Markets & Economy

Global Fixed Income

Brexit: Now It Gets Real

May 31, 2017
The Bank of England is ill-equipped to deal with a possible UK economic slowdown, so it may pay to remain cautious on gilts and sterling.

Key Points

  • Article 50 has been invoked and the UK must leave the European Union (EU) by the end of March 2019. Negotiations over the terms of the UK’s exit—and its future trading relationship with the EU—are likely to be conducted in a tense atmosphere, making it difficult to agree on a deal before the deadline.
  • The prospect of no deal being struck and the UK switching immediately to World Trade Organization terms is higher than is currently priced in by the markets—and could have a major negative impact on the country’s economy.
  • If this happens, the Bank of England has few tools at its disposal to help reignite growth—there is hardly any scope to cut interest rates and little appetite to extend quantitative easing.
  • Fiscal measures such as helicopter money may be considered, though this would bring its own risks. As such, we believe it will pay to remain cautious on gilts and sterling for the foreseeable future, although price volatility may present some buying opportunities.

The Phony War Is Over

It is just about two months since the UK triggered Article 50, formally signaling its intention to leave the EU, and separation proceedings between the two have already become fractious. Amid increasingly belligerent rhetoric from both sides and a number of major obstacles still to overcome, it seems unlikely that an agreement over the terms of the UK’s departure from the bloc can be reached before the March 2019 deadline. The possibility of a “cliff edge” scenario in which the UK falls onto WTO terms without a transition period, plunging it into a period of severe economic turbulence, is higher than is currently priced in to markets—and it is not clear whether the country has the tools at its disposal to manage such an outcome.

As yet, there is not even an agreement over how the negotiations between the UK and EU should be conducted. The EU wants to follow a sequential approach, focusing separately on, in order: (1) the UK’s “exit bill,” (2) the residency rights of EU and UKcitizens living within each other’s borders, and (3) trade. Negotiations over trade should only begin when an agreement is reached on the bill and residency issues, the EU has argued. By contrast, the UK would prefer to treat the exit bill and residency rights as bargaining chips within trade negotiations and discuss all three issues simultaneously.

If an agreement can be reached on the structure of negotiations, the first major challenge will be the exit bill. According to reports, the EU is reportedly planning to ask the UK to pay anything between €50 billion–€100 billion, but the UK government wants to pay a small fraction of that. Agreement on residency rights should be more straightforward as there is a mutual benefit in granting UK and EU citizens currently residing within each other’s borders the right to remain.

Assuming there is some kind of agreement over the bill, there will still be an enormous amount of work to be done for a new trading deal to be in place on the day the UK leaves the EU. Trade deals typically take many years to come to fruition, and given that negotiations between the EU and UK are likely to be conducted in a less-than-friendly atmosphere, the prospect of rapid progress would appear slim.

The possibility of a “cliff edge” scenario in which the UK falls onto WTO terms without a transition period, plunging it into a period of severe economic turbulence, is higher than is currently priced in to markets.

EARLY ELECTION LIKELY TO HARDEN UK’S POSITION

UK Prime Minister Theresa May’s decision to call a snap election in June should help to provide some clarity on the position the UK takes. As things stand, May’s Conservative Party is expected to return to power with an increased majority. How this will affect its negotiating strategy is not clear. Some observers believe that a new influx of euroskeptic Conservative Members of Parliament will embolden May to adopt an even more aggressive approach to talks and hold more firmly to her “12 priorities” for Brexit; others have argued that a comfortable majority will reduce pressure on her to “play to the gallery” and enable her to adopt a more pragmatic stance, possibly even compromising on some key issues. Of these, we believe the former is more likely.

Personalities matter, too. There is clearly animosity between May and Jean-Claude Juncker, president of the European Commission, and May does not have a close relationship with German Chancellor Angela Merkel. New French President Emmanuel Macron has emphasized the importance of “defending the integrity” of the EU’s key principles on labor movement and trade in Brexit negotiations and expressed concern that if the UK were seen to benefit from leaving the EU it could “kill the European project.” Macron and Merkel look set to cement the Franco-German bond on which the EU depends, and this will only strengthen further if Merkel is defeated in this year’s German elections by one of her main rivals, who are considered even more pro-EU than she is.

In summary, Brexit negotiations are likely to be conducted by an invigorated UK prime minister with a stronger electoral mandate and a newly strengthened and united EU. There is little sign that either side is likely to back down anytime soon.

"Cliff Edge" Approaches

The full range of possible Brexit outcomes stretch from, at one end, a negotiated settlement that guarantees the UK’s continued participation in the single market in one form or another, to, at the other, a sudden end to negotiations with no deal in place, forcing the UK onto WTO terms with no transition period. We believe the UK is further on the path toward the second of these outcomes than is currently priced in by markets. There is nothing inevitable about this—indeed, there are many who still believe that pragmatism will ultimately prevail and that a deal will be struck that brings the greatest mutual benefit to both parties. But the tone of the most recent publiccomments from both sides suggests that this is a long way off, and it is notable that the UK government, having previously been publicly bullish about its chances of retaining full access to the single market, has more recently focused its attention on trying to persuade the electorate that leaving the bloc without a deal would not be a problem after all.

In reality, falling on WTO terms would not be a straightforward option for the UK. 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 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 UK. Negotiations to iron out these complications are likely to be highly contentious, making the process of reestablishing the UK as an independent WTO member very complex and time-consuming.

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. This uncertainty will weigh on consumption and investment, which in turn will put enormous pressure on the public sector. Gilt yields plummeted following the Brexit vote but have risen again since the autumn (Figure 1). Yields are likely to rise further, while sterling could 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? Having cut interest rates and announced an extension of quantitative easing last August, the Bank of England has limited room to maneuver on the monetary policy front. Interest rates are already at 0.25%, giving the BoE virtually no space to cut further before it goes into negative rate territory—something that the BoE has indicated that it would be very reluctant to do. There is also little appetite for an extension of QE—the general perception of QE in the UK is that it rewarded large institutions and wealthy individual asset owners, particularly those in London, but did not benefit lower-income people without assets. Therefore, while it would be possible for the government to extend its asset purchase program further, such a move would carry political risks.


Given the limitations to any further monetary stimulus in the form of rate cuts or further QE, 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

Considering the strong possibility of the UK leaving the EU with either a deal that provides it with significantly reduced access to the single market or, in a worst-case scenario, no deal at all, gilts and sterling should be treated with caution for the foreseeable future. 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, the economic impact of Brexit has been delayed rather than avoided and will probably begin to be properly felt later this year. Our concern is that, having largely exhausted its monetary policy options, the UK government will have a limited ability to protect the economy from a significant slowdown.

As such, we are 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, mean 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 as and 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 May 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 for illustrative purposes only.

T. Rowe Price Investment Services, Inc., Distributor.

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