Hard Brexit maths – walking away

400dpiLogo

Macro Letter – No 77 – 19-05-2017

Hard Brexit maths – walking away

  • The UK’s NIESR estimate the bill for Hard Brexit to the UK at EUR 66bln
  • I guesstimate the cost of Hard Brexit to the EU at EUR 62bln
  • Legal experts for both sides suggest UK obligations cease on Brexit
  • A Free-trade deal with the EU may not begin until after March 2019

…How selfhood begins with a walking away…

C. Day-Lewis

It has been estimated that if the UK accedes to EU demands for a further EUR 100bln in order to begin the process of establishing a bi-lateral trade deal with the EU post-Brexit, it will cost the UK economy 4.4% of GDP. According to estimates from the NIESR, to revert to WTO Most Favored Nation terms (the Hard Brexit option) would only cost between -2.7% and -3.7% of GDP (EUR 61bln to EUR 84bln).

In January UK MP May stated:-

No deal is better than a bad deal.

It looks, on this basis, as though the UK may indeed walk away from its purported EU obligations.

A more considered analysis from, the politically influential Brussels based thin-tank Bruegel – Divorce settlement or leaving the club? A breakdown of the Brexit bill – suggests a more modest final bill:-

Depending on the scenario, the long-run net Brexit bill could range from €25.4 billion to €65.1 billion, possibly with a large upfront UK payment followed by significant EU reimbursements later.

This substantial price range is due to the way the UK’s share of liabilities is calculated. At 12% (the UK’s rebate-adjusted share of EU commitments) it is EUR 25.4bln. At 15.7% (the UK’s gross contributions without a rebate adjustment) it rises to EUR 65.1bln.

The House of Lords legal interpretation – Brexit and the EU budget:-

Article 50 provides for a ‘guillotine’ after two years if a withdrawal agreement is not reached unless all Member States, including the UK, agree to extend negotiations. Although there are competing interpretations, we conclude that if agreement is not reached, all EU law—including provisions concerning ongoing financial contributions and machinery for adjudication—will cease to apply, and the UK would be subject to no enforceable obligation to make any financial contribution at all.

This suggests all of the UK’s commitments to the EU are linked to membership. If that legal interpretation is correct, there would be no Brexit bill at the moment of departure. Apparently EU legal experts have arrived at similar conclusions. The Telegraph – €100bn Brexit bill is ‘legally impossible’ to enforce, European Commission’s own lawyers admit has more on this contentious subject.

Setting aside the legal obligations in favour of a diplomatic solution, what is the price range where a potential agreement may lie? The cost to the UK appears to be capped at EUR 84bln in a worst case scenario. One may argue that the ability of Sterling to decline, thus improving the UK’s terms of trade, makes this scenario unrealistically high, but as I discussed in – Uncharted British waters – the risk to growth, the opportunity to reform historic evidence doesn’t support the case very well at all:-

Another factor to consider, since the June vote, is whether the weakness of Sterling will have a positive impact on the UK’s chronic balance of payments deficit. This post from John Ashcroft – The Saturday Economist – The great devaluation myth suggests that, if history even so much as rhymes, it will not:-

If devaluation solved the problems of the British Economy, the UK would have one of the strongest trade balances in the global economy…. the depreciation of sterling in 2008 did not lead to a significant improvement in the balance of payments. There was no “re balancing effect”. We always argued this would be the case. History and empirical observation provides the evidence.

There was no improvement in trade as a result of the exit from the ERM and the subsequent devaluation of 1992, despite allusions of policy makers to the contrary. Check out our chart of the day and the more extensive slide deck below.

