Market developments were dominated by events in the UK last week, where the government published its White Paper for exiting the EU, and suffered two prominent cabinet resignations as a result. The May government was also stung by the visit of US President Donald Trump , where he delivered withering criticism of the government’s Brexit strategy, while England ‘s exit from the World Cup only added to a week of trauma.
Two years on since the Brexit referendum, the compromise deal reached by Theresa’s May government about its planned Brexit negotiations has failed to inspire much confidence. It resulted in the resignation of two prominent cabinet members, the Brexit secretary David Davis and the foreign secretary Boris Johnson, plus a number of junior officials. As a consequence, the final nine months of UK-EU negotiations are likely to be very uncertain, with the government’s survival always in question. Accordingly, the possibility that the talks could ultimately fail is increasing, with the UK potentially leaving the EU next spring without any agreement in place to soften the impact.
Given these developments it was striking how well sterling behaved, even rallying in the aftermath of the government resignations seemingly on the belief that the departure of arch-Brexiteers will make a ‘soft’ Brexit more likely. This appears to be May’s intention, giving the UK what amounts to ‘associate membership’ of the EU’s single market in key areas such as trade in goods and agriculture.
If this is the hope, it is still too early to hold it with a tremendous amount of conviction however. For one thing the EU is quite likely to reject key elements of the government’s White Paper, threatening the apparent unity of the new May cabinet. Indeed any further concessions made to Europe could well spell May’s demise, with a snap general election becoming a distinct possibility. An election might also be seen as hastening a ’soft’ Brexit if the opposition Labour party were to win, but as last year’s surprise election result showed, certainty about the outcome would be by no means guaranteed.
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There is another plausible reason for UK markets being less affected than might have been expected by these latest political developments, which is that for all the pessimism generated about Brexit since the referendum in 2016, the actual economic outturn has not been anything like as bad as feared. The UK Treasury warned before the referendum that a vote to leave the EU would result in ‘an immediate and profound economic shock’ with the UK going into an ‘instant recession’ and with 800,000 jobs likely to be lost within two years. The International Monetary Fund’s Christine Lagarde also famously commented that the outcome of a decision to leave the EU would range from ‘pretty bad to very, very bad’.
The last two years, however, have told an opposite story with steady growth of 1.7 per cent in 2017, and with the unemployment rate plunging to a 43-year low of 4.2 per cent. As a consequence the markets have probably learnt not to pay as much heed to the doomsayers as they did before the referendum. They may even turn out to be right in judging that Brexit will not be as disastrous as many policymakers have predicted. The Bank of England after all quickly reversed the emergency rate cut made in the immediate aftermath of the referendum, and is now poised to raise interest rates again, probably in August in the wake of improving second quarter economic data.
Of course the political dimension is one that could still undercut this benign outlook. While the pound did not collapse last week, its rally was limited and will likely remain so while there is an overhang of political uncertainty. The sterling exchange rate index is now about at the mid-point of its trading range since the 2016 referendum. With Brexit negotiations likely to play out all the way to the April 2019 deadline, this factor should inhibit the pound’s upside, with only a resumption of dollar weakness likely to see it able to gain much ground. But with the rising possibility that the government could fall, the pound’s downside probably remains as the greater risk-reward.
Tim Fox is group chief economist and head of research at Emirates NBD