Brexit – speed bumps, slopes & cake

After 12 months in the departure lounge, Brexit negotiations have started. The Brexit process was always going to be complicated, but the hung parliament, the need to maintain an amorphous government with the DUP, and possibility of cross-party negotiations form an extra ‘speed bump’ on a journey that could take way longer than the two years hoped for by Article 50.

An early UK concession on deferring the trade talks – core to a meaningful deal – until migration, the Irish border, and EU contributions are addressed, looks to be a sign of things to come.

Mr Hammond’s preferred ‘slope’ could end up being a path back close to square one…
Mr Hammond’s more conciliatory tone is welcomed, but is inevitably clouded early on by ‘cherry picking’. This suggests, at least initially, that UK officials will chase their preferred free-trade goals (which we suspect is access to, without full membership of, the Single Market and/or Customs Union), and try to shun elements (uncontrolled migration and heavy regulation) deemed undesirable.

But, this too will have to rebalance, as the realities of the alternatives to EU membership set in (see chart 1 below). In practice, our negotiations could take years to potentially end up back close to square one, in terms of striking the free trade agreement that most parties want. If the parties cannot agree, the possibility of another, earlier election would be an unwelcome complication.

When the deal is struck it will need Parliamentary approval, and be subject to a ‘phasing in’ period, and this after sign-off by our 27 EU peers. Whichever route is taken, the deployment of UK civil servants to unwind membership would push other priorities (e.g. environmental) down the line.

Even after a Brexit, any bilateral treaty to re-access the Single Market would probably necessitate freedom of labour movement. Switzerland, for example, accepted this condition, though after its own referendum in 2014, is now looking to re-negotiate this.

Striking a US trade deal by the 2022 UK election needs talks to start now…
Meantime, EU law forbids trade-deal ‘bigamy’ in terms of enacting agreements elsewhere while still an EU member. This precludes a quick compensating tie-up with the US, for example. There, new trade deals take an average four years to complete. This suggests striking a US deal by the 2022 UK election needs talks to start now – well before Mr Trump’s 2018 ‘Mid-Terms’ campaign.

And another big challenge for UK officials is to remain close enough to the European negotiating table to maintain the best trade and regulatory deals for services. These account for 80% of our gross value added (compared with 50-60% in Germany and France), and are the driver of the recovery. This makes it more ambitious than a Canada-style deal.

If the UK loses the ability to provide cross-border financial services, the industry will be faced with significant, additional costs such as establishing local branches in other European centres, maintaining local capital, and the compliance costs of seeking approval from multiple local regulators. Also, 44 years of EU regulations have been fully/part implemented into UK law. Many of these apply directly to member states; they would ultimately fall away on a Brexit, and have to be passed as new UK law. Even outside the EU, regulation would still be needed, and could not happen overnight.

Critically, the ECB is already threatening London’s privileged clearing position, bestowed upon it by the ECJ.

Which, on the macro side, leaves the BoE watchful that a weaker pound doesn’t keep pumping inflation. Even if the worst of Brexit is priced in, the pound has limited upside. No major economy has in the long-term net loosened its overall (monetary and fiscal) stance more than the UK. And, given the inflation premium, there’s little coincidence those running more expansionary policies have generally sustained the weaker currencies.

The BoE could feasibly reverse its 25bp ‘safety net’ rate cut from last August. But, in the absence of a recovery in real wages, we doubt they would hike any more aggressively…
Their hope is that productivity begins to lift from 2018, justifying higher wage claims. If it does, they could admittedly then get twitchy fingers. But, they do have another lever to pull to cap the rise in Bank rate, by beginning to wind down their £445bn balance sheet.

As a guide, we estimate the trade-off from peaking out at a historically low Bank rate could, over time, be to wind down over half of their QE-bought bonds.

Selling these assets back is one for later, to avoid disruption during the Brexit talks. But, as a prelude, tapering the Bank’s reinvestments would be the gentlest way of tightening. If it in any way helps facilitate “the smooth Brexit”Governor Carney craves, he may then be able to have his ‘cake’ (unhindered consumption) and ‘eat it’ (still low policy rates).

Neil Williams – Chief Economist – Hermes Investment Management