Seven reasons why devaluation doesn’t improve the UK balance of payments …

1 Exporters Price to Market…and price in Currency…there is limited pass through effect for major exporters

2 Exporters and importers adopt a balanced portfolio approach via synthetic or natural hedging to offset the currency risks over the long term

3 Traders adopt a medium term view on currency trends better to take the margin boost or hit in the short term….rather than price out the currency move

4  Price Elasticities for imports are lower than for exports…The Marshall Lerner conditions are not satisfied…The price elasticities are too limited to offset the “lost revenue” effect

5  Imports of food, beverages, commodities, energy, oil and semi manufactures are relatively inelastic with regard to price. The price co-efficients are much weaker and almost inelastic with regard to imports

6 Imports form a significant part of exports, either as raw materials, components or semi manufactures. Devaluation increases the costs of exports as a result of devaluation

7 There is limited substitution effect or potential domestic supply side boost

8 Demand co-efficients are dominant

 

But what is the economic impact on the EU? CIVITAS – Potential post-Brexit tariff costs for EU-UK trade postulates some estimates:-

Our analysis shows that if the UK leaves the EU without a trade deal UK exporters could face the potential impact of £5.2 billion in tariffs on goods being sold to the EU. However, EU exporters will also face £12.9 billion in tariffs on goods coming to the UK.

Exporters to the UK in 22 of the 27 remaining EU member states face higher tariffs costs when selling their goods than UK exporters face when selling goods to those countries.

German exporters would have to deal with the impact of £3.4 billion of tariffs on goods they export to the UK. UK exporters in return would face £0.9 billion of tariffs on goods going to Germany.

French exporters could face £1.4 billion in tariffs on their products compared to UK exporters facing £0.7 billion. A similar pattern exists for all the UK’s major EU trading partners.

The biggest impact will be on exports of goods relating to vehicles, with tariffs in the region of £1.3 billion being applied to UK car-related exports going to the EU. This compares to £3.9 billion for the EU, including £1.8 billion in tariffs being applied to German car-related exports.

The net Trade Effect of a Hard Brexit on the basis of these calculations is EUR 7.7bln in favour of the UK.

Then we must consider the UK contribution to the EU budget, which, if the House of Lords assessment is confirmed, will be zero after Brexit. This will cost the EU EUR7.8bln, based on the 2017 net EU budget of EUR 134bln, to which the UK is currently the second largest contributor at 5.8%.

Next there is the question of the impact on EU27 economic growth. These headwinds will be felt especially in the Netherlands, Ireland and Cyprus but the largest absolute cost will be borne by Germany.

According to a February 2016 study by DZ Bank, a Hard Brexit would be to reduce German economic growth by -0.5%, from 1.7% to 1.4% – EUR 18.5bln. Credit Agricole published a similar study of the impact on the French economy in June 2016. They estimated that French GDP would be reduced by -0.4% in the event of a free-trade agreement and -0.6% in the event of a Hard Brexit – EUR 13.2bln. The Netherlands Bureau for Economic Policy Analysis (CPB) estimated the cost to the Netherlands at -1.2% – EUR 8.2bln. Italian Government forecasters estimate the impact at -0.5 to -1% – taking the best case scenario – EUR 8.3bln. A leaked Spanish Government report from March 2017 (interestingly, the only estimate I have been able to uncover since the Brexit vote) indicates a cost of between -0.17% and -0.34% of GDP – again, taking the best case – EUR 2bln. Ireland, given its geographic position, shared language and border, has, perhaps the closest ties with the UK of any EU27 country. Back in 2016 the Irish ERSI estimated the impact on Ireland at only -1%, I suspect it might be greater but I will take them at their word – EUR 2.6bln.

In the paragraph above I have looked at just five out of the EU27. Added together the cost to just these five countries is EUR 52.8bln, but I believe it to be representative, they accounted for 84.74% of EU GDP in 2016. From this I arrive at an extrapolated cost to the EU of a Hard Brexit of EUR 62.3bln.

