Where now for the UK? The referendum asked us whether we wanted to be ‘in’ or ’out’, but not what kind of ‘out’ we wanted. This is unfortunate, as the question is a critical one for the future of our country. Politicians will have to infer an answer, knowing that the question was never properly debated. Do we want the ‘lite’ form of Brexit enjoyed by Norway, Switzerland and others, where nothing much changes? Brexit-lite would minimise economic uncertainty by maintaining existing trade arrangements with the European Union (EU); it would probably help foreign investment into the UK to resume and the pound to recover much of its losses. Or do we want a more extreme, Canadian-style arrangement where we are clearly in control of immigration from the EU but, commercially, more isolated? This would take longer to negotiate, maximising economic uncertainty and prolonging weakness in the pound.
Given that so much of the referendum debate was focused on immigration, Conservative party politicians could choose to base their negotiating strategy on immigration, requiring restrictions on the freedom of movement from Europe to the UK. Absent EU legislation allowing similar rights for all EU members, this would preclude Brexit-lite. However, the government’s ability to utilise immigration as a core tactic is dependent on the path taken by the economy. Right now, immigration is still the primary issue.
However, due to the collapse in the pound, the electorate will soon feel the sting of higher prices on imported goods. They may come to associate Brexit with a higher cost of living. The public may hear of projects being cancelled, redundancies and even companies going bankrupt. They may respond by saving more and consuming less, causing a slowdown in UK economic growth, a fall in house prices and rising unemployment. Public polling and survey history show that economic concerns trump immigration concerns. If the government then wishes to win the next general election, or even preserve its current majority, it would be well-advised to favour an economically-friendly Brexit-lite at the expense of controls over immigration.
There is a feedback effect at work here: the more that the pound declines, the more inflation rises and the more likely the public is to associate Brexit with a higher cost of living. Likewise, the more the economy slows, the more that Brexit will come to be feared. These outcomes would push politicians toward Brexit-lite which, ultimately, reduces economic risk and is good for the pound.
Conversely, a rally in the pound in the short-term, or the absence of economic weakness, would embolden politicians to push ahead with a more extensive form of Brexit. However, this would deter foreign investment into the UK, extending the period of economic uncertainty and of high currency volatility. The feedback effect then kicks in again, with any renewal of weakness in sterling, or prolonged period of economic weakness, raising the possibility of a backlash in public opinion against Brexit. This logic impels us to the conclusion that an extreme Brexit is very hard to achieve and that pragmatism, which favours the status quo (and, hence, Brexit-lite), is likely to prevail.
A similar feedback effect complicates policy decisions for the Bank of England. Following the pound’s decline, and taking into account the rebound in oil prices, inflation is likely to surge from 0.5 per cent currently to nearly 3 per cent by the end of next year. If sterling continues to weaken, inflation will rise further, preventing the Bank of England from cutting rates. In this scenario, the most appropriate action would actually be to raise rates. This would be a very poor outcome for the UK: we might experience rising interest rates, meaning less affordable mortgages, while property prices would be falling, consumer income diminishing (eroded by inflation), and consumer wealth declining due to falling house prices and poorer job prospects. While we hope this does not materialise, the real cost of the referendum is the fact that we have to run this risk at all. A rally in sterling, in contrast, would enable the Bank of England to choose from a much wider range of policy options, including more that actually assist economic growth.
To complicate things further, our European neighbours will be well-aware of these factors, and will harden or soften their negotiating stance accordingly. All parties to Brexit, therefore, are focused on forthcoming releases of UK economic data. Politicians will then be very focused on subsequent opinion polls and surveys of consumer sentiment. Those polls and surveys will be followed by the setting-out of the government’s position in more detail, which will prompt a reaction in capital markets, feeding back into the political strategy, and so on.
The kind of ‘out’ is also a critical question for the direction of our portfolios, as the impact on the pound could be quite different in each case. Sterling has been the mechanism which conferred stability on our portfolios in the face of Brexit related risk. As the pound fell to a 30-year low, investments denominated in foreign currencies rose proportionately. This more than offset an initial collapse in stockmarkets around the world.
An extraordinary thing then happened. Rather than perceiving the referendum result to be the beginning of the end of the European Union and the eurozone, investors suddenly found the courage to ignore it! Driven by surging US economic data, stockmarkets rallied mightily all over the world, many ascending to above their pre-referendum levels. Even government bond yields, which are nowadays in a state of permanent gloom, eventually recognised a slight improvement. As a result, the only assets still acknowledging the chance of some economic damage from the referendum are the pound, share prices within certain UK industries, UK government bonds and UK property. Brexit is no longer considered a systemic risk.
Our belief that Brexit-lite is the most pragmatic, realistic outcome suggests that we should now be favouring Sterling over foreign currencies. We have acted accordingly, hedging much of our US Dollar exposure – as a result, in our balanced portfolios the foreign currency exposure has diminished from 48 per cent before the referendum to 32 per cent now.
One important counterargument to this view is the risk that the pound weakens again, perhaps because UK economic data dramatically underperforms expectations, or because politicians draw up battle lines that imply an extreme form of Brexit. However, as discussed above, such scenarios eventually create their own backlash among the electorate, pushing the most likely path back towards pragmatic Brexit-lite. Moreover, there are also some scenarios in which sterling rallies violently. These currently appear somewhat outlandish, but are worth considering. For example, the Conservative government might decide to call a general election (despite the Fixed Term Parliament Act, such manoeuvres are still possible). Such a strategy would be sensible if it became apparent that the economic cost of Brexit would be too high for the electorate generally, but the political cost of backing down on immigration was also considered to be too high. Or the Labour party might recreate itself around a mandate for remaining in the EU.
Just over 48 per cent of the electorate voted to remain, a vocal group of these people are desperate to revisit the topic. This could attract significant new voters from other parties, returning Labour to electoral relevance overnight. The combination of New Labour plus others of the 75 per cent of MPs that voted to remain could be enough to force a no-confidence vote in the government and a general election, effectively blocking Brexit.
Our portfolios will still benefit from weakness in the pound. They retain significant exposure to foreign currencies, principally through investments in Asian stockmarkets and Emerging Market bonds. This type of position could still provide some offset in the event of another Brexit-related collapse in the pound, having (collectively) outperformed sterling, the US dollar and most major currencies in 2016.
Chris Darbyshire is chief investment officer at 7IM
