Economic Insight. Brexit: Three months on

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1 e Economic Research Economic Insight Brexit: Three months on Exactly three months since the British electorate voted to leave the EU, we are not much further forward in terms of how matters will proceed. The UK government has gone to great lengths to suggest that it will abide by the will of the electorate. But it is also aware that the national economic interest will be put at risk. Consequently, the Article 50 process will not be triggered this year although there are suggestions it will be initiated in We take a look at the current state of the debate to assess where the UK and indeed, the rest of the world stands today. Key points The UK economy has not shown much sign of weakness although we maintain that caution is warranted and that the longer-term effects will be more substantial. Uncertainty indicators suggest that the recent spike has faded, but it remains elevated relative to pre-referendum levels (pp. 1-3). 23 September 2016 All we know for certain is that Article 50 will not be triggered this year. There have been suggestions that it will be initiated in early 2017 but the UK government refuses to confirm this. One reason for caution is that the UK does not have the resources to engage in full-blown trade negotiations with the EU, nor does it have any clear idea how it wishes to proceed. But the international community both in the EU and beyond is increasingly in favour of a rapid start to negotiations in order to restore some certainty to the debate (pp. 3-5). We sketch a series of possible post-brexit economic outcomes which might await the UK, assigning a subjective probability of 70% to the likelihood that the UK does indeed leave the EU (pp. 5-7). Assessing the current economic position Three months ago to the day, the UK electorate voted in favour of leaving the EU. In the immediate wake of the referendum, markets collapsed and sentiment indicators pointed to a temporary dip in economic activity. Thereafter, however, much of the hard data has suggested that the referendum outcome did little damage to the economy. Although the manufacturing and purchasing managers indices in July fell below the 50 level consistent with a contraction in activity, they subsequently rebounded in August (chart 1). The surge in July retail sales volumes by 1.9% relative to June was perhaps the most compelling evidence of economic resilience. Indeed, such has been the lack of impact so far that it has given rise to claims that the concerns expressed by Project Fear were overstated and (to quote one newspaper) that economists need to relearn a little humility, especially when it comes to trying to understand the impact of a gargantuan event such as Brexit 1. Whilst it is true that the economy has performed better than expected so far, it is way too early to claim that the economy will be able to shrug off the consequences of the Brexit vote. For one thing, the UK has not yet left the EU and we should review matters in the wake of an Article 50 announcement or better still, after the discussions are concluded. Moreover, economic forecasts made in the wake of the referendum decision were based on the likelihood that Article 50 would be triggered relatively soon thereafter (recall David Cameron s pledge that it would be initiated immediately). In addition, we were braced for a summer of political turmoil in anticipation of the fact that the new prime minister would not be known until September, following a protracted Conservative leadership election campaign. In the event, Theresa May s accession to the premiership on 11 July followed by her pledge not to trigger Article 50 this year removed these two potential sources of uncertainty. 1 Why economists are hopeless when it comes to Brexit, Daily Telegraph, 19 August 2016 For important disclosure information please see page 8. research.commerzbank.com / Bloomberg: CBKR / Research APP available Author: Peter Dixon peter.dixon@commerzbank.com Chief Economist: Dr. Jörg Krämer joerg.kraemer@commerzbank.com

2 CHART 1: PMIs rebound in August Manufacturing Services CHART 2: but GDP growth is still slowing Monthly GDP indicator, rolling percent change vs. previous 3 months Source: Bloomberg Q3 GDP growth likely to be better than feared but worse than in the absence of the EU vote Uncertainty indicators reveal a huge spike over the summer Policy uncertainty showed the biggest jump although it has since diminished It thus appears unlikely that we will see the contraction in Q3 GDP that we anticipated in the aftermath of the referendum. But our monthly GDP tracker, based on actual information to July and estimates through September, suggests that Q3 growth is still likely to moderate sharply compared to the substantial 0.7% increase in Q2 (chart 2). Indeed, May and June were weak months, and with data so far suggesting that July was not strong either, the net effect points to a moderate growth dynamic in Q3 with a quarterly growth rate of just 0.1% to 0.2%. Whilst a positive result is good news, this belies the fact that our pre-referendum forecast was based on