November 4, 2016    12 minute read

Brexit: Doom, Gloom Or Silver Linings?

The Death Of Prognosis    November 4, 2016    12 minute read

Brexit: Doom, Gloom Or Silver Linings?

As far as the UK is concerned, Brexit is the word on everyone’s lips right now. With both the business world and the global public trying to stay on top of the unfolding drama and its toll on the economy, the press is rolling out a constant stream of information, from financial indicators to the inklings of what might go down on the negotiating table. Pundits and markets alike are chipping in with their predictions, but how much optimism or pessimism is justified?

Economics: On Hold

It is crucial to highlight how the traditional importance of economic data and business attitudes has been hugely undermined. Britain is a state of such uncertainty and political turmoil that things like growth figures and currency movements are more redundant than ever for telling the future.

The UK has not yet left the EU, of course, and the data one sees now does not reflect Brexit itself but rather the current state of the economy and the speculative attitude that businesses and investors have taken towards the outcome of the referendum. To get a better sense how things will turn out, in the long run, all eyes are increasingly on the political stage.

So when one hears announcements such as the UK economy’s higher-than-expected growth of 0.5% in the third quarter of 2016, they no longer elicit the same kind of optimism and relaxation that they once did. Though a clear improvement on the 0.3% expected by many forecasts, this means little more than that economists were overly pessimistic about the consequences of the referendum.

0.5% was the UK economic growth in Q3

Hence the minced words from Chancellor Phillip Hammond, who said: “The fundamentals of the UK economy are strong, and today’s data show that the economy is resilient”. Which fundamentals? Resilient enough just to weather the last few months of uncertainty, or to keep on growing?

Pro-Leave optimists may feel vindicated now that warnings of a pronounced effect and likely recession in the period after the referendum have shown to be overly rash. But from their perspective, this can at best only mean a small victory over the architects of “Project Fear.”

It does not necessarily imply that the economy will be able to weather a protracted state of uncertainty. The UK is better equipped than was thought to handle the postponement of investments and withdrawal of capital, which is still expected to drag growth into smaller and smaller figures. It seems to be in large part because the sectors which rely more on the sorts of things which strong confidence brings to the table (such as investments in export-heavy projects, or capital in the property market) are a lot smaller than those who rely less so on.

Source: ONS via FT

Source: FT

This could be why the service sector, the biggest of the economy, has continued to grow while manufacturing and construction have shrunk.

And ultimately, the margins involved in building the overall picture of growth are small. For example, it is estimated that about 0.1% of recent growth was due to strong performance from the film and TV industry this summer – less favourable winds in the next quarter could come closer to swinging things the other way.

Taking A Pounding?

As many have been quick to point out, the positive story of recent growth figures does not somehow prove that Brexit will work out fine. Though nor does the plummeting pound by itself mean that the economy will tank.

Much has been made of the massive fall in the pound since the referendum result. And whilst few may take seriously assertions that better-than-expected GDP performance vindicates the pro-Leave camp, not many are challenging the orthodoxy on the currency, with many taking it as given that its depreciation spells doom for the coming years.

The enormous uncertainty towards Britain’s economic future is no secret. But it is rash to jump to conclusions about the fall in the pound without qualifying them.

There is good reason to be concerned over the coming months as the weak pound will drive up the prices of imports. Optimists, on the other hand, point to the upside: the cheaper pound could mean a boost in demand for British products and services.

Consumers will undoubtedly feel the hit in the short term: though retailers and customers have in recent weeks called bluffs from distributors and businesses are using depreciation as an excuse to drive up prices for things which do not rely all that much on foreign inputs, it is only a matter of time until inflation filters through. And in the months to come, will British exports be buoyed enough to offset the squeeze on their balance sheets due to increasingly expensive imported inputs?

In the long term, prices will pressure the economy into rebalancing, as consumers turn towards UK-made substitutes for more and more expensive imported goods, and British businesses find ways to rely less on increasingly expensive foreign inputs in order to stay competitive. But is the British economy flexible enough to accommodate this quickly, or successfully?

One could take a leaf out of Paul Krugman’s book and hope for an export-led recovery of the kind he argues have taken place in other countries in similar situations. Or one could be an “elasticity pessimist,” doubting whether the cheaper pound will really do much good for British exporters at all: for example, the Financial Times’ Martin Sandbu argues that exchange rate fluctuations can outweigh any effects on trade by creating uncertainty in businesses’ profit calculations.

Brexit is such an unusual situation that it is a harder task than ever to apply economic principles in a reliable way. On the one hand, the pound’s value has been changing so rapidly that one could easily be inclined towards Sandbu’s predictions. On the contrary, the drop is so substantial that some degree of ‘elasticity optimism’ can surely be justified. One could easily see a similar story to previous runs on the pound, such as that following Britain’s exit from the Exchange Rate Mechanism in the early 1990s (where British exports ultimately came out a lot better off than the markets expected).

But this assumes that other currencies will remain stable over the coming years – by no means a safe bet. The slim but undeniable possibility of a Trump presidency would probably lead to a similar crash in the dollar. The collapse of the euro cannot be written off either, whether it be due to systemic debt-related grievances getting the better of Brussels, or the end of the EU as one knows it (given, for one, the very real chance of a Le Pen victory in the French presidential elections this year). How much longer will the pound actually stay the sick man of the currency world?

A Bubble Burst?

There are other reasons to re-evaluate the dominant narrative towards the weak pound. The above concerns the consequences of the falling Sterling, not enough seems to have been made of its causes.

