Market Bulletin - Red letter day
As Theresa May triggered the UK’s EU exit process, investors began to focus on the negotiations that lie ahead, and the likely outcome.
Letters have a chequered history. Henry VIII’s letter to the Pope asking for a divorce precipitated the break with Rome, while Neville Chamberlain’s 1939 letter to Hitler became just one more badge of his ineffectiveness in Europe. The contents of Theresa May’s six-page EU divorce notification, which arrived in Brussels last Thursday, might be remembered as anything from a hopelessly optimistic act of self-harm to the dawn of a new age of opportunity for the UK. Either way, it was a historic moment.
It also marked a change of tone from the more confrontational rhetoric she employed at the Conservative Party Conference last autumn. Instead, the letter highlighted “the liberal, democratic values of Europe – values that the United Kingdom shares” and said that the UK would pursue exit negotiations “constructively and respectfully”. Aside of implying that security cooperation could be used as a bargaining chip, the letter adopted a conciliatory tone, hinting at compromise on key areas such as the UK’s exit bill and single market access, which may mollify European leaders.
Meanwhile in parliament, David Davis formally announced the Great Repeal Bill, which will annul the European Communities Act 1972. However, it won’t repeal any laws (but instead place all EU law into UK law), it isn’t really a bill (more a discussion paper), and the word ‘great’ is not allowed to appear in the official title. The House of Commons Library said that what follows will be “one of the largest legislative processes ever undertaken in the UK”. The Bill also uses ‘Henry VIII clauses’ to give powers to the prime minister enabling her to change many laws without parliament’s consent – a practical necessity given the volumes involved.
If investors have offered an assessment of the Brexit outlook, it is a mixed one. Sterling has fallen significantly since the referendum, but investment is buoyant and stocks have performed well; although the less UK-sensitive FTSE 100, which slipped 0.19% last week, has been the best-performing UK index. Last week it was confirmed that the UK economy grew at 1.8% (annualised) in the fourth quarter – the second-fastest rate among G7 countries.
Theresa May had hoped that the nature of the new EU-UK relationship could be worked out alongside the divorce settlement, but Angela Merkel quickly made clear that the proper sequencing cannot be altered. Broadly speaking, this is viewed as falling into three stages. Michel Barnier, chief EU negotiator for Brexit, believes there will be 18 months in which to make it through those stages, given the need for preparation time beforehand and ratification time afterwards.
“The phoney war is over and the real battle for the future of Britain has begun – current government bravado is about to be confronted by the reality of the UK’s rather weak negotiating position,” said Stuart Mitchell of S. W. Mitchell Capital. “The ordeal for the prime minister is to regain control of both immigration and ‘sovereignty’ whilst at the same time getting the best possible deal for Britain’s economy and preserving the Union. This, however, will only be possible if we accept something very close to the current status quo; freedom of movement of labour and the continued adoption of the various rules and regulations that European Union countries follow.”
If negotiations do fall into Barnier’s three-stage schedule, then the remainder of this year will be spent unravelling past ties and commitments, which means addressing issues like the exit bill and citizens’ rights. The first half of 2018 would then be spent agreeing the aims for future relations, in areas such as financial services and single market access. Finally, July to October 2018 would be spent detailing the terms of the inevitable transition period. Ratification by European parliaments would follow. Oxford Economics puts the probability of some kind of free trade agreement at just above 50%.
“The brutal reality is that European trade is more important to the UK than UK trade is to Europe,” said Mitchell. “Remember, some 46% of British exports go to Europe, whilst only 8% of Europe’s exports go to the UK. The added challenge for the UK is that the European economy is at last starting to recover rather vigorously. The trick will be to try to present something close to current conditions as a victory. May’s move to withdraw from the single market may go somewhere towards this. A weaker British economy could also make the presentation of a status quo deal somewhat easier.”
Thus far, the responses of major companies to the prospect of Brexit have suggested there is no shared view on what it will mean for doing business in the UK. Lloyds said it would move 100 staff to a new EU headquarters in Brussels, JPMorgan said it was looking at shifting several operations to Dublin, Deutsche Bank has just committed to a new office in London – and Siemens is due to do the same. Single market access is clearly a major concern – last week, 40 European business lobbies representing 20 million companies in 34 countries issued a statement calling for maintaining market consistency.
If consumers are supposed to be worrying, there were scant signs of it last week, as figures showed that the household savings ratio slumped to a record low of 3.3% in the first quarter, far down from the 5.5% recorded just six months ago. At least part of the explanation may lie in rising inflation, which eats away at consumers’ spare financial capacity. It also hurts cash savers; a point reinforced in analysis published by Schroders last week, which showed the extent to which inflation has diminished the returns made by Cash ISA savers since the scheme was first launched in 1999. With inflation set to rise further, and little prospect of imminent interest rate rises, savers only have a couple of days left in this tax year to make best use of this year’s ISA allowance.
On Tuesday last week, Donald Trump signed an executive order to begin to dismantle the Obama administration’s environmental reforms. Ignoring price constraints, the move in theory opens the way for coal to make a resurgence – “Trump digs coal” was a billboard favourite in mining regions during the election campaign. Blue-collar regions will also be glad of his tough talk on China, which continued last week as the president said his forthcoming summit with Xi Jinping, the Chinese president, would involve a “very difficult” conversation about trade. Despite the rhetoric, stocks climbed once more last week – the S&P 500 ended the period up 1%.
Markets elsewhere followed the US’s lead. In Europe, German inflation saw a surprise fall to 1.6% (down from 2.2%), lifting some of the pressure on Mario Draghi to taper the ECB’s quantitative easing programme. That changing expectation may also have helped sentiment, as the Eurofirst 300 rose 1.2% over the five-day period. Meanwhile, borrowing from eurozone sovereigns and associated bodies this year has reached the second-highest level ever. The Nikkei 225 in Tokyo fell 1.8% to a seven-week low, leaving it down for the quarter by 1.1%.
If Theresa May signing her Article 50 letter to Donald Tusk provided newspapers with the photo of the week, there was a Celtic echo to come. The image released on Friday from the office of Scotland’s first minister showed Nicola Sturgeon writing to Theresa May. The letter, which followed a vote of recommendation by the Scottish Parliament last week, asked the UK prime minister to call a second referendum on Scottish independence between autumn 2018 and spring 2019. Letters, it seems, are as contentious as ever.
S. W. Mitchell Capital is a fund manager for St. James’s Place.
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