One-year Brexit anniversary

One year on from the Brexit vote and a number of its knock-on effects for the UK economy are still very much in focus.

Sterling’s steep decline, for example, was among the immediate headlines after the referendum and the currency’s lower value has persisted to become the main driver of rising inflation. In turn, this ‘cost-push’ (= ‘bad’) inflation is straining consumer confidence and real income levels, which is a headwind that will need close monitoring in the UK’s heavily consumption-driven economy. It’s a key point just noted by Bank of England Governor Mark Carney in his Mansion House speech, and a main reason why interest rate rises are on hold for now despite the recent higher-than-expected Consumer Prices Index (CPI) readings.

This month’s UK general election, meanwhile, was a poor result for Prime Minister Theresa May, having gambled that the move would significantly boost her majority ahead of the pending Brexit negotiations. Instead, with the outcome of a ‘hung parliament’, we face the possibility of a new Conservative Party leadership battle and even another general election later this year. Such renewed uncertainty seems unlikely to be helpful to the UK’s negotiating hand in Brussels. In the long term, I believe the impact of Brexit will largely depend on trading relationships. Importantly, higher trade barriers, if implemented, will adversely affect growth and productivity in the short to medium term. However, much will depend on how the negotiations progress over the next two years, and it remains too early to speculate on what the impact might be in financial markets. The fall of the pound in the aftermath of the hung parliament vote was relatively modest (less than 2% against its major trading partners), suggesting that some expect the election result to produce a ‘softer’ version of Brexit. The fundamental valuation of sterling may have also prevented bigger losses for the currency – on a Purchasing Power Parity (PPP) measure (an example of which is the Economist’s “Big Mac Index”), the pound is already a very ‘cheap’ currency, perhaps 12% below its fair value.

From the softness evident in retail sales, house prices and inflation-adjusted incomes, the momentum of UK economic growth is fading as we move through 2017. As the election result and ongoing Brexit-related uncertainty suggest this trend continuing, the BoE’s monetary stance remains dovish, although the views of its rate setting committee have become more divided against the rising inflation factor (and a speech by MPC member and Bank of England Chief Economist Andy Haldane this week suggested he was considering joining the ‘hawks’ on the Committee, provoking higher short-dated gilt yields). For government watchers, the new, weaker Conservative administration may apply less austerity and fiscal tightening in future, but we do not yet expect a significant rise in gilt issuance. The goal of reducing the UK’s debt/GDP over the next few years is likely to remain in place, but the ratings agencies are getting nervous, and further downgrades to the UK’s credit ratings are increasingly possible.

My global bond strategy has generally underweighted sterling exposure since before the Brexit vote (I’ve long been worried about the UK’s current account deficit), with preferred currency exposures that have included a sizeable (but reduced in the wake of the large ‘Trump bounce’) allocation to the US dollar. Within bond markets, my favoured exposures include US dollar-denominated floating rate bonds from blue-chip banks and financial issuers, largely as a play on the strengthening US economy and rising US interest rates. I’ve lately reduced some corporate bond exposure within my funds – not because default rates have become worrying (they remain very low), but because they’ve performed so well over the past year and valuations have become less attractive.

Jim Leaviss – Head of Retail Fixed Interest – M&G Investments