On the face of it, it is not good news: currency depreciation signifies a drop in investors’ confidence as speculative funds are pulled out of the UK. But Ashoka Mody points out that a significant part of the funds which have been withdrawn is made up of risky investments in the property market. Looking at indices since June 23rd, property-related asset prices have followed the value of the pound fairly closely.

Source: The Independent

Source: The Independent

His argument is that a finance-property bubble centred around London has built up over the years as the capital was seen as a safe bet for speculative financial capital. With UK banking becoming more and more organised around leveraging up existing property assets, this became a “bubble” which increased the value of the pound. Hence, he argues, the British economy was living on borrowed time, and the Brexit-induced currency depreciation let the air out of the bubble gently – saving us from a more violent burst otherwise.

The idea that the pound was overvalued before the referendum is not out of the fringes, either. The IMF reckoned in February 2016 that it was overvalued by about 15%.

But even if one buys the view that Britain was, therefore, living beyond its means – able to buy more foreign goods and services with its currency while domestic producers lost their competitiveness, their exports becoming more expensive to foreigners – it is no easy feat of analysis to show that the process can be reversed cleanly, for the reasons touched upon above (and more).

The Death Of Prognosis

There are already many factors which will influence how the weaker pound will take effect, be it in the optimists’ expected direction or otherwise, and each element, in turn, has been made fuzzier by the dramatically unfamiliar context that Brexit throws it into.

The same is true for more than just currency depreciation. Business decisions, too, have become harder to analyse. For example, when Nissan hinted at having cold feet about maintaining production in the UK, public reaction immediately bolted in two extreme directions: this was either concrete proof that businesses no longer have faith in Britain, or crafty corporates exploiting the pessimistic climate to grab some taxpayer-funded security all the while knowing their Sunderland car plant would stay viable under new trading conditions.

The reality is probably somewhere in between the two. But with so many important players in the UK lining up to make similar moves, and each one standing to be affected differently by the possible changes to economic conditions, it is harder than ever to get an overall picture and interpret business confidence reliably.

Of course, it would be rash to conclude that the markets are making clumsy or flat-out wrong predictions. But the inability to rely as much on traditional indicators like currency performance and growth figures (in addition to the unique circumstances of Brexit) means that speculators are focusing more on politics to make their predictions.

The problem is that they do not seem to be that good at it. For example, the FT’s Roger Blitz reported that until Theresa May set the March 2017 date, a significant minority of investors believed that Article 50 would never be triggered or would not be triggered for quite some time. This is reflected in the attitude that many European politicians have taken: much thought for some time and possibly still believe that Brexit could just fizzle out.

This comes as some surprise to anyone with more than a cursory understanding of British politics. Perhaps it is down to the gap between very different political cultures, easy to underestimate in countries otherwise very similar. Perhaps it is down to a particular interpretation of history – the thought that, just as the EU found a way around French and Dutch referenda opposing the European Constitution, it could find a way around Brexit too.

Who knows? The important lesson so far is that there is an asymmetry in political understanding of a kind not to be found in the world of finance and economics. It is not just across borders, but between ordinary people and the political and financial classes. The biggest flop in market predictions, of course, was to think that Brexit would never happen – a catastrophic failure to hedge bets correctly, particularly in that speculation was more in favour of Remain than the already-flawed polling could have possibly justified.

People are arguably still getting their predictions wrong. For example, many across the Channel (and even a few Treasury wonks) seem to think that a “soft Brexit,” whereby the UK remains part of the European single market, is still possible. Yet anyone immersed in British current affairs would find it almost unimaginable that Mrs May’s government will allow freedom of movement from Europe to continue, and the odds of a compromise from the EU are equally slim given the threat it would pose to its continued existence.

When such predictions play out in financial markets and inevitably turn out wrong, they exacerbate existing uncertainty.

Keeping An Open Mind

Economic pessimism can become self-fulfilling if its concrete effects snowball into a state in which expectation-defying performance is less and less able to recover the economy from dire straits. For example, postpone investments long enough and some businesses will not have the strength in their accounts to make it to the (hypothetical) stage where things turn out to be financially viable later on.

Yes, a closer look into supposedly positive news like expectation-defying growth confirms the importance of not getting complacent (which in fairness the Treasury probably are not, despite Hammond’s rosy soundbites). But decision-makers should not be afraid to cast a critical eye at the gloomy either.

The Conservative government, showing up its lack of imagination in policy, has failed to live up in action to the ruddy optimism in its words. The assurances that Theresa May has given to Nissan suggest a lack of faith.

Her government has supposedly promised to shield the Japanese car manufacturer from adverse trading conditions. But the certainty of a “hard Brexit” means that they know that tariff-free access to the EU market is unlikely at best. Therefore it is very likely that some fiscal guarantees have been offered.

The fact that the Tory government is willing to put money against Brexit sends a signal to the markets that is bound to reinforce pessimism. Whether right or wrong, this signal will be magnified by the heightened reliance on the political information.

And if there is one lesson the last year has taught, it is that the political elite is not terribly good at predicting things on this scale. So now more than ever, it will be down to investors and businesspeople to seek out opportunities.

This could mean taking seriously investments in British exports if it looks like the weak pound is doing them more good than harm, for example, or backing businesses which look set win out in domestic markets as those that rely too much on imports lose their competitive edge. Or it could mean taking a long, hard look at the future of the Eurozone and assessing whether shifting operations across the Channel is really the lesser of two evils.

Alternatively, the uncertainty of it all might mean such risks are too huge to take. Perhaps the most justified response is neither optimism nor pessimism, but to continue frozen in panic, waiting for something to break the ice.

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