a Q3 growth rate of around 0.6%. It is easier to rebut the charge that 90 per cent [of economists] believed that Armageddon was on the cards merely as a result of the Leave vote. The majority of the economics profession (including ourselves) believed that the full implications of Brexit would only be evident in the medium term and of the four market predictions we made between February and April, only one was not realised 2. A question of uncertainty Uncertainty was, and remains, a key element of the economic and policy landscape. In order to measure it, we have created our own index based on a range of indicators 3 (chart 3). The aggregate uncertainty index, which includes financial and real economic factors spiked sharply in June and July, although nowhere near as much as in autumn But the domestic indicator, which focuses only on the real economy and policy uncertainty, hit a record high in July on data back to The primary contributor to this was the massive unprecedented spike in the news-based policy uncertainty index (chart 4), created by Stanford economist Nick Bloom and colleagues, which draws on newspaper counts containing the terms uncertain or uncertainty, economic or economy, and one or more policy-relevant terms. Recent trends in this indicator are notable for a number of reasons. First, even today the policy uncertainty index remains elevated far more so than prior to the EU referendum. And second, although economists stand accused of generating uncertainty, let us not forget that this index is based on media citations of uncertainty. A standard measure of uncertainty used in the economic literature is the dispersion of forecasts, which has risen sharply since the referendum. Using a simple average of the difference between the high and low forecasts derived from the range of consensus projections, it is evident that dispersion has increased (chart 5). 2 See Brexit: A market perspective, Economic Insight, 14 April 2016 where we highlighted that GDP would continue to show positive growth and that the longer-term impacts would take up to six years to fully show through. We also noted that four market outcomes were likely in the event of a Brexit vote: (i) sterling would collapse by 10%; (ii) the BoE would respond with a rate cut; (iii) equities would rebound after an initial decline and (iv) gilt yields would rise. In the event, the first three of these occurred although the fourth did not. 3 The aggregate indicator is a simple average of the deviation from the long-term trend of the following eight indicators: UK equity volatility; EURGBP 1-year volatility; GBPUSD 1-year volatility; a policy uncertainty indicator; expected consumer finance situation; expected household economic situation; expected household unemployment situation and the impact of uncertainty as a factor limiting corporate capex. The domestic indicator excludes the first three of these 2 23 September 2016

3 CHART 3: The uncertainty spike is fading Number of standard deviations from long-term average Domestic (ex. financial variables) Total CHART 4: Policy uncertainty was the real problem Number of standard deviations from long-term average, 20-day ave Source: Theresa May says Brexit means Brexit but nobody really knows what that means It is still possible although unlikely that the UK will decide not to leave CHART 5: Economic uncertainty remains elevated Average difference between max and min GDP growth forecasts, % This is typical behaviour when the economy is subject to significant shocks. However, market risk measures have declined significantly: FX option market volatility has fallen back to January levels, even at longer horizons (chart 6), as has equity volatility. There is a sense that Brexit concerns are no longer featuring on markets radar screens, primarily because nothing has happened with regard to implementing Brexit over the past three months. But this may be overly complacent. The open questions of if The political establishment has gone through a phase of bloodletting since the referendum, with the departure of David Cameron as prime minister and his replacement by Theresa May resulting in a change of government personnel and policy emphasis. Upon taking office, Mrs May promised that Brexit means Brexit. It is far from clear what this means: Increasingly, we interpret it is a means of taking some of the heat out of the debate in the wake of the referendum and holding the disparate wings of the Conservative Party together until such times as the government has figured out what to do next. Mrs May has also indicated that there will be no attempts to stay in the EU by the back door. On the surface this suggests that the government is committed to initiating the process of taking the UK out of the EU. But we should beware of inferring too much from such comments, particularly since Mrs May was (perhaps somewhat reluctantly) a Remain supporter. The House of Lords Constitutional Committee (HoL) 4 suggested that It will be the Government s task to determine how the will of the people, expressed in binary terms in the referendum, should be implemented, and where among the range of potential outcomes the final settlement by which the UK leaves the EU will be made. But a careful reading of this key paragraph does not CHART 6: Longer-dated FX vol has retreated ATM implied volatility, percent Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug year 3-year Source: Consensus Economics, Commerzbank Research Source: Bloomberg 4 The invoking of Article 50, House of Lords Select Committee on the Constitution, HL Paper 44, 13 September September

