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26 Aug 2016
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25 Aug 2016
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25 Aug 2016
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25 Aug 2016
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23 Aug 2016
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23 Aug 2016
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22 Aug 2016
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19 Aug 2016
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19 Aug 2016
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18 Aug 2016
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17 Aug 2016
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17 Aug 2016
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16 Aug 2016
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16 Aug 2016
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15 Aug 2016
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15 Aug 2016
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12 Aug 2016
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12 Aug 2016
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11 Aug 2016
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11 Aug 2016
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10 Aug 2016
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10 Aug 2016
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09 Aug 2016
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09 Aug 2016
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05 Aug 2016
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05 Aug 2016
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02 Aug 2016
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02 Aug 2016
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01 Aug 2016
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The data and monetary policy:


A load of redundant chatter followed the release of economic data which came straight after the UK’s decision to leave the European Union. Leavers and Remainers were quick to claim that one set of figures or another validated their view over how the UK economy would fare in a post-Brexit world. Everyone is understandably anxious to gain some clarity over the global outlook following the referendum. However, anyone with an axe to grind jumped on the data as evidence that the UK/EU is thriving (will thrive), or is falling apart (will fall apart). This really is a pointless exercise. It’s just far too early to tell, particularly as it’s going to be difficult to strip out the effects of Brexit from other forces affecting the global economy. It’s worth considering the major post-referendum events in chronological order. First up, there was no emergency budget as threatened by then-Chancellor of the Exchequer George Osborne. Rather, the new Chancellor Philip Hammond said that he would deliver an Autumn Statement as normal. The BoE’s Monetary Policy Committee (MPC) held back from taking action following their 14th July meeting, with members saying they wanted more time to assess the economic impact of Brexit. This was widely applauded as being a sensible and measured response following charges that the Bank had been excessively alarmist about the economic outcome of a vote to leave the Union. Three weeks later and the MPC cut its headline Bank Rate by 25 basis points to a fresh record low. This was pretty much priced in as the Bank and its Governor Mark Carney had already put investors on alert for monetary easing over the summer. But what took investors by surprise was the MPC’s decision to add £60 billion to its Asset Purchase Facility, announce its intention to buy up to an additional £10 billion in corporate bonds and set up a new Term Funding Scheme for banks worth up to £100 billion. This is a hefty shot of stimulus and it’s worth mentioning that while all nine members of the MPC voted for the rate cut, three were against the additional measures. Analysts were left wondering just what the Bank had seen in the post-Brexit economic releases to make them take this action. Some suggested that the MPC has jumped the gun in taking what could turn out to be stimulus overkill. They were also concerned about the negative psychological effects of the intervention which could lead to less economic activity as businesses worried about the outlook for growth (the Bank downgraded its GDP forecast for 2017 to +0.8% from +2.3%). Yet others felt that the Bank was doing the right thing acting ahead of an economic downturn, echoing Mark Carney’s belief that these actions were vital to fend off heavy job losses and outright recession. The MPC now forecast a loss of 250,000 jobs due to the UK leaving the EU rather than the 500,000 predicted in the absence of any stimulus. Considering the data which followed the BoE’s July meeting, the first significant releases (CPI and RPI) showed a modest uptick in inflation, no doubt thanks to sterling weakness (this was confirmed in mid-August with yet another bigger-than-expected pick-up in both CPI and RPI). Then we saw an unexpectedly large fall in the Claimant Count change, with the Unemployment Rate coming in below 5% for the first time in ten and a half years. In addition, Average Earnings posted their largest quarterly year-on-year increase for 2016. All these numbers had the Leavers shouting about how the UK was thriving in the post-Brexit environment. But just one day later they were silenced as Retail Sales fell by 0.9% in June, giving succour to the Remain camp, desperate to show how Britain’s economy was set to crumble without the protection of the EU’s cosy trade club. The Remainers had even more to cheer about when advanced Manufacturing and Services PMIs both slumped below 50 indicating contraction in both sectors with business activity dropping to its lowest level since spring 2009. The drop-off was confirmed just days ahead of the Bank’s August meeting. The completed surveys showed that July’s Manufacturing PMI had dropped to 48.2, its lowest level and fastest pace of contraction since February 2013. Levels of production and incoming new orders both slumped, thanks to increased business uncertainty on the domestic market which more than offset a pick-up in new export business, lifted by the post-Brexit sell-off in sterling. It was the same story for Construction and Services. Markit’s PMI for construction activity slipped to its lowest level since 2009 (when the economy was last in a recession). All three sub-sectors - housing, commercial and civil engineering – had readings coming in below 50. Finally, the Services PMI came in at 47.4 – unchanged from last month’s number, but still indicating contraction in the sector. Post Brexit Ahead of these PMI releases we did get an encouraging second quarter GDP number. This showed quarter-onquarter growth of 0.6% - well above the first quarter’s growth of 0.4% and better than the +0.5% expected. However, this covered the period from April to June, so didn’t include any “Brexit effect”. Taken all together, as we approached the Bank’s August MPC meeting it became apparent that sentiment had soured. It was hard to find any analyst who didn’t expect the MPC to cut the headline Bank Rate by at least 25 basis points with some speculating that this would be backed up by restarting the Asset Purchase Facility which had been held at £375 billion for the past four years.


