Chris Bailey, European Strategist, discusses equity performance and currency valuation in the U.K. following the June 2016 Brexit vote.
“Every exit is an entry somewhere else.”
– Tom Stoppard
When the economic, political and social historians look back on 2016, there is only one event that will matter in the U.K.: the referendum decision to exit the European Union made in late June. The decision was close – approximately 52% versus 48% – but it has set off a series of headwinds spanning well beyond the borders of the U.K.
Unlike a General Election, this referendum is not an immediate political earthquake. Rather, it is a slow dance with an unclear practical outcome, and it will likely remain this way for another couple of years. While the immediate impact was a change of the U.K. Prime Minister and a sharp fall in the value of the British Pound against other major global currencies, the second stage of Brexit will begin at the end of March 2017, when the divorce papers with the European Union – known as “Article 50” – will be filed. There will then be a period of around two years before Brexit becomes a practical reality, in theory, as no country has ever left the European Union. This entire process has an element of guesswork attached to it.
A casual look at the U.K.’s leading share index – the FTSE 100 – would have you quickly concluding that Brexit is far from problematic for the U.K. economy, as the equity market has been one of the better global performers in local currency terms over the last few months. Unfortunately, the key aspect is “in local currency terms” because the sharp plunge in the value of the British Pound has proven a huge boon for the average U.K. large-cap company, which typically generates well over two-thirds of its operating profits outside of the U.K. The translation benefits of these “hard currency” earnings has pushed up the FTSE 100, which still remains down year-to-date in U.S. dollar terms.
Still, the direction of the FTSE 100 has been correct on at least one aspect of the U.K. economy post-Brexit: it has not (yet) fallen off a cliff. The Bank of England cut interest rates and re-imposed quantitative easing stimulus in the six weeks following the Brexit referendum vote, but data since then has been at worst dull and on average better than expected. For every downbeat report, there have been plenty more upbeat ones with corporations suggesting it was business as usual or that there had been a discernible bounce back from the rigors of the end of the second quarter when the Brexit referendum vote occurred.
The reality is, however, the U.K. economy has not seen anything yet. The application of the Article 50 divorce papers by March 2017 theoretically sets the clock ticking on a two-year exit timetable by which the U.K. must exit the European Union. However, with the near majority of U.K. trade with the European Union – and the U.K. being an important market for the Eurozone countries too – critical decisions about future trade relations remain unanswered. The European Union is broadly a free-trade zone for goods and services among its members. The U.K. exiting the European Union rips up such arrangements for any member and with trade deals – as America has found out recently – typically taking many years to sign off on, prospects for the U.K. having even rudimentary trade relations in place in a couple of years’ time is low. Even resorting to World Trade Organization arrangements would still imply the imposition of tariffs on many U.K. imports and potentially U.K. exports. In the popular parlance at the moment, a “hard Brexit” has few winners.
Within this environment, the U.K. economy faces muted growth created from uncertainty. There is no scope for a U-turn (as the new British Prime Minister Theresa May likes to quote: “Brexit means Brexit”) but there is scope for some slow going. The remaining members of the European Union – led by Germany – have always had a complex relationship with the U.K. At this moment in time, the European Union appears to prefer a “soft Brexit” where trade relations could be allowed to stretch into the next decade in some key areas. However, with incumbent politicians under pressure throughout Europe, the lure of trying to attract more jobs in high profile areas like financial services – in which the U.K. dominates across Europe – may prove high. And while Europe needs new jobs, poaching them from other European Union members, past or present, is unlikely to be ideal for the whole region.
In short, we are at the end of the beginning but not the beginning of the end for Brexit. Future trade relations remain hard to predict but critical, and the lower Pound – for the U.K. – is a clear safety valve, albeit at the cost of more inflation. It would be great to think that the potential liberation benefits of greater flexibility, self-control and less regulation would be the positive focuses of the Brexit debate for the U.K. This may be true at some point next decade, but today the minutiae of trade policies and the reaction of former regional partners matter more.
Brexit remains complex.
The FTSE 100 Index is a share index of the 100 most highly capitalized companies listed on the London Stock Exchange.