The European Commission has indicated that the cost for the UK to begin negotiating the terms of a new free-trade agreement with the EU may be as much as EUR 100bln. The cost to the UK, of simply walking away – Hard Brexit – is estimated at between EUR 61bln and EUR 84bln per annum. The cost of Hard Brexit to the EU is estimated (I should probably say guesstimated, since there are so many uncertainties ahead) at EUR 62bln. A simple cost benefit analysis suggests that both sides have relatively similar amounts to lose in the short term. And I hate to admit it, but looked at from a negative point of view, in the long run, the UK, with its structural current account and trade deficit, may have less to lose from simply walking away.

Conclusion and Investment Opportunities

Brexit negotiations are already and will remain deeply political. From a short-term economic perspective it makes sense for the UK to walk away and re-establish its relationships with its European trading partners in the longer run. Given the UK trade deficit with the EU it has the economic whip-hand. Working on the assumption that Jean Claude Junker is not Teresa May’s secret weapon (after all, suggesting ever higher costs for negotiating a free-trade deal makes it more likely that the UK refuses to play ball) one needs to step back from the economics of the situation. The politics of Brexit are already and will probably become even more venal. For the sake of the UK economy, and, for that matter the economies of the EU, I believe it is better for the UK to walk away To those of you who have read my previous articles about Brexit, I wish to make clear, this is a change of opinion, politics has trumped economic common sense.

The implications for the UK financial markets over the next 22 months is uncertainty, although May’s decision to adopt a Hard Brexit starting point has mitigated a substantial part of these risks. Sterling is likely to act as the principle safety valve, however, a fall in the trade-weighted value of the currency will feed through to higher domestic inflation. Short term interest rates, and in their wake Gilt yields, are likely to rise in this scenario. Domestic stocks are also likely to be vulnerable to the negative impact of currency weakness and higher interest rates on economic growth. The FTSE 100, however, with 70% of its earnings derived from outside the UK, should remain relatively immune.

Advertisements

Which parts of the UK economy and which stocks will be the winners from Brexit?

400dpiLogo

Macro Letter – No 63 – 14-10-2016

Which parts of the UK economy and which stocks will be the winners from Brexit?

  • Sterling has fallen to its lowest since 1985 on fears of a “Hard Brexit”
  • UK stocks, led by the FTSE100, have rallied sharply
  • Sectors such as IT and Pharmaceuticals will benefit long-term
  • Even construction and financial services present investment opportunities

If you are in the habit of reading the mainstream financial press you will see headlines such as:-

The Times – Leak of gloomy Brexit forecast pushes pound to 31-year low – 12th October

The Economist – The pound and the fury – Brexit is making Britons poorer, and meaner – 11th October

Over the last three months, this has been typical of almost all financial media commentary. Sterling, meanwhile, has fallen, on a trade weighted basis, to a low not seen since the effective exchange rate index was recalibrated in 1990. At 73.79 it has even breached its close of December 2008 (73.855):-

sterling-effective-excahnge-rate-1990-2016

Source: Bank of England

The recent weakness in Sterling has been linked to the publication of parts of draft cabinet committee papers, suggesting UK revenues could drop by £66bln. From a technical perspective the “Flash Crash” in Cable (GBPUSD) last week has exacerbated the situation, creating the need for the currency to retest the low of 1.18 during normal market hours – the market reached 1.2086 on 11th – more downside is likely:-

gbpusd-2014-2016

Source: DailyFX.com

As the two charts above reveal, Sterling has weakened by 16% versus the US$ and by 18.5% on a trade-weighted basis.

Here is the chart of GBPUSD since 1953. It reinforces my expectation, from a technical perspective, that we will see further downside:-

cable-since-1953-fxtop

Source: fxtop.com

Given the seismic impact of a “Hard Brexit” on the UK economy, it would not be surprising to see a return to the February 1985 low of 1.0440.

I am not alone in my expectation of further weakness, Ashoka Mody – who organised the EU-IMF bailout of Ireland – told the Telegraph this week that Sterling was between 20% and 25% overvalued going into the Brexit vote.