4 Article 50: Not this year, but when? Unclear whether domestic parliament will have any say Government has set up a Department for Exiting the European Union which is headed by a eurosceptic, but it will not operate independently of the PM s office suggest that the government is bound by the result to leave the EU. We continue to assign a non-zero probability to the possibility that the UK may not actually invoke Brexit, although this subjective figure is significantly less than 50%. and when the UK is likely to leave the EU If the UK is to leave the EU it will have to trigger Article 50 of the Lisbon Treaty, as the HoL reaffirmed, which will open up a two year negotiation process. The UK government appeared at one point to hold out the prospect that the EU would give some preliminary guarantees before the process was initiated which would make it easier to reach an agreement within the specified time frame. However, the EU appears to have quashed this hope. We are thus in limbo, without any indications when the UK will begin exit negotiations. All we know at present is that Mrs May has ruled out invoking Article 50 this year. The prime minister recently told parliament that she will not give a running commentary on exit plans and made it clear that the government will not take decisions until we are ready or reveal our hand prematurely. There have been numerous suggestions that the decision could take place in early 2017 but it would be wise to remain cautious at this stage. Moreover, the UK is still struggling with the question of whether parliament will be given any say over the process. One leaked source told a national newspaper in August that Mrs May will not hold a parliamentary vote on the matter. However, a group of lawyers has posed a legal challenge, arguing that Article 50 can only be invoked once the European Communities Act of 1972 (the legislation drawn up when the UK originally entered the EU) is repealed, which would require a parliamentary vote. The case is due to be heard in the High Court in October. The HoL report also explicitly recommended that The Government should not trigger Article 50 without consulting Parliament. Dealing with the immediate issues raised by Brexit What we do know is that the government has set up a Department for Exiting the European Union (DEEU) with responsibility for overseeing negotiations to leave the EU and establishing the future relationship between the UK and EU. It is headed by veteran eurosceptic David Davis and is formed of staff from existing government departments, which has prompted fears of a turf war as staff are transferred around Whitehall. As we illustrate in chart 7, the DEEU will be very much subject to the demands of the prime minister s office and it is questionable how much freedom it will have to pursue its objectives. One of its immediate tasks will be to find the trade negotiators required to conduct discussions with their EU counterparts amidst concerns that the UK does not have sufficient staff to cope. Mr Davis s initial parliamentary speech in his new role was vague, but he did indicate that it was very improbable that the UK would remain within the single market if it means accepting the free movement of labour a view which was rejected by the prime minister. This highlights a growing split between MPs who favour a quick exit and who are less concerned about single market access, and those seeking a more considered withdrawal in order to maintain access. CHART 7: Stylised representation of how government may handle the key Brexit issues Immigration 10 Downing Street Trade negotiations Article 50 Single Market access DEEU 4 23 September 2016

5 CHART 8: The confused state of the Brexit debate: What politicians are saying Brexit means Brexit Theresa May 11 July 2016 If a future treaty between the UK and the EU 27 is deemed to be a mixed competence, it will have to be ratified by 27 national parliaments. I think I am right in saying the shortest time in which that has been done in any EU treaty is just under four years Chancellor Philip Hammond 12 July 2016 It would be a fatal error to assume that the negative result in the UK referendum represents a specifically British issue European Council President Tusk 13 September 2016 We would be happy if the request for Brexit could happen as quickly as possible... There can be no a la carte access to the single market European Commission President Juncker14 September 2016 What now? The world wants to know No plans for dealing with the immigration question The UK is finding it difficult to decide what to ask for and how best to achieve it The UK will not have everything its own way We highlight the outcomes which might await the