Just over two years ago, economists warned of a Brexit shock to the UK when the British voted to leave the European Union (EU). Investors and companies were expected to shun a country that had decided to leave the world’s largest trading bloc, dealing a damaging blow to the economy. In reality, the aftermath is turning into a slow economic asphyxiation for the UK.
Firstly, let’s remember that the UK is on a tight schedule. On 18 October, Prime Minister Theresa May’s proposals will form the starting point for negotiations at an EU Summit in Brussels. Less than six months later, the UK is scheduled to leave the EU at 11 pm UK time on 29th March 2019 and enter a transition phase ending by December 2020.
As the clock ticks, the UK’s economic future seems increasingly uncertain. Among this uncertainty is the fact that the worst projections for the post-referendum economy have failed to materialize. Just days before the 2016 referendum, for example, the International Monetary Fund warned of a stock market crash and a 5.5% fall in GDP by 2019 while the UK Treasury at the time predicted an “immediate and profound shock” with a year-long recession. So how has the UK fared over the last two years?
One bright spot has been the performance of the FTSE 100 index of leading UK shares. That is in large part due to currency effects. Sterling has fallen by more than 13% against both the Euro and the US dollar since the referendum. The declines, driven by Brexit uncertainty and, more recently, USD strength, have supported UK blue chips that earn only 19% of their revenue from within the UK.
Our view is that further support for UK equities is limited. Sterling is approaching levels that already price in a high level of Brexit-related risk. Still, there is potential we believe, for a dip as low as USD 1.20 (from about USD 1.30 at present), but little more than that. Our three-month view on GBPUSD is at 1.29, and our 12-month forecast at 1.33. Our EURGBP targets over the same period are stable around the current level of 0.89.
A lack of a Brexit agreement would undoubtedly be GBP-negative, and while not our expectation, the scenario should be taken seriously given its economic implications.
In the wider economy, annual growth of the gross domestic product (GDP) in the UK has averaged 1.6% since June 2016. Over the same period, eurozone GDP has averaged 2.2% and 2.1% in the US (see chart). The UK unemployment rate has continued to fall since 2016 and now stands at 4.2%, but the long-term trend in wage growth is persistently weak. The UK’s enduring productivity puzzle shows little sign of a solution and still lags key European peers.
One key support has been continued loose monetary policy from the Bank of England (BoE). This shows signs of fading as the Bank unwinds its post-crisis stimulus and, on 2 August, it lifted the base rate by 25 basis points to 0.75%, the highest level since 2009.
The decision looks like a “dovish hike,” in other words a modest rise with a signal that another won’t follow soon. The BoE warned that the economy “could be influenced significantly by the response of households, businesses and financial markets to developments related to the process of EU withdrawal.”
The UK is in an economic limbo. In reality, it can do little while such an enormous change dominates the landscape. The next few months will decide the UK’s path as a fragile EU withdrawal strategy exposes it to inevitable compromises.
It may yet dawn on the UK’s political class and a part of the population that the balance of power in its EU negotiations isn’t, and rarely ever was, in Britain’s favor. That miscalculation, which is in the process of swapping a powerful neighbor and ally for a powerful neighboring rival, is leaving the British economy struggling for air.
Stéphane Monier is the Chief Investment Officer, Banque Lombard Odier & Cie SA