Trade

The EU is the UK’s largest trading partner, accounting for 44% of goods and services exports in 2015 – though this was a decline the on previous year. Of greater concern to the neighbours, is the 53% of UK imports which emanate from the EU. In theory Sterling weakness should benefit UK exports; the impact has been minimal, so far:-

united-kingdom-exports-5yr

Source: Tradingeconomics.com, ONS

Similarly, imports should be falling – they are not:-

united-kingdom-imports-5yr

Source: Trading Economics, ONS

I discussed the prospects for UK growth and the effect of Sterling weakness on the balance of trade in Macro Letter – No 59 – 15-07-2016 – Uncharted British waters – the risk to growth, the opportunity to reform – quoting in turn from John Ashcroft – The Saturday Economist – The great devaluation myth:-

There was no improvement in trade as a result of the exit from the ERM and the subsequent devaluation of 1992, despite allusions of policy makers to the contrary.

…1 Exporters Price to Market…and price in Currency…there is limited pass through effect for major exporters

2 Exporters and importers adopt a balanced portfolio approach via synthetic or natural hedging to offset the currency risks over the long term

3 Traders adopt a medium term view on currency trends better to take the margin boost or hit in the short term….rather than price out the currency move

4 Price Elasticities for imports are lower than for exports…The Marshall Lerner conditions are not satisfied…The price elasticities are too limited to offset the “lost revenue” effect

5 Imports of food, beverages, commodities, energy, oil and semi manufactures are relatively inelastic with regard to price. The price co-efficients are much weaker and almost inelastic with regard to imports

6 Imports form a significant part of exports, either as raw materials, components or semi manufactures. Devaluation increases the costs of exports as a result of devaluation

7 There is limited substitution effect or potential domestic supply side boost

8 Demand co-efficients are dominant

If Sterling weakness will not improve the UK terms of trade, what will happen to growth? Again, in Macro Letter 59  I quote, Open Europe’s worst case scenario – that UK economic growth will be 2.2% less, on an annual basis, than its current trend, by 2030. Trend GDP growth between 1956 and 2015 averaged 2.46%. Is the media gloom justified and…

Are there any winners?

I concluded my July article saying:-

Companies with foreign earnings will be broadly immune to the vicissitudes of the UK economy, but domestic firms will underperform until there is more clarity about the future of our relationship with Europe and the rest of the world. The UK began trade talks with India last week and South Korea has expressed interest in similar discussions. Many other nations will follow, hoping, no doubt, that a deal with the UK can be agreed swiftly – unlike those with the EU or, indeed, the US. The future could be bright but markets will wait to see the light.

The UK stock market has already jumped the gun. The chart below shows the strong upward momentum of the FTSE100, dragging the, less international, FTSE250 in its wake; yet UK property has been hit hard by expectations of a slowdown in foreign demand:-

ambrosebexit

Source: Daily Telegraph

The obvious winners in the short term are companies with non-Sterling earnings – the constituents of the FTSE100 have an estimated 77% of overseas revenues – 47 of them pay their dividends in US$. The FTSE250 is not far behind, its members have 50% of foreign revenues. This is not dissimilar to the French CAC40 and German DAX. The table below lists the top and bottom ten FTSE350 companies by Sterling revenues:-

10 FTSE 350 companies with lowest sterling revenues
Company Sterling revenues
Vedanta Resources (VED) 0%
Hikma Pharmaceuticals (HIK) 0.20%
BHP Billiton (BLT) 0.30%
Antofagasta (ANT) 0.40%
Mondi (MNDI) 0.40%
Tate & Lyle (TATE) 0.60%
Rio Tinto (RIO) 0.70%
British American Tobacco (BATS) 1%
Laird (LRD) 1.60%
Victrex (VCT) 1.80%
10 FTSE 350 companies with highest sterling revenues
Company Sterling revenues
Saga (SAGAG) 69.80%
Capita (CPI) 70.40%
Wm Morrison (MRW) 70.60%
Booker Group (BOK) 70.80%
Intu Properties (INTU) 71.60%
Home Retail Group (HOME) 72.10%
OneSavings Bank (OSBO) 72.50%
Standard Life (SL) 88.90%
Grainger (GRI) 96.30%

