The triggering this week of Article 50 of the Lisbon treaty to facilitate Britain’s exit from the EU is undoubtedly a momentous event. At issue in the forthcoming talks will be whether Britain can win back control over immigration and lawmaking without wrecking trade relations in its biggest market and damaging London’s status as the pre-eminent international financial centre.
A minimum of two years of difficult and complex negotiations over the “divorce bill” and future trade relations between Britain and the 27 remaining members of the EU will be a hazardous process, with a real risk of total breakdown. Financial markets will be hostage to every twist and turn of the negotiations. Yet the move does not have clear-cut market consequences. Indeed, the destabilising impact for equities may be less than the historic nature of this move might seem to imply.
For a start, investors have already factored in calculations of the likelihood of a hard Brexit in which Britain trades with the 27 under World Trade Organization rules. They have also made their estimates of the damage to UK-based banks if they lose their passporting rights in the single market. Equally important, UK equities are relatively detached from the domestic economy. Companies in the FTSE 100 derive more than 70 per cent of their earnings from overseas, so geography matters remarkably little to its performance. The post-referendum devaluation of sterling was a significant boost since those foreign earnings became instantly more valuable.
Below that level companies will be buffeted by the ups and downs of the negotiating process. Yet we are in the midst of a near-synchronised global reflation in a relatively mature recovery. Yes, it is a journey into the unknown. But there could hardly be a more benign economic background in which to go through the tortuous process opened by invoking Article 50. Meantime, weaker sterling has provided a prize opportunity for policymakers to rebalance the economy away from the debt-fuelled, consumption-driven growth.
While there has been much talk of a squeeze on real incomes following the rise in inflation induced by weaker sterling, households still appear remarkably untroubled by Brexit and house prices continue to rise, albeit at a slower rate. So the UK economy is hardly down and out.
As for the future of the City, there will clearly be some erosion of its market share as business is lost to the eurozone. But in international finance there are huge advantages in incumbency that derive mainly from economies of scale. The range of the City’s activities and the depth of its markets will ensure that it remains the dominant financial centre in Europe.
There may even be advantages in shrinkage. EU leaders are anxious to shift clearing and settlement of eurozone securities from London to the eurozone. Since regulators have been steering business away from over-the-counter markets into organised clearing houses, these institutions have potentially become too big to fail. So if the business moves, the British economy may be a bit less vulnerable in a financial crisis. Continental Europeans should be careful what they wish for.
There is one UK market where geography really does matter and which has been acting as a haven for international money. That is the commercial property market. Have its attractions been seriously undermined by Brexit?
Capital values tumbled after the referendum and only stabilised in late autumn. Yet the total return on commercial property in 2016 as measured by the IPD index still emerged as a positive number at 3.9 per cent because the decline in capital values was outweighed by strong rental income.
That said, it is hard to see how the office market, the natural place for haven investors, will be as attractive as in the pre-Brexit world. Estate agents LaSalle, for example, are forecasting negative rental growth for prime UK offices from 2017 to 2021. A haven that threatens to deliver capital losses and negative rental income cannot qualify as a haven.
I suspect the biggest instability will be in the currency markets around sterling — not necessarily a weaker one. When the European Central Bank retreats from quantitative easing the currently undervalued euro could bounce sharply, thereby accentuating Britain’s handy devaluation. In sum, when embarking on a course so fraught with uncertainty, the muddle through scenario is usually the best working assumption for market practitioners.