Macro investors have lamented the lack of volatility in markets. It’s too bad they can’t trade the British Parliament. Brexit has made the legislative process as chaotic as any market. People can’t even agree on what the consequences of a no-deal Brexit would be. Many economists and market participants think that a no-deal Brexit would be bad for the British economy, while some British politicians are more sanguine. This difference of opinion has led to some unusual interactions in Parliament, most notably between Brexit supporters and Bank of England Governor Mark Carney. Unlike Carney, not every public servant in the U.K. has been called a “second-tier Canadian politician” who couldn’t get a job in his own country, but then again, not every public servant in the U.K. is from Canada. 1 1 Close BBC: “Jacob Rees-Mogg calls Mark Carney a ‘failed-second tier politician,’” 11/28/18. The debate over the economic effects of a no-deal Brexit often comes down to disagreements about the merits of the European Union, what type of regulation is best for the U.K., and the importance of national sovereignty. Such grand concerns, while noble, are secondary to market participants. 2 2 Close Market participants are surprisingly diverse in their political views, though the level of discourse is not always high. I may or may not have heard an argument about whether prorogation was what the process of making dumplings is called in Poland. Last month the British pound hit its lows for the year as the odds of a no-deal Brexit rose. Traders weren’t selling the sterling to show their philosophical affinity with the EU or to endorse the remain camp. Market participants tend to be more practical and occasionally short-sighted. 3 3 Close This isn’t always the case. We would argue that in the case of some equity markets occasionally overweight long-term potential gains over concrete current profits. When dealing with existential issues like Brexit, they think mostly about near-term ramifications with only a passing consideration of what might happen later on. Let’s take a look at why they fear a no-deal outcome so much.
Despite opting to keep its own currency, the U.K. is a member of the European Union and the common market. Goods can cross the English Channel freely. British doctors, lawyers, accountants, and other professionals can provide their services in Europe. Being a part of the EU also means that the U.K. is subject to the European Court of Justice on some issues including its directives on EU workers. After over twenty years in the EU, for better or for worse, the British economy has become very integrated with continental Europe.
If the U.K. leaves the EU without an agreement, it would no longer enjoy open borders with EU members. Trade would instead be governed by the World Trade Organization. The U.K. has said that it won’t tax most incoming European goods, but Brussels has not given any assurances that it will reciprocate, so there could be tariffs on some goods. There would be border checks on goods. Supply chains, which are currently seamless, could be disrupted. While there may not be acute food shortages, the movement of consumer goods would likely be slowed. It could result in some price increases as well.
The potential for a no-deal Brexit has created plenty of uncertainty. Private investment has been weak in the U.K., which indicates that the uncertainty is already affecting business decision making. After a no-deal Brexit, the U.K. may become less attractive to European businesses. Why would a European company run a factory in a place with potential trade barriers, when it could build the same factory in a country within the European Union? 4 4 Close If labor was cheaper, productivity was higher or there were incentives, you might. But the free movement along supply chains is important. While the U.K. may be able to replace the lost trade with more business with the rest of the world, the transition would probably be rough even if it leads to a better outcome in the long run.
Markets also must consider the effects on capital flows. The U.K. is one of the largest financial centers in the world, and it serves as a banking hub for Europe. London is an international city whose real estate market has been quite popular with foreign investors. The U.K. runs current account deficits, which are financed through inflows. No one really knows how a hard Brexit would affect the U.K.’s status as a financial center or as a place to park capital, but if it did have to make an adjustment via its current account, it would likely hurt consumption and increase prices.
General political uncertainty within the U.K. has risen. There are a few outlier risks such as a breakdown of the rules that govern the relationship between Ireland and Britain. Another election is possible, and questions about the new government are becoming important. 5 5 Close Events are happening so fast on this front that anything we say about it will be dated in the time it takes to click send on an email. Politics in the U.K. is becoming more fragmented, as it is in many other developed countries. It is possible that there will be some convoluted coalition or a minority government. The new government may not be as business friendly as past governments. While markets may not be thinking longer term, the new government’s policies may end up being more important than the initial Brexit outcome.
Some folks have expressed skepticism about Brexit forecasts, because many folks had warned of an economic apocalypse after the leave vote, which did not happen. The referendum led to a much weaker British pound while the U.K. maintained its EU trade privileges. While uncertainty about the future agreement has weighed on investment, some of this was offset by improved competitiveness from the exchange rate. Meanwhile, goods and services could still move freely in and out Britain. That experience has little bearing on what will happen in a no-deal Brexit, except to prove the point that forecasters can be wrong.
The other thing we’ve learned in the past few years is that markets aren’t much better than forecasters when it comes to big political events. Market participants are making guesses just like the rest of us. In the case of Brexit it is understandable why they consider no-deal as the worst outcome, but it doesn’t necessarily mean that a no-deal Brexit will permanently ruin the U.K. economy. Other proposed policies may do that.
What We Are Watching
European Central Bank Meeting (Thursday) As eurozone growth has slowed over the last year, the European Central Bank (ECB) has pivoted from a discussion of policy normalization to talk of renewed easing. At the last ECB meeting in July, President Draghi announced that policymakers were looking into a range of measures, “including ways to reinforce our forward guidance on policy rates, mitigating measures [for the impact of further rate cuts on banks] … and options for the size and composition of potential new net asset purchases.” 6 6 Close ECB Introductory Statement, 7/25/19. Expectations are now high for a comprehensive easing package, although some ECB policymakers have recently expressed reservations about the need for aggressive stimulus. If officials announce a smaller-than-expected rate cut or a more modest asset purchase program, it could lead to a rally in the euro and weakness in domestic fixed income. If the ECB moves its deposit rate further into negative territory, investors in regional equity markets will be interested in the details of measures to support bank profitability, such as a tiered reserve system. If these measures are seen to be well-designed, eurozone financial stocks could rally.
U.S. CPI (Thursday) U.S. inflation appears to be stuck between two offsetting forces. On the one hand, strong services inflation supported by rising rents is putting upward pressure on CPI; while on the other hand, soft goods inflation weighed down by falling apparel prices is holding down CPI increases. This divergence between the services and goods sectors has been persistent and the net effect has been range-bound core inflation prints throughout the current expansion. However, recent signs of acceleration in goods inflation, perhaps partly influenced by tariffs, could change the outlook. Should core goods prices continue to accelerate, inflation dynamics in the U.S. could shift from benign to aggressive. Given this risk, market focus will likely be placed on core goods next week, in search for signs of firmness that could reshape the outlook for inflation.
U.S. Retail Sales (Friday) The U.S. consumer has remained resilient this year, despite increased uncertainty in global trade and a slowdown in global manufacturing. John Williams, the President of Federal Reserve Bank of New York, went so far as to say, “The consumer is now carrying all of the weight, or much of the weight, for growth going forward.” 7 7 Close Bloomberg: “Fed Officials Warn Consumer is Alone in Carrying U.S. Economy,” 9/4/19. Retail sales, excluding the more volatile components of autos and gasoline, grew 4.2% YoY as of July 2019. 8 8 Close U.S. Census Bureau. One area of strong growth this year has been in non-store retailers, which includes online sales. Consumers continue to shift consumption from brick and mortar stores to e-commerce, and retailers have invested more heavily in online platforms. Given the meaningful weight of consumption in U.S. GDP, a downside surprise to this week’s retail sales data could increase recession concerns. Alternatively, an upside surprise could help reduce pressure on the Fed to take a more dovish stance at its upcoming meeting.