Trade and business

Ahead of the referendum President Obama stated that the UK would be “at the back of the queue” when it came to negotiating a trade deal with the US should British citizens vote to leave the EU. This was despite the fact that the EU itself still hasn’t got a trade deal with the US, which rather undermined the threat. It turned out to be an empty one anyway as (at the time of writing) there are 26 countries (including the US, China, Germany, India and Mexico) that have signalled their eagerness to strike trade deals. As political blogger Guido Fawkes points out: “The total GDP of all of these countries is nearly $50 trillion dollars – 67% of global GDP. In comparison, the EU’s GDP of $16 trillion equates to just 22%. Britain is open for business”. Out of the 10 largest economies by GDP only France and Italy have shown reluctance to negotiate. Ahead of the vote there were plenty of corporate executives warning about how a Brexit vote would be so devastating for the UK economy, citing ensuing economic uncertainty, the blocking of free trade and London losing its importance as a financial centre. Yet since the referendum we’ve seen a number of important companies announce significant investments in the UK. These include GlaxoSmithKline and London’s City Airport, McDonald’s and Boeing. Meanwhile, Deutsche Börse shareholders have approved the proposed merger with the London Stock Exchange. The latter deal was expected to fall apart on a Brexit vote. I’m not trying to suggest that everything is rosy. There are businesses that will flourish in the post-Brexit world, but there will be others that struggle and may even fail directly as a result of us leaving the EU. But once again, just as there are plenty of countries anxious to strike trade deals with us, there are plenty of companies ready to invest in the UK, with some now expressing hope that Britain will be an even better place to do business if leaving the European Union leads to less costly regulation and a more competitive economic environment. But in reality there’s a mountain to climb when it comes to the UK disentangling itself from the EU. And no matter what other countries say about their willingness to do business with the UK, no one wants to begin negotiating fresh trade deals until the UK has gone some way to extricating itself from Europe. Before that can happen, the UK has to trigger Article 50 which would formally begin the two-year leaving process. Yet the UK government appears in no hurry to fire the starting pistol. At the end of July at a press conference in Rome, Prime Minister Theresa May (together with her Italian counterpart, Matteo Renzi who has demanded a “clear timeline” for the UK’s exit), reiterated that the UK government had no plans to trigger article 50 anytime soon, since all parties needed to work out the “nature of our relationship”. So as things stand there’s no withdrawal schedule in place. The UK, EU member countries and the bureaucrats within the EU Commission itself haven’t decided on their initial negotiating positions. Also of some concern are calls for the referendum to be run again, suggestions that the House of Lords will delay or even withhold approval for triggering Article 50 and Scotland’s First Minister Nicola Sturgeon threatening a second referendum on Scottish independence. All this speculation has led to bookmakers tightening the odds on Article 50 not being triggered until 2018, if at all.


Negotiating Brexit

So what happens once Article 50 is triggered? Soon after the referendum Philip Hammond (now Chancellor, but back then Foreign Secretary) said that Brexit negotiations could take six years. In a recent research note JP Morgan looked at this in more detail. The bank noted that there are two different sets of negotiations which have to take place. The first concerns the legal withdrawal of the UK from the EU. The second concerns the new relationship between the UK and the rest of the EU. There is also a paper from the Centre for European Reform which explained that there were as many six deals that required negotiation. On top of the legal separation of the UK from the EU, the new relationship between the UK and EU requires a free trade agreement (FTA) with the EU, then interim cover for the UK between its departure from the EU and the entry into force of the FTA. Beyond this the UK then has to negotiate accession to full membership of the WTO, and then come up with new FTAs to replace those that currently link the EU and 53 other countries, and finally (?) work on co-operation on foreign, defence and security policies. JP Morgan goes on to explain that while the legal withdrawal agreement could probably be done and dusted within two years, sorting out new relationships between the UK and the rest of the EU will be a much longer process, both in terms of the scope of negotiating required and ultimately obtaining unanimous approval. Consequently, Philip Hammond’s prediction that the whole process could take around six years doesn’t seem unreasonable, and that means a long period of uncertainty for investors.


