Macro Wrap-Up

Winter is Coming Before Brexit

Topics - Macroeconomics

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Winter is Coming Before Brexit

You haven’t had a Brexit Q&A in a while. Why are you writing about it now?
It changes so much every minute that it’s very difficult to write about in real time, but it is too important to markets to ignore. Even though the details change, the key issues persist.

Why is it so important now?
It’s been two years since British Prime Minister Theresa May invoked Article 50, so we’ve passed the point when the U.K. was supposed to leave the EU. May had come to an exit agreement with EU negotiators, but U.K. Parliament rejected it three times. 1 1 Close Wall Street Journal: “May’s Brexit Deal is Rejected for a Third Time by Lawmakers,” 3/29/19. EU negotiators have been reluctant to negotiate further when May cannot assure them that she can get a majority in Parliament. If the EU hadn’t granted two extensions, there would have been a no-deal Brexit.

Why can’t U.K. Parliament come to a compromise on Brexit?
Because there isn’t enough support for any individual proposal. When Parliament held indicative votes on various plans, none of them got a majority. 2 2 Close BBC: “Brexit votes: MPs fail to back proposals again,” 4/2/19. The compromisers who cross party lines want some kind of limited participation in the EU, such as staying in a customs union. Brexiters, mostly in May’s own party, think this gives up too much sovereignty, while Remainers, in opposition Labour and the Scottish National Parties, prefer a second referendum or a Norway-plus agreement. 3 3 Close In Norway-plus, the U.K. would technically leave the EU, but little would change, except that it would lose its participation in EU policy groups and its seats in EU Parliament. It would maintain all economic ties. Norway-plus does not have enough support to be a realistic alternative. There is also at least one smaller party that seems to vote no on most everything. Some Brexiters think that no-deal is preferable to a suboptimal compromise. Some Remainers seem to think that if nothing gets done, fear of the worst outcome will force the others to come to their position, but no side has felt the need to budge. 4 4 Close Maybe the opposite is true: there is no good solution so they’re all right. The disagreement is causing tension within both major parties, and they have seen some defections.

You mention a customs union. What is that?
A customs union allows free trade among its members and determines tariffs with outside countries. In some of the customs union proposals, the U.K. would give up its seats in the EU government and no longer be bound by EU policies on migration, but remain in a customs union. This would smooth the transition, prevent severe disruptions of goods across the Channel and give the U.K. and Europe some certainty about future economic prospects. U.K. Parliament came very close to getting a majority during the indicative vote, but there are some drawbacks for the U.K. First, the U.K. would give up its right to negotiate trade deals with other countries and may or may not have a say in the EU’s negotiations. Second, a customs union outside the EU bloc could require border checks, so the flow of goods may not be as fast as it is now. 5 5 Close Turkey has a similar, slightly more comprehensive arrangement, but the customs union it has with the EU isn’t referred to as Turkey-minus.

What kind of a compromise might May come to with the opposition Labour Party?
Labour leader Jeremy Corbyn has asked for a deal to include a customs union and some representation on agencies and in EU policy. May seems to have softened her position on some of these issues, but they aren’t on the same page yet. It is possible Corbyn may want another election as part of the deal. 6 6 Close It’s not clear it would get enough support, even if May promised it. Even if May and Corbyn agree, they still might not have enough votes in Parliament or the support of EU negotiators, so there are still many obstacles. Market participants, however, seem optimistic.

Has Brexit affected the European economy?
Business investment has been very weak in the EU for the past year. Brexit may have contributed because it has made planning difficult for companies. Companies have spent months preparing for the different potential outcomes, time that could have been used for more productive activities.

Why has the U.K. economy held up so well?

The U.K. is still in the EU for now, so trade has not been disrupted yet. Even though it has probably hurt business investment, some of the effects have been offset by the weaker British pound, which has actually helped trade.

What is a flextension? Is it a new home workout machine?

A flexible extension, or flextension, grants the British more time to come up with an acceptable agreement, but gives them the option of leaving at any time. It satisfies both the need for innovative thinking on how to delay decisions and the desire for awkward combination words. The EU agreed to a flextension until Halloween (October 31, 2019), which will give Parliament another six months to remain deadlocked.