UK Indeed, it is far from clear how the government intends to shape its attitude towards the single market although it is clear that other EU nations would be keen to get the process underway (chart 8). Non-EU countries take a dim view of the UK s efforts to leave the EU. Mrs May received a cautious reception at the G20 summit in early September, where President Obama reiterated that the first priority of the US is to ensure a successful conclusion of negotiations on the TTIP rather than securing a deal with the UK. The Japanese government went further, issuing a 15-page report outlining the problems which Brexit could cause for Japanese firms. The thrust of the document was a plea for business conditions to remain broadly as they are now, otherwise this could force Japanese companies to reconsider their business activities. What we do not know is how the government intends to deal with the vexed issue of immigration, which was the key element at the heart of the referendum campaign. For domestic political reasons, the government does not appear inclined to accept a continuation of the status quo. But Mrs May has vetoed the idea of a points-based immigration system, which sets quotas for migrants based on their skills and potential contribution to society, and which was championed by prominent members of the Leave camp. There are no alternative plans on the table at present. Whilst many foreign investors are keen to know the UK government s timetable three months after the referendum, it is evident that all of the questions raised before and after the referendum campaign remain open. This is partly because the impression was created during the campaign that the referendum would produce a binary outcome: a vote to leave would result in Article 50 being triggered and exit would proceed thereafter. This was always a false assumption. For one thing, there was a presumption in government that the electorate would not vote to leave, with the result that there was no plan for what to do next. Moreover, the relationships between the UK and EU are so tightly intertwined that it is difficult to decide both what to ask for and how best to achieve it. What sort of future? Contrary to what we heard during the domestic campaign, the decision as to what happens next will occur on a negotiated basis everything will depend on what both the UK and the EU want. And the UK does not hold a very strong hand: around 47% of UK exports go the EU but only around 16% of EU exports are bound for the UK. We have previously highlighted the problems which the UK could face in the event that obstacles are placed in the way of access to its largest single export market. In order to give some idea of the post-brexit arrangements which might await the UK, we set out a number of scenarios and assess what their economic consequences might be (table 1). As a starting point, note that we have assigned a subjective probability of 70% to the likelihood that Brexit will happen, implying a 30% chance that it does not. Many people might believe that such an estimate is way too high, but it is designed simply to show that the likelihood that Brexit will not take place is non-zero and maybe higher than many people assume. However, this figure will be subject to change as events unfold and can be expected to decline further. 23 September

6 TABLE 1: Possible scenarios for future UK-EU relations Hard Brexit Swiss option Norwegian option Does not happen Probability 20% 20% 30% 30% Overview Allows the UK to pick and choose UK joins EEA, thus maintaining The best option all round. Could which parts of the legislation it is access to the single market. But happen if Article 50 is never prepared to sign up for. Swiss the UK has no say over triggered. Market reaction Reliance on WTO rules in trade costs per head around 40% of legislation and still pays costs per depends on how it is achieved. If relationships with other EU current UK levels but it has no head of between 80% and 90% it occurs as a result of a one-off members where provisions for agreement on services. If the UK of current levels. Free movement announcement, we see an services trade are limited which were to do some agreement on of labour will definitely be immediate market rally and will badly impact financial financial services, we might required. Good for financial economic confidence bounce. services expect the costs to rise vs. services but economically and But if it is a slow dawning current Swiss levels. Free politically almost the worst process of realisation, the rally movement of labour likely to be possible option. will be far slower required. Growth impact Long-term average closer to 1% Slightly slower than in baseline Normalises in line with previous vs 2% in pre-referendum (1.75% vs 2%) due to more baseline (~2% in medium-term) baseline restricted access to single market Longer-term growth averages 2% BoE takes rates back towards the Short-term rates stuck close to Rates rise towards 3-3.5% with 3-3.5% range but markets Interest rates zero for a prolonged period but BoE begins to nudge rates S&P upgrading UK by one notch continue to demand higher risk premium in