra-EU trade Extra-EU trade FIGURE 5 PROPORTION OF TOTAL UK TRADE WITH THE EU, SEPTEMBER % Proportion of EU Trade % 55% 50% 45% 40% Apr May Jun Jul Aug 2014 Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Period 2015 EU Imports EU Exports Figure 4 & 5 Source: Eurostat. The Great British Trade Off: The impact of leaving the EU on the UK s trade and investment. Centre for European Reform an HM Revenue & Customs: UK Overseas Trade Statistics Sept 2015 remain working in the UK. Ultimately this all puts pressure on wage rates and in turn the economic health of the UK in the short run. Finally, we should expect the prolonged period of uncertainty, brought about by the extended renegotiations to dampen GDP growth generally, sapping confidence and undermining activity more broadly. Markets Looking more specifically at markets again the main concern is uncertainty. While the politicians take their time debating who gets to keep the dog in the divorce the markets could work themselves up into a frenzy. If there is heightened volatility and a lack of confidence more generally in markets this makes for a tricky time for investors. Firstly, UK Gilts could be seen as less of a safe haven, due to the possibility that companies may move their headquarters elsewhere on fears that the BoE could struggle to maintain its grip on policy. However, the majority of Gilt holders are domestic pension funds and central banks which are unlikely to be flighty investors and leave the UK markets because of the Brexit decision. Therefore, it is likely to be more of a currency and stock 6

7 FIGURE 6 EMPLOYMENT LEVELS BY NATIONALITY EU & NON-EU No. of Persons Employment Levels By Nationality (16+) - Total EU (EU26) Employment Levels By Nationality (16+) - Total Non-EU Source: Macrobond April 2016 specific trade rather than a Gilt trade, and the impact may be limited. Secondly, within the equity markets different sectors will be impacted to varying degrees. The biggest impact unsurprisingly will be Banks while Retail, Other Financials, Insurance and Property are hit to a lesser extent. In contrast to this Utilities and large international companies are unlikely to encounter big moves, assuming of course that Scoxit does not immediately follow Brexit. Financial services provide the UK with a key competitive edge and if the international banks do not make a dash for the channel tunnel there will be a great benefit to the UK economy in the longer term. There are those who have already started moving across to Frankfurt and Dublin so as to avoid any additional bureaucracy as being in London was intended to be their gateway to Europe anyway. The wealthy investment bankers are not the only flight risk. There are probably rumours starting to surface about wealth/asset managers and insurance companies considering legal and regulatory hoops they need The reality is there is unlikely to be very little in terms of a reduction in regulation as in comparison the UK is already less regulated that the EU and where there are regulations the UK often leads the way with stricter rules. to jump through to continue their European business if not via the City. Thirdly, the obvious threats to the property market that would be: the loss of foreign buyers and the impact from bond yields; however the low sterling could counteract this and attract more interest. Should the government decide to change the rules surrounding property investment by non-uk residents we could see a decrease in investment. Though at least the sticky nature of the property market would prevent a quick withdrawal of investment by those already invested. A Plague upon all your houses? Potentially the most pertinent issue is the real risk now that others will follow in the footsteps of the UK s decision to leave. Nicola Sturgeon will rally the troops and have a Re-referendum to untie Scotland from the UK and get back into Europe, though will the Europeans want to take on an economy so dependent upon oil when oil remains an unknown quantity? Maybe they will if they take a long term investment view. 7

8 FIGURE 7 LEVELS OF PRODUCT MARKET REGULATION 3.0 Less regulated More regulated UK EU members after 2004 EU-15 Rest of OECD Source: OECD, quoted by Brexit and EU Regulation: A Bonfire of the Vanities? February 2016 Moving away from the British Isles might we see Frexit alongside other populist parties gaining traction throughout Europe? It has been argued that Britain could be seen as a safe haven amid a disintegrating Europe. This would encourage businesses to stay or indeed move across to the UK Britain s parting blow to the EU. Surely then the wisest move for the EU would be to make the process of Britain s exit as challenging as possible so as to deter others from following in our footsteps? I will speak Regulation to her but use none Regulation was argued to be a key reason to leave the EU and is the final point being considered in this article. Through the EU a number of regulations have come to pass since the Financial Crisis of 2007/08 with the aim of keeping an eye on the financial services and ensuring the general public are treated fairly. With the decision to leave the EU are those null and void until the UK government passes the directives as law? If so does this leave the financial services industry vulnerable or simply more attractive as a place to conduct business with less red tape? The reality is there is unlikely to be very little in terms of a reduction in regulation as in comparison the UK is already less regulated than the EU and where there are regulations the UK often leads the way with stricter rules. Overall, it is clear that a world post Brexit has its challenges as the next period of uncertainty ensues. With no similar events to review in history it is not possible to claim to know what will really happen on day one. One thing is certain All the world s a stage and all the men and women merely players. They have their exits and their entrances; And one man in his time plays many parts, how the world reacts to Britain s exit however, only time can tell. 8

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