Why was there any debate about giving the U.K. an extension? It seems obvious.
You know nothing, interview questioner. Some European leaders, most publically French President Macron, did not want the British to have continued influence over EU policy. They were uncomfortable with allowing U.K. participation in the upcoming EU elections. They feared the wildlings on the north side of the Channel, but ultimately granted them more time. This means we may not have a resolution for a while.

How have markets reacted to all the news?
They seem complacent about Brexit. Currency volatility has been low, although options premium on the British pound has been elevated. 7 7 Close The 100 day realized volatility of the British pound has been 8.8% annualized vs. the 100 day average of implied volatility on 1 month options has been 11.6% annualized. The implied volatility of 1 month options has fallen from more elevated level over the past few days, as the Brexit deadline date was extended. Source: Bloomberg as of 4/12/19. This indicates that recent news hasn’t changed people’s views much, but investors still fear what they perceive as low-probability bad outcomes.

Could the underlying economies be affected by different Brexit outcomes?
Yes, definitely. A no-deal Brexit would be a red wedding (divorce?) for both Europe and the U.K. Even though they have had plenty of time to prepare, there will likely be major disruptions. A customs union compromise would probably help EU countries because it would remove some of the uncertainty holding back investment. It’s not clear how much it would help the U.K. in that trade wouldn’t be as seamless and other countries might still avoid investment there. However, one thing to keep in mind is that no matter how bad it seems in the short run, both the EU and U.K. will have productive economies in almost any outcome.

Is there anything else that might affect British assets besides Brexit?
If all of this kerfuffle leads to another U.K. election, the new British leadership could take a radically different approach toward markets, the economy and the rest of the world. The election’s results could be as important to the British pound and the FTSE 100 as Brexit is.

Did you just go through the Q&A without explaining May’s original plan?
Yes. It had gotten to the point where she’d promised to resign if Parliament approved her plan. By that standard, she may be PM forever. The proposal could be revived, but it doesn’t seem likely to pass.

Is there anything enjoyable about following the Brexit saga?
Watching the Speaker in the House of Commons say “OR-DERR.” Whether or not you agree with his politics or his rulings, he knows how to say “order.” If you don’t believe me, look him up on YouTube. It will kill the time before the GoT season premier.

What We Are Watching

China GDP, Industrial Production, Retail Sales, Fixed Asset Investment (Wednesday)
The Chinese economy has faced several headwinds over the last year: tighter domestic credit conditions due to a clampdown on off-balance sheet lending, a major trade dispute with the U.S., and a slowdown in global growth. Chinese data has pointed a meaningful loss of momentum, with key series such as GDP and Industrial Production showing the slowest growth since the Global Financial Crisis. In recent months, the Chinese government has sought to loosen both fiscal and monetary policy, while a trade “truce” may have reduced fears of further tariff increases in the near term. PMI data for March suggested that growth may have stabilized. This week, the National Bureau of Statistics will publish GDP data for the first quarter along with monthly activity data for March. If these indicators confirm that growth is starting to improve, it could provide support to regional equities as well as commodities sensitive to Chinese demand, such as copper.

New Zealand CPI (Wednesday)
At its latest policy meeting, the RBNZ indicated that the low inflation backdrop in New Zealand justified continued monetary policy accommodation. Amid weaker global growth and reduced momentum in domestic spending, the central bank shifted its policy bias from neutral to dovish, noting that the next move in the policy rate was likely down. The statement also noted concern about the strength of the New Zealand dollar, as dovish monetary policy shifts among New Zealand’s trading partners have put upward pressure on the currency. Next week’s CPI report will shed light on the extent to which past appreciation of the New Zealand dollar has weighed on import prices. A particularly low inflation reading might be sufficient to trigger a rate cut from the central bank at one of its upcoming meetings.

U.S. Retail Sales (Thursday)
U.S. retail sales data has been volatile recently, making it difficult to discern the underlying trend. While there was likely some true slowdown in spending this past December, surprises since then may reflect temporary factors, such as residual seasonality in first quarter data, warmer weather (which may have weighed on winter apparel purchases), and the delayed timing of tax refunds. Other gauges of consumer spending would suggest U.S. consumers continue to open their pockets. Notably, after a few months of slowing sales, March auto sales were stronger than forecast. This week, the Census Bureau will publish retail sales data for March, which may shed light on whether consumer spending is still providing a boost to the U.S. economy. The rebound in March sales of big-ticket items such as autos, a late season pickup in tax refunds, and recent improvement in consumer sentiment survey data would seem to bode well for this reading.


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