gilts forces towards the 2-2.5% range to AA+ but fails to get AAA rating premium because UK's position steepening of yield curve back. as a reliable safe haven has been permanently damaged Sterling Ultimately 30% below prereferendum levels Recover to pre-referendum levels and holds there Recover to pre-referendum levels and holds there GBP ultimately 5-10% above prereferendum levels A hard Brexit would be the worst outcome But there are problems with maintaining access to the single market Probably the worst possible outcome from a UK perspective would be the scenario of Hard Brexit. This could occur if the UK triggers Article 50 and is unable to reach an agreement with the EU after the mandatory two years with the result that trade negotiations have to proceed on the basis of WTO rules. Since provisions for services trade are not well developed this could have a major adverse effect on financial services. At least the UK would be able to impose the immigration controls which many of the Leavers desire. But limiting labour input would likely reduce the UK s long-term growth rate, resulting in a further sell-off in GBP denominated assets. We assume the UK government will wish to avoid this outcome, and therefore assign a probability of just 20%. The scenarios entitled Swiss and Norwegian options involve ways in which the UK would be able to maintain access to the single market. Both are likely to involve some form of free movement of labour and both are likely to be relatively expensive. Indeed, whilst the Norwegian option would pose the least economic disruption, it essentially is the model the UK already enjoys as an EU member except that it gives up its right to influence the legislation. This make it almost the worst possible choice from a political angle. But the EU will be less than keen to offer Swiss-style access to the single market, particularly in view of the 2014 referendum in which the Swiss voted in favour of limits to immigration. Simply put, the EU appears increasingly less willing to offer single market concessions to countries which are not prepared to abide by the commitment to free movement of labour, and can be expected to extract a high price from those who enter into any such negotiations. Ultimately, the UK will not secure a deal which is exactly the same as those offered to other nations. For one thing the economy is larger than either Norway or Switzerland which may give it a bit more clout. Moreover, Mrs May has already suggested that the model we are seeking is one unique to the United Kingdom and not an off-the-shelf solution. Immigration will certainly prove to be a stumbling block unless the EU is prepared to offer some form of concession. The prospect that the UK remains in the EU is still on the table but the likelihood is dwindling So what are the prospects for the UK remaining in the EU? Newspaper reports from the latest EU summit in Bratislava suggest that the EU may well take a hard line position which makes the UK think twice about leaving. This would not be a very sensible attitude for it runs the risk that both sides adopt entrenched positions, and with UK government unable to be seen to capitulate for domestic political reasons this would make it difficult to come to an agreement. However, an alternative strategy would be for the EU to adopt a more emollient tone whilst wrapping the 6 23 September 2016

7 procedure in red tape, which prolongs the UK s membership to the point at which a future government secures a mandate to stay in the EU. Of course, this would mean that the UK s future within the EU would only evolve over a period of time, with the result that uncertainty regarding business decisions would lift correspondingly slowly. Thus, even if such an outcome is in the UK s best long-term interests, there may still be significant short-term costs. However, from an EU standpoint, this would not be such a problem since it would highlight that there are economic costs associated with efforts to leave. Last word The UK government faces a far bigger dilemma than it will ever admit to in public even if it has been well documented by the commentariat. If the government does not begin exit proceedings, it will stand accused of failing to listen to the will of the people. But if it invokes Article 50 without knowing what the end result is likely to be, it risks a deal which is not in the UK s national interest. This is a classic Catch-22 position: If it risks the national interest, it will almost certainly make the electorate economically worse off. But if it looks out for the national interest, it will further enhance the distrust of the political class, which played such a role in the referendum result, and could lead to even more extreme political outcomes. This highlights one glaring necessity: Compromise must be the name of the game, both in order to ensure political stability in Britain but also to ensure the longer-term survival of the EU project, which would almost certainly be damaged in a bruising fight. Fortunately, compromise is something the EU is very good at achieving. 23 September

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