Markets & Economy

Fixed Income

Brexit: Beyond the Politics

July 24, 2017
To protect against economic uncertainty associated with Brexit, we are defensive on gilts and sterling while seeking idiosyncratic opportunities.

Key Points

  • We believe the economic impact of Brexit has been delayed rather than avoided and will probably begin to be properly felt later this year.
  • Our base case is that, barring a major political change of course in the UK during the next year or so, a “hard-ish” Brexit is still the most likely outcome, meaning the country falls upon World Trade Organization terms soon after March 2019, if not immediately.
  • It is reasonable to assume that a prolonged period of economic uncertainty would follow the UK’s exit from the EU, possibly exacerbated by a wider global economic slowdown.
  • We therefore remain defensively positioned in both gilts and sterling. Volatile price movements may mean that short-term buying opportunities arise, but the possibility of a hard Brexit means that the environment for UK investment is likely to be uncertain.

More than a year has passed since the UK electorate voted to leave the European Union (EU), but we are hardly any closer to understanding how the separation will be managed or what will follow. Although formal Brexit discussions between the British government and Brussels have finally begun, there is a very long way to go before an agreement over the terms of the UK’s departure is likely to be reached—if there is an agreement at all. While the politics remain complicated, however, the likely economic impact of Brexit can be estimated with more confidence—and as investors, this is ultimately what matters most.

In our view, the UK faces a very challenging few years as the country deals with its departure from the EU. Investors who adopted an underweight position on the UK immediately following last summer’s referendum have been surprised by how well the UK economy has held up since the vote. However, we believe the economic impact of Brexit has been delayed rather than avoided and will probably begin to be felt later this year. Our concern is that, having largely exhausted its monetary policy options, the UK government will have limited ability to protect the economy from a significant slowdown.

…we believe the economic impact of Brexit has been delayed rather than avoided and will probably begin to be felt later this year.

WEAKENED MAY STILL LIKELY TO PURSUE “HARD-ISH” BREXIT

The result of the UK’s general election in June has certainly complicated matters. Prime Minister Theresa May called the election to strengthen the ruling Conservative Party’s majority in parliament in order to ease the way for any new Brexit-related legislation; her failure to deliver this was both a shock and a major setback for the government. As the head of a minority government, May is considerably weaker than she was before the election, making her task of negotiating with the EU and passing any subsequent legislation at home much more difficult. Compromises may be necessary.

There have been signs of this already as at least one senior member of the UK government has begun talking of the need for a post-Brexit transition deal—something hardly mentioned before the election. Chancellor Philip Hammond said in a speech in Berlin that he wanted to see a transitional agreement in place with the EU to avoid the “cliff edge” of falling on WTO terms overnight and reiterated his desire for a “smooth path” for businesses. The potential impact of a transitional deal should not be underestimated. An arrangement that enables British businesses to continue accessing the single market for a number of years after March 2019 would give them more time to prepare for operating effectively outside the bloc. Result: a much smoother Brexit.

It should be noted, however, that other members of the government—most notably Brexit minister David Davis—have insisted that the UK will be fully out of the EU customs union and single market by March 2019. It should become clearer over the next few months whether the UK ultimately seeks a quick, hard Brexit or a softer, more protracted version. Our base case is that, barring a major political change of course in the UK during the next year or so (which is possible given the vulnerability of the government), a “hard-ish” Brexit is still the most likely outcome, meaning the country falls upon WTO terms soon after March 2019, if not immediately.

“WTO option” tricky and complicated

This would have major repercussions. The UK is already a member of the WTO but operates through the EU. To become an independent member, the UK would need to have its own schedules of tariffs and quotas that it would apply to other countries’ products. Negotiating new schedules would be complicated, so the UK would likely choose, instead, to simply keep them exactly as they are currently under the EU’s common external tariff. However, this might be seen as politically embarrassing given the supposed reason for leaving the EU in the first place was to take back control.

More problematic is that if the UK were to leave the EU but keep the common external tariff in place, a company moving components between the UK and the EU would incur charges every time it crossed a border. In addition, the EU’s existing tariff-rate quotas, which allow a certain amount of particular goods to enter at a cheaper rate, would need to be individually reviewed to determine how each quota would be divided between the EU and the UK. Negotiations to iron out these complications are likely to be highly contentious, making the process of re-establishing the UK as an independent WTO member very complex and time-consuming.

ECONOMIC REALITY BEGINS TO BITE

It is almost certain that the UK’s economy will suffer a slowdown if it falls suddenly upon WTO terms in March 2019—what is less clear is how severe that slowdown will be and how long it will last. Given the complications associated with rejoining the WTO as an independent member, however, it is reasonable to assume that a prolonged period of economic uncertainty would follow the UK’s exit from the EU, possibly exacerbated by a wider global economic slowdown.

Indeed, there is evidence that the economic effects of Brexit are already being felt. Net investment is now virtually negligible in terms of its contribution to gross domestic product—significantly lower than the UK Treasury’s target of a 1% contribution. Households, which account for 66% of the UK economy, are also squeezed: Wage growth is tracking around 2.1% while inflation is around 2.9%, so there is a negative disposable income dynamic at work. This has been registered in weaker retail sales and profit warnings from some popular chain stores.

Declining consumption and investment will put enormous pressure on the public sector, which will push gilt yields higher. The Bank of England’s (BoE) accommodative monetary policies caused gilt yields to decline significantly from 2007 onward, but yields look set to rise as these policies are reversed (Figure 1). Sterling could also weaken significantly.

The monetary cupboard is almost bare

In the event of a sharp economic slowdown, what tools would the UK have at its disposal to stimulate growth? In line with many other central banks, the Bank of England is edging toward tightening measures, meaning that rate cuts or further quantitative easing are highly unlikely. Given this, the next viable option would be to explore fiscal measures, such as arranging for the BoE to underwrite government debt. In other words, the government could fund major infrastructure programs such as the High Speed 2 rail link by issuing zero-coupon bonds directly to the central bank, which would pay for them with newly printed money. The BoE would likely promise never to sell the bonds or withdraw the money it created from circulation and, instead, create a permanent loss by expanding its liabilities without receiving an offsetting asset.

This would be helicopter money in all but name—and it could become reality in the UK if the economic aftershocks of Brexit are severe enough. But helicopter money carries its own risks, including uncontrolled inflation, political instability, and the erosion of central bank independence. Therefore, it would only likely be used as a last resort.

Caution key in uncertain period

It is difficult to predict with confidence the likely direction of talks between the UK and the EU over Brexit—media reports tell a different story every day. What can be predicted with more confidence is that the UK economy will take a hit when the country leaves the EU, especially if this coincides with a global economic slowdown. A transitional deal may ease the pain for businesses, but as things stand, it seems more likely that the UK will leave the EU with either a deal that provides the UK with significantly reduced access to the single market or, in the worst-case scenario, no deal at all.

We therefore remain defensively positioned in both gilts and sterling. Volatile price movements may mean that short-term buying opportunities may arise, but the possibility of a hard Brexit, and the headwinds to consumption that it will create, means that the environment for UK investment is likely to be uncertain. Accordingly, it should pay to approach the UK with caution while retaining the flexibility to buy into weakness when opportunities occur.

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of July 2017 and are subject to change without notice; these views may differ
from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments involve risk. All charts and tables are shown.

 

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