Transition period extension talk with the EU | June 2020
In this episode we discuss the post-Brexit transition period extension talks with the EU are a short-term risk for sterling.
Unsurprisingly, following the COVID-19 induced lockdown, the latest UK macroeconomic data has slumped. April underlying retail sales volumes (excluding fuel) registered a record decline of 18% from a year ago, while consumer confidence has fallen to levels last seen in 2012. The independent Office of Budget Responsibility forecasts a near 13% real GDP decline for 2020. If correct it will be biggest decline since the Great Frost of 1709, which was the coldest winter in Europe for more than 500 years.
[0.27] Let’s turn to the UK economy first. How large an impact is Covid-19 having on growth?
- Unsurprisingly, following the COVID-19 induced lockdown, the latest UK macroeconomic data has slumped
- underlying retail sales volumes (excluding fuel) registered a record decline of 18%1 from a year ago, while consumer confidence has fallen to levels last seen in 2012
- the independent Office of Budget Responsibility forecasts a near 13% real GDP decline for 20202
- if correct it will be biggest decline since the Great Frost of 1709, which was the coldest winter in Europe for more than 500 years
[1.23] Brexit has been largely forgotten amid the crisis, but there is an important deadline coming up, isn’t there?
- the slump in UK (and EU) output caused by COVID-19 has overshadowed the upcoming 30 June deadline; the last straightforward opportunity to extend the post-Brexit transition period beyond the end of 2020 by 1 or 2 years
- given that valuable negotiation time has been lost by COVID-19 and the wide gap in the two negotiating positions, politicians do have a valid reason to extend the transition period
- however, the UK government’s view is that without a cliff edge the necessary compromises won’t be made, so more time would not make any difference
[2.21] How do you rate the chances of a deal?
- with so much to do and the personalities involved, there is plenty of risk that the UK and the EU fail to reach an agreement in the time available
- for example, fisheries policy appears to be a sticking point in current negotiations
- ultimately, the EU could well back down: there is no way to force the UK to allow European fishermen to have the same access to British waters, there may be a move in this direction
- the press reported that Michel Barnier, the EU’s chief negotiator, has conceded on the need to shift from the “maximalist” mandate on fisheries demanded by France, Spain, Belgium and the Netherlands
[3.32] What happens if there is no agreement by the end of June?
- If an agreement is not reached by the end of June, an extension can still be agreed by end-December before the current transition period runs out
- however, once the June deadline passes, the legal and political obstacles to agreeing one further down the road are significantly higher
- that’s because it would be likely require another treaty change and therefore unanimous agreement by the other 27 member states.
- Post-June, any single member state could block an extension, as against the current arrangement where only agreement by the UK-EU Joint Committee (the body to oversee and monitor the Withdrawal Agreement) is required
- although decisions made by the UK-EU Joint Committee must be approved by the Governing Council (the heads of state), it is nevertheless hard for a hold-out nation to block the “consensus” of Council members. For example, France failed in its bid to take a hard-line stance on Article 50 extension in April 2019
[4.42] What is the likely impact on sterling?
- Sterling could be vulnerable over the coming months; with big trade and budget deficits, zero interest rates, around 30% of government debt held overseas3.
- the lack of clarity on the UK’s future relationship with the EU could be a potential catalyst
- nevertheless, over the longer-term, the strong build-up of US money supply should be a negative for the USD leg of the ‘cable’ currency pair of the dollar against sterling
- assuming the world recovers, more of this money will pour out of the US through a widening fiscal and current account deficit
- this would then increase the supply of USD in the global financial system and could well lead to a new downward leg in the greenback and a rally in GBP
[5.44] Let's turn to another subject. Inflation has been benign in recent years, but is there a risk it could reignite?
- A sudden rise in inflation is a key risk for any unprepared portfolio
- currency devaluation, more local supply lines, tariffs and trade-war could all increase costs
- potentially, higher inflation could mean central banks are forced to tighten monetary policy in order to abide by their mandates.
- in the near term (1 to 2 year) the outlook across the post-COVID-19 globe is disinflationary, which is reflected in very low government bond yields
- one way to observe this is through US real GDP growth and its lead on underlying inflation
- with the consensus forecasting large GDP declines, US core (ex food/energy) consumer price inflation is expected to drop from its current position of around 2% to near zero in 20214
[7.08] What would this mean for stock markets?
- Equity investors should not despair. From data going back to 1965, a 0-2% inflation range for each country has seen annual US S&P 500 and German DAX returns of 10.3% and 11.9% respectively5
- for the moment, global equities are in a sweet spot of current low inflation enabling policymakers to step-up monetary and fiscal stimulus to lift markets higher
- the MSCI All Country World index has already retraced more than half of its losses since the market peaked in mid-February6
- nevertheless, the risk of higher consumer price inflation over the medium-term (3-5 years), primarily due to policy responses to COVID-19, has increased and is a potential risk for portfolios
- essentially, more money is being directed to Main Street (consumers) over Wall Street (banks)
- the opposite of what happened during the Global Financial Crisis (GFC) in 2008 when funding was used to repair balance sheets of the financials
- looking forward, when consumer confidence recovers and unemployment rates decline following the lifting of lockdowns, pent-up demand could lead to higher inflation in the years ahead
- to hedge against this risk, we favour inflation protected government bonds (particularly US Treasury Inflation-Protected Securities) and gold.
1 Bloomberg, April 2020
2 Bloomberg, April 2020
3 Refinitiv, May 2020
4 Refinitiv, S&W Investment Strategy calculation, as end of May 2020
5 Refinitiv, S&W Investment Strategy calculation, as end of May 2020
6 Refinitiv, S&W Investment Strategy calculation, as end of May 2020
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This episode was recorded on 28/05/2020
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