The Silver Bullet | The High Price of a Hard Brexit

In her speech to the Conservative party last week, PM Theresa May spelt out her vision of “a global Britain” and “a fairer economy that works for everyone”. Behind the slogans, there is a huge gap between promises and reality.

May’s unelected government has promised a country and an economy that works for everyone, more fiscal spending, a normalisation in monetary policy and swift action to reduce immigration while at the same time remaining in the single market. We believe these objectives, together, are simply unrealistic and unachievable.

European leaders have reacted strongly against an EU membership a la carte, asserting that freedom of movement and freedom of trade cannot be separated. We expect this stance to stay unchanged. This means the UK will likely face a common front line against bilateral negotiations. Meanwhile, by announcing she will trigger Article 50 by the end of March and ruling out a parliamentary vote, PM May has burned her ships after landing in an unknown economic territory.

What happens next? Investors have already spoken. The verdict on May’s confusing (“Brexit means Brexit“), hard-nosed negotiating strategy has been undoubtedly negative. The first victim is Sterling; Gilts could be next. We expect a long and tough negotiation period for the current government, both with the EU and domestically. We believe the lack of a realistic plan will hurt the UK economy through more currency depreciation, higher inflation and a potential loss of investment and jobs. In a Hard Brexit scenario, we estimate the direct economic cost at £140bn for the UK economy, equal to 7.5% of GDP.

The UK and the EU may eventually find an agreement, but without structural reforms the many problems mentioned in May’s speech – inequality, a lack of economic restructuring, too-loose monetary policy – will remain.

Hard Brexit Becomes the Base Scenario

PM May has promised to trigger Article 50 by no later than the end of March 2017. In our view, there are three possible scenarios ahead:

We think the probability of a Hard Brexit has gone up considerably, given PM May’s strong statements about immigration control and a plan to withdraw from the jurisdiction of the European Court of Justice. In order to retain access to the Single Markets, the UK needs to join the European Economic Area (EEA) like Norway, Iceland and Liechtenstein or join the European Free Trade Area (EFTA) like Switzerland. Both the Norwegian model and the Swiss model would require free movement of people – the fomer due to EEA membership requirements and the latter under bilateral agreements in return for free trade benefits. It is unlikely for the UK to win exceptional terms. To the contrary, other EU countries are likely to form a common-front in the negotiations in order to set a tough precedent and deter other potential exiters. In addition, triggering Article 50 before the French Presidential and German federal elections could mean even less leniency towards the UK, as the incumbent governments are likely to act tough to appeal to their respective electorates.

Soft Brexit is now less likely. It would require the PM to soften her stance on immigration and EU laws. This could happen following a Parliamentary vote against Brexit. PM May so far has agreed to a Parliamentary debate, but stopped short of promising a Parliamentary vote (FT). Meanwhile, a legal challenge has been brought against the government’s plan to invoke Article 50 without a Parliamentary vote. The High Court is due to hear the challenge in London on October 13^th and 17^th (Bloomberg).

A U-turn to a Bremain decision might only be possible with an overwhelming parliamentary vote against Brexit or new elections. This seems highly unlikely, as we do not expect MPs to vote against their constituents and new elections will likely again result in a Conservative majority government led by May.

Unrealistic Expectations Likely to Meet the Reality of a Hard Brexit

In her speech, PM May promised more public investment, less reliance on monetary policy, measures to address inequality and humanitarian support for refugees. However, the reality is the UK still suffers from among the highest deficits in Europe and rising public and private leverage, while economic imbalances and social imbalances are deeply rooted across the country. With the costs of a Hard Brexit starting to kick in, the same parts of the electorate who voted for Brexit will be the most hurt.

Estimating the Cost of a Hard Brexit

In a Hard Brexit, the UK could lose its passporting rights for financial services and face tariffs for exports of goods to the EU. Sterling will likely depreciate further, potentially to parity with the Euro. In our view, the UK will face direct costs in three areas: loss of jobs and investment, loss of tax revenues and erosion of wealth due to inflation.

Rising Inflation + Higher Deficits = Short Gilts

UK government bonds are amongst the most vulnerable assets to a Hard Brexit, in our view. Under a Hard Brexit, the UK is likely to enter a period of stagflation, as Sterling’s depreciation will push import costs higher: the UK imports nearly 46% of its energy and 50% of its food. Inflation expectations have already risen (to 3.6% for the 5-year, 5-year forward), yet 10-year Gilt yields remain well below at around 1%.