Brexit and its effect on the rest of the EU:

There are fears that the UK’s vote to leave the EU could be the catalyst that leads to the breakup of the Eurozone, and indeed the EU itself. In a recent interview with CNBC, JP Morgan’s CEO Jamie Dimon claimed that the integrity of the Euro zone would be at risk once Britain leaves the European Union. Mr Dimon isn’t alone in this assessment. This is why Europe’s leaders (elected and unelected) along with the “financial elite” (including the IMF) warned UK voters of the dire consequences of a vote to leave. Their fear is that Britain’s exit encourages voters in other countries to agitate for the same. There is growing popularity for Eurosceptic parties all over the EU. How Europe’s elites deal with this is crucial. They could take action to reform the Union and cede back political control to individual countries. Alternatively, the EU could speed up political integration and push further towards the Commission’s ultimate goal (as it appears to many observers) of a unified bloc with every member having to accept the euro as its currency along with common banking and fiscal union, and the transfer of funds from economically strong countries to weaker ones – all without the benefit of a common language as exists in the USA. The latter is obviously a far more problematic route, but that’s not to say it won’t be taken.


Market reaction:

While few commentators expected the UK to vote for Brexit, the initial market reaction to the result was pretty much as predicted. Sterling, the FTSE100 and FTSE250 all fell sharply, and as anticipated there was a large divergence in the performance of specific stock market sectors. The sectors and companies worst hit were those with a domestic focus. UK housebuilders, retailers and financial stocks were marked down heavily as were those companies which derive a significant amount of their revenues from the EU itself. The rationale was that the uncertainty caused by the UK/EU split would lead to a sharp slowdown in economic growth making life particularly difficult for UK/EU-centric companies. Post Brexit In its Quarterly Inflation Report (released 4th August) the BoE said it expects GDP for 2017 to rise by 0.8% rather than the 2.3% predicted in its May outlook. In the Bank’s opinion outright recession was only being avoided by its rate cut and programme of bond-buying. Despite the general sell-off in global risk assets that followed the referendum result, multinationals with a geographically-diversified customer base fared relatively well – particularly those with high dollar earnings. This was demonstrated most clearly by contrasting the FTSE100 and FTSE250. The former is dominated by large multinationals whose foreign-based revenues are buoyed by a weaker pound. The latter comprises smaller companies with, for the most part, less international exposure. Less than a week after the referendum decision the FTSE100 had made back all its losses and more. It went on to build on those gains and by the second week of August was around 7% higher than its close the night before the referendum. Over the same period the FTSE250 was 2% above its preBrexit close – still an impressive recovery but some way short of the FTSE100’s performance, boosted as it was by companies benefiting from sterling weakness. Both indices have rallied around 18% from their post-Brexit lows and, at the time of writing, are around 4% below their respective all-time highs from last year. As far as the British pound is concerned, the GBPUSD lost 5% on the day following the referendum. Partly this was due to sterling rallying sharply ahead of the vote as the market completely misread the runes and was convinced that the UK would vote to remain. However, sterling fell further over the next two weeks in a move which saw cable break below 1.3000 and go on to hit its lowest closing level since the mid-1980s. Its losses against the euro were less spectacular, but enough to persuade many UK holidaymakers to shun Europe thanks to the unfavourable exchange rate. But while equity markets bounced back almost indecently quickly, sterling continues to hover near multi-year lows. At the time of writing (week two in August) there’s plenty to suggest that the GBPUSD could take out its postBrexit intra-day low under 1.2800. The fall in sterling and rise in the UK’s two major stock indices are linked to some extent. As mentioned before FTSE100 multinationals benefit from a lower pound as it increases their competitiveness so boosting overseas sales and translating into better earnings. In addition, the cheaper currency makes the UK more attractive for foreign investors. It’s also worth remembering the political uncertainty that succeeded the referendum. Following David Cameron’s resignation it looked like there was going to be a drawn-out and fractious battle for leadership of the Conservative party. The fact that it was resolved so quickly and (relatively) painlessly (especially as calls for a General Election to cement Theresa May’s legitimacy as Prime Minister were rejected without too much opposition) helped to calm investors’ nerves. On top of this, the Bank of England made it quite clear early on that it was ready to loosen monetary policy. The fact that it followed through on this, and indicated a willingness to act further, helped to boost equities while depressing sterling. This monetary easing means that the BoE now joins the world’s major central banks (the European Central Bank, Bank of Japan and People’s Bank of China) in maintaining a loose monetary policy. Not only that, but it appears that the new UK government may be more open to providing fiscal stimulus as well. We’ll have to wait for the new Chancellor’s Autumn Statement in November to see if that expectation is fulfilled. Let’s not forget either the role of the US Federal Reserve in all this. The Fed stands out as the only major central bank considering tightening monetary policy. It would like the markets to believe that the US economy as robust enough to handle a 25 basis point rate hike in the near-future. More than that, members of the Fed are desperate to keep the next FOMC meeting over 20th/21st September “live” in terms of it being the stage for a rate hike. But the market isn’t convinced. The fed funds futures index (where you put your money where your mouth is) was (as of 16th August) assigning just a 9% probability of an increase in September. The probability rises sharply to 37% for the December meeting, which follows the US Presidential Election. Whenever it may come (assuming the Fed’s next move is tightening rather than loosening policy) rate hike talk continues to support the dollar as does any piece of positive US economic data.



