"If only I don’t bend and break” Keane, Bend and Break: Hopes and Fears
Against a backdrop of rising uncertainty and falling asset prices, there are a surprising number of significant focal points for financial markets at the current juncture. At the forefront of sentiment and headlines in the UK, the Brexit debate appears to be reaching a crescendo. While the backbench revolt from the ERG through the 1922 Committee has, for now at least, come up short of the 48 letters required to attempt to remove Theresa May, the next few days are crucial to the continued premiership of Mrs May, the lifespan of the Withdrawal Agreement in its current (if modestly amended) state, and perhaps even the reign of the Conservative Party.
Writing in the Telegraph today, Dominic Raab highlighted the three points that he felt he could not be party to - the same three points that a broad array of MP’s (from all corners of the House) have specific concerns with. The first is the Northern Ireland backstop, that if used could see Northern Ireland facing additional regulatory requirements compared to the rest of the UK. What we would argue however, is that under such a scenario, NI would also have a greater access than any other part of the UK to both markets and thus its designation as a Special Enterprise Zone could perhaps balance the loss with a (potentially significant economic) gain. The second is the fact that the exit from transition without the invocation of the backstop requires mutual consent - effectively giving a veto to the EU on UK plans to exit transition.
Thirdly, Raab points to what he describes as a late concession in the text setting the basis for the Future Relationship to "build on the single customs territory” set out in the backstop. While we have specific concerns with the first two points, there are some signs that discussions may ultimately include a technology-based alternative to the backstop - not to mention the fact that it is unlikely that the EU would wish to retain the UK in a position where it would effectively maintain its access to the single market while not complying with the four freedoms. The third point is potentially more troubling, however, and the detail or context is key. Our interpretation of Chequers was that it aimed to provide a mechanism for medium term change, initial convergence followed by managed gradual divergence through a ‘common rulebook’ - accepting that divergence may come at a cost. If this is the ‘starting point’ then it can still be deemed compatible with Chequers. This was referred to in the House of Commons (PMQ's) today as "balancing market access today with freedom to diverge tomorrow".
"So much of design is context” Steve Madden
From our perspective, the Political Declaration is key, not just to deciphering the starting position and intended direction of travel, but also the commitment of both sides to reach an end point that avoids the backstop and all the negative connotations that this brings. French demands for access to UK fishing waters and Spanish demands over Gibraltar are unlikely to derail proceedings. A failure of the Declaration to allay the three concerns above are a significant concern. However, we remain of the opinion that the Withdrawal Bill will ultimately pass through parliament and in order to do that it is critical that the PM / Brussels demonstrate sufficient mutual interest to prevent the UK from being left in a ‘vassal’ state or addendum to the EU indefinitely.
On a wider UK context, ex-Bank of England MPC member David Miles gave an interesting account of proceedings this morning in suggesting that the order of magnitude of the economic implications of Brexit medium term are ~ /-2-3% GDP (though we would argue that the longer-term positives are higher), but that the economic implications of not addressing the UK’s productivity challenge are more likely in the order of magnitude ~ /- 20% of GDP.
This week, the IIF’s Robin Brooks published an interesting paper that challenges a dominant view on financial markets about the eurozone current account surplus and its implications for the relative valuation of the EUR and thus its theoretical forward bias. "Many see the Euro Zone current account surplus as a sign the Euro is too low & should rise. But the surplus reflects large output gaps on the periphery. Once you adjust IMF gaps for that and factor in recent Euro strength, the current account is negative!” Robin Brooks, Twitter
The implication of this analysis is that the EUR is over, not under-valued. Against the current backdrop of a (potentially troubling) slowdown in eurozone growth momentum, this reinforces our near term negative EUR bias - particularly vs. GBP.