Macro Wrap-Up

Yet Another Brexit Q&A

Topics - Macroeconomics

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Yet Another Brexit Q&A

As the Brexit deadline looms, it’s time for Brexit Q&A.

The Brexit vote was almost two and a half years ago. Why are we having a Brexit Q&A? Aren’t you a little late?

We still don’t know what Brexit will look like, and the outcome will almost certainly move markets. Brexit day is March 29, 2019.

Why are these negotiations so difficult?

It is very confusing. Ideally the U.K. would like to retain its trading privileges with the EU but not have to follow other EU rules, including the ones on migration. As you would imagine, the EU will not assent to that. To make matters worse, the two sides can’t even negotiate a new comprehensive trade deal until after the U.K. leaves, because until then the U.K. is still technically part of the EU. 1 1 Close How’s that for logic? It makes things really confusing. So, arguably the most important part of the deal will have to be done during the transition period. The two sides did come to an “agreement in principle” in March, which outlines the transition process and resolves some issues such as who will pay for what. There are, however, still some outstanding issues that must be resolved before the deadline.

What are the specific sticking points?

The biggest is Northern Ireland. Northern Ireland does not want a physical border with the rest of Ireland. The U.K. wants free movement of goods from England, Scotland, and Wales to Northern Ireland. It is very difficult to have both EU rules and U.K. rules for the same place at the same time. Some have talked about a high-tech border or having Northern Ireland in the customs union with the EU and the rest of the U.K. on a separate trade agreement. 2 2 Close Explaining the nuances of the Northern Ireland situation including the backstop would take three of four weekly Wrap-Ups. No solution appears to be acceptable to all of the parties in the U.K. and the EU. They still haven’t found what they’re looking for.

You keep referring to the U.K., EU, and Northern Ireland’s positions. Aren’t there diverging views within these places? Seems like you’re making questionable generalizations.

Yes, the Brexit vote was close, and now there seem to be even more opinions about it. Views on Brexit are not consistent within parties. And the place refers to the leadership, not everyone in it. These are some pointed questions.

This must make it difficult for the U.K. Prime Minister, Theresa May.

She is facing opposition from Brexiters in her own party for making too many compromises and criticism from the opposition Labour party. The EU rejected her Northern Ireland plan. She reshuffled her Brexit team and David Davis, the Brexit secretary, resigned. 3 3 Close Technically he was the Secretary of State for Exiting the European Union. But that is just too long.

What is a hard Brexit?

It would mean the U.K. leaving the EU completely, most likely without a deal at all. 4 4 Close The exact definition of “Hard Brexit” is a bit fuzzy. Some use it to mean a “no deal Brexit,” while others use it more broadly to include any major change to the status quo. Even though the agreement in principle lays out some guidelines, it has not been turned into a formal, legally binding deal. If there is no deal, it’s not clear how trade between the EU and U.K. would proceed. It would probably be governed by the WTO, but things could get chaotic. Many in the U.K. fear import disruptions and potential shortages; though others say it would be manageable. So far the indications are that it would be very complicated for businesses.

Have companies been preparing for Brexit?

Yes, some have started moving staff to continental Europe. Banking seems to be an area that is particularly affected, although there is talk of a workaround. Some companies have made contingency plans for a hard Brexit.

What would a hard Brexit mean for markets? What is priced?

A hard Brexit would probably be bad for U.K. assets because of the uncertainty. 5 5 Close The Bank of England may react by cutting interest rates to support the economy, which could benefit U.K. government bonds. The markets are pricing some premium for it as the British pound has underperformed since the referendum, but it is probably not fully priced. Markets also could be underestimating the negative effects on European assets.

Why would it be bad for European assets? Why would they care about losing an island in the Atlantic?

The U.K. is a large trading partner for the rest of Europe. Whether EU folks like to admit it or not, it would hurt the EU economy to lose that trade. It would be another blow to the credibility of Europe in a time when there is no shortage of internal dissent. The EU folks would like to teach the U.K. a lesson and send a warning to others considering similar action, but it is not without cost.