Source: S&P Global Market Intelligence

Some of these companies are not exactly household names. Below is a table of the top 30 stocks in the FTSE100 by market capitalisation as at 28th September. The table also shows the year to date performance by stock as at 12th October:-

Company Ticker Sector Market cap-£mln (28-09) YTD (12-10) >50% Non-£ revenue % of non-£ revenue
Royal Dutch Shell RDSA Oil and gas 149,100 16.33% Yes 85%?
HSBC HSBA Banking 113,455 15.97% Yes
British American Tobacco BATS Tobacco 92,162 28.58% Yes 99%
BP BP Oil and gas 81,196 25.99% Yes 85%?
GlaxoSmithKline GSK Pharmaceuticals 80,629 32.02% Yes 91%
AstraZeneca AZN Pharmaceuticals 64,771 18.72% Yes 93%
Vodafone Group VOD Telecomms 59,259 6.10% Yes
Diageo DGE Beverages 55,931 20.41% Yes
Reckitt Benckiser RB Consumer goods 50,446 20.66% Yes
Unilever ULVR Consumer goods 46,917 32.18% Yes 85%?
Shire plc SHP Pharmaceuticals 45,899 16.56% Yes 96%
National Grid plc NG Energy 41,223 15.14% Yes
Lloyds Banking Group LLOY Banking 39,634 -29.62%
BT Group BT.A Telecomms 38,996 -15.03%
Imperial Brands IMB Tobacco 37,677 13.35% Yes
Prudential plc PRU Finance 35,544 -3.61% Yes 60%
Rio Tinto Group RIO Mining 34,715 6.72% Yes 99%
Glencore GLEN Mining 30,135 94.96% Yes
Barclays BARC Banking 28,089 -34.34% Yes
Compass Group CPG Food 24,528 37.40% Yes
WPP plc WPP Media 23,330 16.44% Yes 87%
BHP Billiton BLT Mining 23,169 5.18% Yes 97%
CRH plc CRH Building materials 21,314 50.45% Yes
Royal Bank of Scotland Group RBS Banking 20,799 -46.12%
Associated British Foods ABF Food 20,481 -27.11%
Standard Chartered STAN Banking 20,403 -9.76% Yes
Aviva AV. Insurance 17,925 -3.27% Yes 60%
BAE Systems BA. Military 16,698 16.87% Yes
RELX Group REL Publishing 15,842 27.83% Yes 85%?
SSE plc SSE Energy 15,548 -1.75%

Source: Stockchallenge.co.uk, Financial Times

The table indicates where non-Sterling revenues exceed 50% and, where I have been able to glean current data, the most recent percentage of international revenues. These 30 names represent 70% of the total market capitalisation of the FTSE100 Index. The positive impact of the fall in Sterling on the performance of the majority of these stocks is unequivocal.

On a sectoral basis this is a continuation of the price action evident in the week following the Brexit vote. The chart below was published by the FT on 29th June:-

ftse350-sectors-29-06-2016

Source: Bloomberg, FT

The underperforming sectors are not difficult to explain. Banks and Insurance companies, despite having international revenues, have been hurt by concerns about the loss of access to EU markets after Brexit. Real Estate remains nervous about a collapse in international demand, now the UK is no longer the gateway to Europe. Meanwhile, the retail and household sectors are likely to suffer as UK economic growth slows, consumer spending declines, inflation – driven by higher import prices – squeezes corporate profit margins and the Bank of England is forced to respond to higher consumer prices with monetary tightening.

