Brexit, Boris, and the U.K. election

The new government led by Boris Johnson has a commanding majority in Parliament, enabling it to pass the Withdrawal Agreement by Christmas, which will then set the scene for the more difficult and prolonged trade negotiations. The presumption that these negotiations can be completed before the end of 2020 requires remarkable, and hitherto, unprecedented cooperation between Europe and the United Kingdom (U.K.).

The Withdrawal Agreement represents an agreement on the framework for the eventual trade deal. The government has announced its intention to insert a clause in the Withdrawal Agreement so that the transition period cannot be extended beyond the end of 2020. This is a response to the successful Conservative Party election slogan, “Get Brexit Done,” which itself was the successor to the winning strategy in the 2016 Brexit referendum to “Take Back Control.” In our opinion, this is an aggressive negotiating tactic, likely a response to the European Union’s (EU’s) approach to discussions—one that Financial Times contributor Wolfgang Münchau has described as being similar to the victors of Versailles, who were determined to punish the weaker party.¹

The British government has tried this negotiating tactic before and seems determined to stick with it despite evidence that it has mostly failed to work so far. Albert Einstein is said to have defined insanity as repeating the same experiment and expecting to achieve a different result. Governments make laws, break laws, and amend laws, but this provision will raise the bar for extending the transition period. It can happen but is only likely at the last minute, which will inevitably maintain elevated uncertainty.

The background to this discussion is that trade negotiations between the EU and Canada took seven years—in other words, negotiating trade deals can take a long time. Prior to the government’s surprise push to rule out extending the transition period, the assumption was that an extension could give Britain time to clinch a good trade deal with the EU, and a larger-than-expected majority could be helpful. However, that isn’t to be: The new government seems to believe that where there’s a will, there will be a way. After all, it only took nine months for the United States and China to agree to phase one of their trade deal. Besides, the United Kingdom and the EU have the added advantage of starting from a position of regulatory and trade alignment.

Only time will tell whether the government’s strategy will work. The problem here is that previously dissension came from within the ranks of the U.K. parliament. In the next round, dissension will likely come from within Europe—between EU members that are willing to provide the United Kingdom with better terms and those who feel differently. Faced with the risk that their joint negotiating position could be undermined, it’s likely that the EU will continue with its uncooperative bargaining position. Investors had hoped that the risk of a hard Brexit would be eliminated by December’s election, but in our view, the there’s still a 20% to 25% chance that it could happen, higher than many will feel comfortable with.

Game theory teaches us that under conditions of uncooperative bargaining, the stable equilibrium outcome is suboptimal. Businesses have been building up their cash holdings as the elevated uncertainty has curtailed investment since the 2016 referendum. The optimists among us are hopeful that the increased certainty provided by the decisive Conservative victory, along with the avoidance of what has been termed as a disruptive socialist experiment (had the opposition Labour Party won), would lead a surge in pent-up investment. However, we believe continued uncertainty over the eventual trading arrangements and the EU’s contention that a short transition period will be disadvantageous should continue to dampen investment intentions.

The British government is planning an expansionary budget. Although the manifesto for the Conservative Party going into the election was light on spending commitments, a recent spending review raised government expenditure by around £14 billion a year. The review also altered the fiscal rule to increase government investment from the current 1.9% of GDP to 3.0%, which will release an additional £100 billion over the life of the Parliament.² It takes time for public sector investment to be deployed in mature, postindustrial economies because of planning regulations and resources. As a result, the impact of this substantial fiscal loosening will not be immediate. More importantly, heightened uncertainty and slower employment growth suggests that additional government expenditure will merely compensate for weaker private sector expenditure, leaving the onus on the Bank of England (BoE) to compensate for weak economic activity and subdued inflationary pressures.

The BoE is already biased toward easing. The vote at its last meeting was 7 to 2 to keep interest rates on hold at 0.75%.³ The U.K. economy has slowed further since its November meeting, with both manufacturing and service purchasing managers indexes coming in below expectation. Employment growth has slowed sharply over the past few months and this was reflected in slower average hourly earnings, with the smoothed annual growth rate to October easing from 3.7% to 3.2%.² In our view, this should lead the central bank to lower base rates over the next few months. Depending on the EU’s reaction to the Boris Johnson’s gambit, we believe a rate cut could come as soon as the end of January. Otherwise, the BoE is likely to wait and review the expected fiscal easing contained within the February budget before deciding to lower rates in May.

The impact on sterling has been to extend profit taking in the wake of the election. Global investors who’ve been underweight in the currency in the hope of gaining clarity from the election now have an incentive to delay further their allocations to sterling. Moreover, since we expect the central bank to lower interest rates, sterling is likely to languish at the bottom of its trading range until that happens. In our view, the sterling continues to be undervalued on most international metrics. In an investment universe where most asset classes are overvalued—or at least appropriately valued—on an historical basis, it’s difficult not to see sterling higher on a six- to nine-month horizon.

1 “The EU must rethink its approach to UK trade talks,” Financial Times, December 15, 2019. 2 Bloomberg, December 16, 2019. 3 “Bank Rate maintained at 0.75% - November 2019,” Bank of England, November 7, 2019.