If there is a deal, would that help markets?

Any deal, even a vague one, would probably help U.K. markets. EU markets too.

Could they just kick the can down the road and agree to negotiate more?

Seems unlikely, but it would not be the first time the EU has delayed taking action on an important issue. It would be a way to ensure that no one is happy, which would appeal to people who like to complain on both sides of the Channel. They could try an indefinite extension of the transition period. It would be sort of an extension of the agreement in principle.

Will there be a second referendum in the U.K.?

Some people want one. Some people also want England to win a second World Cup.

How is the U.K. economy doing otherwise?

Pretty well. Growth is a little slower than last year but still OK. The Bank of England has been able to raise rates twice since the Brexit vote. It also appears as though the government finances are a little better than had been forecast.

Speaking of the Bank of England – what would they do if there was a hard Brexit?

The BOE members have been cagey on the question. It would hurt activity but might increase inflation if the currency fell or shortages occurred. Regardless of what they say, it seems far more likely that they will cut rates. They understand the effects of tighter monetary policy during times when the economy is weak. However, if there is a deal, the BOE will probably hike more aggressively. BOE Governor Carney hinted that the uncertainty over March has been holding them back this year. The data is backing him up.

People are stubborn. Give me one good reason to think there will be a deal.

It’s in the interest of both sides to work something out. And people from the U.K., from continental Europe and from the rest of the world can all dream that someday we won’t have to talk about this anymore.

What We Are Watching 

U.S. Midterm Election (Tuesday) Since the 2016 election, the Republican Party has controlled the presidency, the House of Representatives, and the Senate. Typically, the party that controls the presidency loses seats in midterm elections, particularly when the president has a low approval rating. This pattern appears highly likely to hold this year, with polls showing a sizeable swing towards the Democratic Party. Election models 6 6 Close Such as that published by ABC News’s FiveThirtyEight. generally see a high likelihood that Democrats will take control of the House, while the Senate is more likely to remain in Republican hands. From the point of view of markets, the most important legislative accomplishment of the current Congress was likely the tax bill passed in late 2017, some provisions of which are scheduled to expire over the next few years. A Democratic victory in either chamber would significantly reduce the probability that tax cuts are extended or any additional tax legislation is passed, and would therefore imply somewhat tighter fiscal policy. Conversely, if Republicans maintain control, fiscal policy may be loosened further, perhaps providing a boost to corporate profits and GDP growth. As a result, if Republicans outperform their polls and unexpectedly maintain control of both chambers there may be a positive reaction in U.S. equities and a negative reaction in bonds.

FOMC Meeting (Thursday) The Fed has recently been in a steady rhythm of quarterly rate hikes, with moves in December, March, June, and September. The Summary of Economic Projections published in September showed a large majority of FOMC participants expecting to hike rates once more in 2018 and multiple times in 2019. This hawkish policy trajectory reflects the continued strength of U.S. economic data, as GDP growth has remained rapid, unemployment has fallen to a multi-decade low, and inflation has risen to around the Fed’s 2% target. 7 7 Close Bureau of Economic Analysis, Bureau of Labor Statistics. However, there are signs that the shift towards tighter monetary policy may be starting to impact investor sentiment, as rising bond yields may have been one of the triggers for equity market weakness in October. While no change in policy is likely to be announced at this month’s Fed meeting, markets will be watching the statement for any sign that the central bank is softening its hawkish rhetoric. Acknowledgement of recent equity market weakness (or of slower growth numbers abroad) might be seen as an indication of a more dovish attitude moving forward.

U.K. GDP (Friday) Policymakers at the Bank of England (BoE) remain cautious due to ongoing uncertainty over the Brexit process. Meanwhile, U.K. unemployment remains low and activity data has pointed to a modest pickup in growth. If the upcoming initial estimate of third quarter GDP confirms this positive trajectory, it may prompt a more hawkish approach from the BoE in the event that a Brexit deal is reached relatively soon.