Yet, looking at the table below, the dividend cover of the consumer sector is robust and the data we have seen since Brexit – retails sales +6.2% in July and 6.3% in August, combined with the rebound in consumer confidence – suggests that the consumer is what might be deemed serene:-

dividend-cover-ftse350-q4-2015

Source: Daily Telegraph, Highcharts

Other UK economic indicators also seem to be rebounding. Manufacturing PMI was 55.4 in September –its highest level since the middle of 2014. Services PMI, at 52.6, is still expanding and Construction PMI, at 52.3, has returned to growth. Rumours of the death of the consumer may be grossly exaggerated. Even consumer credit, which dipped in July, rebounded in August.

The “Sterling Effect” on stock valuation has more to deliver in the near-term, but once the currency stabilises this one-off benefit will diminish.

Who will the longer term winners be?

It is difficult to assess the long run impact of a “Hard Brexit” without reviewing the WTO – Most Favoured Nation – Tariff schedule for the EU. The trade weighted average tariff for 2013 was 3.2%, but on agricultural products it was a much higher 22.3% whilst it was only 2.3% on Non-Agricultural products:-

wto-eu-mft-tariffs-2015

Source: WTO

A “Hard Brexit” will probably entail a reversion to Most Favoured Nation terms with the EU under WTO rules.

The 18.5% decline in the Sterling Effective Exchange Rate means the cost to the UK of exporting, even agricultural products – excepting dairy – has been priced in. No wonder economists are busy revising their 2016/2017 growth forecasts higher – until Brexit actually happens, UK exports to the EU, and the majority of our other trading partners, will remain incredibly competitive.

Developing beyond this theme, a recent speech – The economic outlook – by Michael Saunders, a Bank of England MPC Member, reminded the Institute of Directors in Manchester:-

…we should not lose sight of the UK economy’s considerable supply-side advantages, with relatively flexible labour and product markets, openness to foreign investment, low-ish tax rates, strength in knowledge-intensive services and hi-tech manufacturing…

And the winners are…

This by no means an exhaustive list – some sectors are an obvious response to the decline in the currency, others are rather less certain.

Tourism – with the UK suddenly an inexpensive destination for tourists from around the world. In 2015, 7.3mln tourists visited the UK, of which 4.6mln were from the EU. Tourism Alliance estimates the UK tourist industry was worth £126.9bln in 2013. The chart below shows the volatile but upward sloping evolution of tourism revenues:-

united-kingdom-tourism-revenues

Source: Trading Economics, ONS

Here is an edited table of the Leisure and Travel constituents of the FTSE350, it excludes bookmakers, travel agents and airlines:-

Ticker Company
CCL Carnival
CINE Cineworld Group
CPG Compass Group
DOM Domino’s Pizza Group
FGP FirstGroup
GNK Greene King
GOG Go-Ahead Group
GVC GVC Holdings
IHG InterContinental Hotels Group
JDW Wetherspoon (J.D.)
MAB Mitchells & Butlers
MARS Marston’s
MERL Merlin Entertainments
MLC Millennium & Copthorne Hotels
NEX National Express Group
RNK Rank Group
RTN Restaurant Group
SGC Stagecoach Group
WTB Whitbread

Source: Shareprices.com

There should also be a positive impact on construction, as many operators, particularly within the unlisted sector, upgrade their facilities to capture the increased demand.

Not all the omens are positive; many of the jobs created by tourism are temporary and seasonal, the impact of a “Hard Brexit” is likely to lead to an increase in average earnings – good for employees, though not necessary for employers:-

united-kingdom-wage-growth-average-weekly-earnings

Source: Trading Economics, ONS

The trend in wage growth has been steady for several years, but as inflation picks up and UK immigration declines, wages will rise.

Value Added Industries such as IT, Technology, Pharmaceuticals – these are growth industries in which the UK has a comparative advantage. Typically their growth is delivered through productivity enhancing innovation. That they will also benefit, from a structurally lower exchange rate, is an added bonus.

Property and Construction should recover strongly – according to the Nationwide, UK house prices increased again in September. Only in central London, where stamp duty increases on higher value properties has undermined sentiment, have prices eased.