Conclusion:

Financial markets have weathered the immediate aftermath of the Brexit vote and reset at fresh levels. But this is just stage one. With the Brexit negotiation process likely to extend well beyond the next planned UK General Election in 2020 there’s still a large dark cloud hanging over financial markets. The big question now is if this uncertainty will have a sharp negative impact on UK/EU economic growth (with a corresponding rise in unemployment) or whether the UK (and Europe) manages to muddle through. One thing is apparent: the BoE (along with other central banks) stands ready to extend monetary stimulus to mitigate any slowdown in economic growth, stave off recession fears and minimise job losses. With echoes of the ECB’s Mario Draghi, BoE Governor Mark Carney said that the “BOE stands ready to take whatever action is needed.” Yet Mr Carney also made it clear that he is not in favour of negative interest rates. This suggests that the Bank won’t follow Japan and others in taking key rates below the zero-bound, although it looks like the market has other ideas. Gilt yields continue to hit record lows and the yields on some short-dated UK government issues briefly went negative recently. This followed news that the Bank could not find enough sellers for it to buy £1.17bn worth of gilts on the first day of open market operations to implement its £60 billion addition to its government bond buying programme. So we’re now stuck in a post-Brexit “phoney war” as we wait for all sides to work out their negotiating positions and for the UK government to trigger Article 50. In the meantime we can expect financial markets to react to other underlying forces, dominated by central bank behaviour and the promise of government fiscal stimulus. If central banks continue to print and governments extend fiscal stimulus, then we can expect equities and bonds to head higher. If the apparent divergence between the BoE’s and US Federal Reserve’s monetary policies continues to widen, then we can expect the downside pressure on cable to continue. The outlook for the EURGBP currency pair is a bit more nuanced, particularly given the political uncertainty facing the three biggest countries within the Euro zone. The French Presidential Election takes place in April/May next year. President François Hollande looks set to face a serious challenge from the right wing anti-EU Front National led by Marine Le Pen. Meanwhile, German Chancellor Angela Merkel has to confront growing domestic discontent and increased support for Germany’s own Eurosceptic party Alternative fur Deutschland (AfD). The German federal election has to take place no later than October 2017. Italian Prime Minister Matteo Renzi is also under pressure as he struggles to deal with Italy’s ongoing banking crisis. Italian banks are drowning under €360 billion of non-performing loans. If Mr Renzi can’t persuade the EU to break new rules which currently prevent a government (taxpayer) bailout of Italian banks then he risks having to go to the polls early and face down Italy’s Eurosceptic party, Movimento 5 Stelle (Five Star Movement). So the political pressures on the Euro zone can’t be overstated exacerbated as they have been by the UK’s decision to leave the EU. But there is another danger which may trump all these, in the short-term at least. As mentioned before, the US Federal Reserve currently stands alone as the only major central bank considering tighter monetary policy. If this stance leads to the dollar strengthening against other currencies, either because of its higher yield and/or role as a safe-haven, then the Chinese yuan will strengthen with it. China has “unofficially” pegged the yuan to the dollar. China cannot cope with a currency that is too strong due to its reliance on exports. If the yuan becomes uncompetitive, then China loses out producers with a cheaper currency. We have seen China’s response to yuan strength before back in August last year and again in January this year. China devalued the yuan and helped to trigger a meltdown in global financial markets. Nobody wants that, especially the Fed ahead of a highly controversial US Presidential Election.



Disclaimer:

Spread Co is an execution only service provider. The material on this page is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by Spread Co Ltd or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

 

Posted by David Morrison

Tagged: Bulletin PM

Category: PM Bulletin


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