Gilts are currently anchored by QE-expansion expectations which, in our view, cannot be delivered by the BoE. First, global monetary policy is shifting against negative interest rates, as we wrote earlier in September (The Silver Bullet | Central bankers: the tide is turning). Second, the BoE will have to deal with higher inflation soon. Third, many UK firms are now under pressure on rising pension deficit, made worse by low long-term Gilt-yields. This means at most another rate cut to zero, which is becoming increasingly unlikely as Sterling depreciates. Fourth, a fiscal stimulus would imply more issuance: the OBR had forecasted £72.2bn in government borrowing in 2015-2016 vs BoE additional purchases of £60bn over 6 months.

Rising Inflation + Higher Deficits = Short Gilts

UK government bonds are amongst the most vulnerable assets to a Hard Brexit, in our view. Under a Hard Brexit, the UK is likely to enter a period of stagflation, as Sterling’s depreciation will push import costs higher: the UK imports nearly 46% of its energy and 50% of its food. Inflation expectations have already risen (to 3.6% for the 5-year, 5-year forward), yet 10-year Gilt yields remain well below at around 1%.

Gilts are currently anchored by QE-expansion expectations which, in our view, cannot be delivered by the BoE. First, global monetary policy is shifting against negative interest rates, as we wrote earlier in September (The Silver Bullet | Central bankers: the tide is turning). Second, the BoE will have to deal with higher inflation soon. Third, many UK firms are now under pressure on rising pension deficit, made worse by low long-term Gilt-yields. This means at most another rate cut to zero, which is becoming increasingly unlikely as Sterling depreciates. Fourth, a fiscal stimulus would imply more issuance: the OBR had forecasted £72.2bn in government borrowing in 2015-2016 vs BoE additional purchases of £60bn over 6 months.

Real Solutions: Re-engineering the UK Growth Model

The UK has become a Divided Kingdom, after decades of imbalanced growth, fiscal and monetary policies aimed at boosting asset prices and a lack of long-term investment. These issues call for a deep economic restructuring.

Below are some of the real solutions that we think could make a real difference.

Prevent another rise in household leverage, by increasing the supply of housing and tightening macro prudential measures. The UK has been in a net-housing deficit since 2008, with the number of new households exceeding the number of new homes built. In England alone, 232k to 300k new units are needed each year, or around two to three times current supply, according to the UK Parliament. While the government may be unable to increase subsidies for new affordable housing due to fiscal restrictions, housing supply could be increased through building on the UK’s Green Belts. Additionally, the Bank of England could tighten macro prudential policies through tighter thresholds on loan-to-income mortgages, while limiting subsidies on mortgages extended under the Help-to-Buy scheme.

Encourage private investment in the real economy, including in infrastructure. Over the past three decades, the UK has spent less on infrastructure than the OECD average of around 2.5 – 3% GDP. As a result, while the quality of UK’s infrastructure is close to the OECD average, it is lower than the G7 average (OECD). The largest infrastructure spending needs are in electricity generation, air transport and road (for example, Heathrow operates at nearly 99% capacity every day, according to reports). The UK needs infrastructure investment at 3.5% of GDP to maintain Britain’s competitiveness and Britons’ quality of life, according to the OECD (UK Parliament). However, public sector infrastructure spending was only around 1.5% of GDP in 2015 and may average around 1.3% GDP between 2016-2021 even if the government’s ambitious £100bn infrastructure commitment is executed.

Reduce inequality, increase access to education, consider a reform in taxation. Inequality in the UK has been rising steadily over the past decade, as declining interest rates have supported asset prices. In more recent years, global QE has further bolstered the wealth of asset owners, thereby contributing to the rise in inequality, in our view. Simultaneously, tighter fiscal policy has penalised income relative to assets, as while the top income tax rate is 45%, capital gains tax is only 28% (and 0% for primary residencies). Implementing tax on property or wealth values– which the UK does not apply, unlike most other developed markets – could help rebalance the rise in inequality while also helping reduce the fiscal deficit and incentivising asset owners to reallocate funds away from UK property and towards real-economy assets such as stocks and bonds. Conversely, stamp duty is an inefficient form of taxing property, penalising transactions yet incentivising forms of parking cash.

Access to education is key to increasing social mobility. In the UK, 0.8% of the population who graduate from Oxford and Cambridge account for 75% of Senior Judges and 38% of the Lords (Social Mobility and Child Poverty Commission).

Diversify the financial system away from banks, towards financial markets and other alternative sources of funding. Relative to the rest of Europe, the UK is less reliant on bank funding, and its financial system is among the largest in the world, compared to GDP. However, as UK banks may constrain new lending following Brexit, the BoE could encourage alternative forms of corporate funding through bonds, private placements and securitisations.

Redefine immigration policy. There is little or no evidence that immigration has lowered wages or taken away jobs from British workers (LSE research). Tightening immigration policy, on the other hand, would have a negative impact on UK services and on the housing market itself.