The UK has a shortage of residential property. Whether interest rates remain low or not, this situation will not change until there is genuine planning reform. The three largest housebuilders Barratt Developments (BDEV) Taylor Wimpey (TW) and Persimmon (PSN) are all trading with P/E ratios below 10 times. The only real concern is the difficulty these companies may experience in securing skilled manual labour – Barrett Developments source between 30% and 40% of their current workforce from mainland Europe.

There are other companies in the construction sector such as Balfour Beatty (BBY) Carillion (CLLN) and Kier Group (KIE) which will benefit from increased public investment in infrastructure projects. Monetary policy is nearing the end of its effectiveness – although the central banks still have plenty of stocks they could buy. The next step is to pass the gauntlet back to their respective governments’. I believe fiscal stimulus on a substantial scale will be the next phase.

Banking and Financial Services may seem like the last place to look for performance. The regulators have been tightening the noose since 2008 – as the current crisis at Deutsche Bank highlights, this trend has yet to run its course. However, challenger banks and shadow banking institutions, including hedge funds, are beginning to fill the void. In the days before the financialisation of the economy, banking was the servant of industry. The real-economy still needs banking and credit facilities. The oldest of the Peer to Peer lenders (unlisted) Zopa, announced their first securitisation this summer. After a decade of development their business it is finally coming of age.

The CMA – Making the Banks Work Harder For You – August 9th is certainly supportive for the digital disruptors of traditional banking. Government support is no guarantee of success but it’s easier to have them on your side.

You may argue that the success of companies such as Zopa are based on technological advantages but the recent history of banking has been about harnessing technology to increase trading volumes and reduce the costs of financial transactions. Growth in the profitability of financial services is integrally tied to advances in technology.

A final argument for Banks is the FTSE350 Banks Index:-

big

Source: Bigcharts.com

The high in 2007 was 11,263, the low in March 2009, 2,782 – a 75% decline. The index nearly doubled in in the next six months, reaching 5,224 in September of the same year. This June the index failed to break to a new low after the Brexit vote. A base is forming – the banking sector may not have seen the last of fines and regulation but I believe the downside is limited.

Uncharted British waters – the risk to growth, the opportunity to reform

400dpiLogo

Macro Letter – No 59 – 15-07-2016

Uncharted British waters – the risk to growth, the opportunity to reform

  • Uncertainty will delay investment and damage growth near term
  • A swift resolution of Britain’s trade relations with the EU is needed
  • Without an aggressive liberal reform agenda growth will be structurally lower
  • Sterling will remain subdued, Gilts, trade higher and large cap stocks well supported

Look, stranger, on this island now
The leaping light for your delight discovers,
Stand stable here
And silent be,
That through the channels of the ear
May wander like a river
The swaying sound of the sea.

W.H. Auden

thames-chart-collins-3057

Source: Captain Greenvile Collins – Great Britain’s Coasting Pilot – 1693

Captain Greenvile Collins was the Hydrographer in Ordinary – to William and Mary. His coastal pilot was the first, more or less, accurate guide to the coastline of England, Scotland and Wales, prior to this period mariners had relied mainly on Dutch charts. Collins’s charts do not comply with the convention of north being at the top and south at the bottom – the print above, of the Thames estuary, has north to the right. This, and the extract from W. H. Auden with which I began this letter, seem appropriate metaphors for the new way we need to navigate the financial markets of the UK post referendum.

Sterling has borne the brunt of the financial maelstrom, weakening against the currencies of all our major trading partners. Gilts have rallied on expectations of further largesse from the Bank of England (BoE) and a more generalised international flight to quality in “risk-free” government bonds. This saw Swiss Confederation bonds trade at negative yields to maturity out to 48 years.

With interest rates now at historic lows around the developed world and investors desperate for yield, almost regardless of risk, equity markets have remained well supported. Many individual UK companies with international earnings have made new all-time highs. Banks and construction companies have not fared so well.

