After nine months’ gestation, the Brexit process has started. Both sides of the referendum have political points; Brexiters can say the UK economy is growing and there has been no market implosion, while Remainers can say UK assets have drastically underperformed the rest of the world, and the costs of the historic sterling devaluation are yet to be counted.
Now, it is time to work out what will move UK asset prices over the next two years. This will depend on two factors. First, there is the negotiation process. Second, there is the effect that devaluation has on UK inflation, and the knock-on effects that has for monetary policy and the economy.
On both, scenario analysis is wise, and investors should hedge their bets. They should at least have learnt one lesson from the bizarre overconfidence that led the sterling market to price a Remain victory as more than 90 per cent certain.
First, with the negotiations, investors should assume that Brexit itself is a certainty. The chance that somehow Britain stays in the EU is higher than zero, but not by much, and would require some significant external intervention — either a big anti-EU victory in a European election that changed the shape of the EU, or some event that turned opinion in the UK.
Beyond that, scenario analysis gets trickier. On the negotiations, Oxford Economics suggests it can be boiled down to two pairs of issues. First, can the UK negotiate an ongoing trading relationship with the rest of the EU in time for the end of the Article 50 process in two years’ time, or will it be necessary to thrash out an intermediate agreement to tide things over?
Second, which of two broad outcomes is more likely after that — a free-trade agreement (which could cover a multitude of sins) or a failed negotiation that leaves the UK and the EU trading with each other on the minimal terms mandated by the World Trade Organisation?
Oxford Economics’s suggestion that there is a two in three chance that they need to opt for a transitional arrangement seems about right. Both sides will want to tackle the hardest issues first. These are the issues that are less salient to the market, but very sensitive politically, covering immigration, the rights of EU nationals already resident in the UK, and thrashing out a “divorce fee” to the EU.
Coming up with a workable compromise on these issues will take time and so we should expect that long before the two years are up we will know that a transitional arrangement will be needed, and that the key trade issues will take beyond March 2019 to resolve. That would mean protracted uncertainty and the old saw is correct that markets dislike uncertainty.
If this happens, then the risk of a “hardest Brexit,” on World Trade Organisation terms (which few if any envisaged during the referendum campaign last summer), would grow. Oxford Economics’ scenario analysis suggests the risk of this is as high as 40 per cent and that this outcome would shave 0.8 percentage points of UK GDP growth each year by 2030. This is alarming and some will doubtless claim that is alarmist.
Still, it should be possible to thrash out a free-trade agreement. Both sides would benefit from tariff-free trade, so it ought to be possible to get to a mutually beneficial conclusion, maybe after a period to soothe feelings after a bruising fight over migration. A protracted period of uncertainty lasting more than two years, followed by a free-trade agreement, is therefore the most likely outcome. Oxford Economics puts its chances at just over 50 per cent, which sounds somewhat conservative.
Are these risks adequately reflected in prices at present? Possibly not. Sterling on a trade-weighted basis has held just above its lows from the 2008 financial crisis. If the nightmare scenario of Britain failing to negotiate a free-trade agreement at all were to come to pass, it would surely need to move lower. It is the currency market that has borne the brunt so far and that is likely to continue.
As for the stock market, whose strong performance in sterling terms has embarrassed the pro-Remain doomsayers, a sectoral breakdown suggests there is disquiet over the risks of Brexit. By far the strongest performers have been mining and resources companies, which are over-represented in the FTSE 100, and for whom the UK economy is almost irrelevant. They rise and fall with commodity prices. Other sectors to rise have been in exporting sectors that benefit from the weak pound.
It is probably fair to say that the FTSE 250 index of smaller companies, which has underperformed the rest of the world in sterling terms by 20 percentage points since June 23, is already discounting the most likely current outcome — an extended process ending with a free-trade deal. Having missed out on the global rally to such an extent, it may even be discounting the risk of complete breakdown in talks.
But now comes the second issue of the pass-through from the devaluation to inflation.
After the last big leg down for sterling in 2007-08, the UK was alone among the developed economies in having above-target inflation for several years. Inflation is now rising, and bond market inflation expectations have risen, with 3 per cent per year for the next five years seen as likely.
If this continues, then either the inflation will require a lower earnings multiple on UK stocks, or the Bank of England will have to raise rates, thereby requiring a lower earnings multiple on stocks. It is because of hawkish noises from the BoE that sterling has been strengthening in the weeks leading up to Article 50.
Broadly, the story is that the fall in the pound has contained the damage for UK assets, but they have still underperformed miserably since the referendum. This shows the FTSE 250 (less aided by exporters and miners) relative to FTSE’s index for the world excluding the UK.
Where does that leave someone trying to allocate capital? Both the currency and the stock markets seem to be discounting a difficult negotiation that ends with a sensible result on free trade. It is hard to see much upside, but there is plainly a significant downside. This is a medium-term issue, but it will make UK assets more volatile over the next two years.
In the shorter term, the risk is inflation. If inflation does stay contained, then again current pricing seems reasonable. The BoE is likely to intervene in the short run if inflation rises, so this would support sterling. The greatest risk in the short term therefore is to stocks. After UK stocks’ impressive rally, investors need to be very confident that inflation will stay under control before buying any more.