Now the dust begins to settle, we have the more challenging task of anticipating the longer term implications of the British schism, both for the UK and its European neighbours. In this letter I will focus principally on the UK.

A Return to the Astrolabe?

Astrolabe

Source: University of Cambridge

The Greeks invented the astrolabe sometime around 200BCE. The one above of Islamic origin and dates from 1309. Before the invention of the sextant this was the only reliable means of navigation.

Our aids to navigation have been compromised by the maelstrom of Brexit – it’s not quite a return to the Astrolabe but we may have lost the use of GPS and AIS.

This week the OECD was forced to suspend the publication of its monthly Composite Leading Indicators (CLI). Commenting on the decision they said:-

The CLIs cannot…account for significant unforeseen or unexpected events, for example natural disasters, such as the earthquake, and subsequent events that affected Japan in March 2011, and that resulted in a suspension of CLI estimates for Japan in April and May 2011. The outcome of the recent Referendum in the United Kingdom is another such significant unexpected event, which is affecting the underlying expectation and outturn indicators used to construct the CLIs regularly published by the OECD, both for the UK and other OECD countries and emerging economies.

It will be difficult to draw any clear conclusions from the economic data produced by the OECD or other national and international agencies for some while.

Speaking to the BBC prior to the referendum, OECD Secretary General, Angel Gurria had already suggested that UK growth would be damaged:-

It is the equivalent to roughly missing out on about one month’s income within four years but then it carries on to 2030. That tax is going to be continued to be paid by Britons over time.

Back in March Open Europe – What if…? The consequences, challenges and opportunities facing Britain outside the EU put it thus:-

UK GDP could be 2.2% lower in 2030 if Britain leaves the EU and fails to strike a deal with the EU or reverts into protectionism. In a best case scenario, under which the UK manages to enter into liberal trade arrangements with the EU and the rest of the world, whilst pursuing large-scale deregulation at home, Britain could be better off by 1.6% of GDP in 2030. However, a far more realistic range is between a 0.8% permanent loss to GDP in 2030 and a 0.6% permanent gain in GDP in 2030, in scenarios where Britain mixes policy approaches.

…Based on economic modelling of the trade impacts of Brexit and analysis of the most significant pieces of EU regulation, if Britain left the EU on 1 January 2018, we estimate that in 2030:

In a worst case scenario, where the UK fails to strike a trade deal with the rest of the EU and does not pursue a free trade agenda, Gross Domestic Product (GDP) would be 2.2% lower than if the UK had remained inside the EU.

In a best case scenario, where the UK strikes a Free Trade Agreement (FTA) with the EU, pursues very ambitious deregulation of its economy and opens up almost fully to trade with the rest of the world, UK GDP would be 1.6% higher than if it had stayed within the EU.

Open_Europe_Brexit_Impact_Table

Source: Open Europe, Ciuriak Consulting

Given that UK annual GDP growth averaged 2.46% between 1956 and 2016, the range of outcomes is profoundly important. GDP forecasts are always prone to error but the range of outcomes indicated above is exceedingly broad – divination might prove as useful.

Also published prior to the referendum Global Counsel – BREXIT: the impact on the UK and the EU assessed the prospects both for the UK and EU in the event of a UK exit. The table below is an excellent summary, although I don’t entirely agree with all the points nor their impact assessment:-

Global_Counsel_-_Brexit

Source: Global Counsel

Another factor to consider, since the June vote, is whether the weakness of Sterling will have a positive impact on the UK’s chronic balance of payments deficit. This post from John Ashcroft – The Saturday Economist – The great devaluation myth suggests that, if history even so much as rhymes, it will not:-

If devaluation solved the problems of the British Economy, the UK would have one of the strongest trade balances in the global economy…. the depreciation of sterling in 2008 did not lead to a significant improvement in the balance of payments. There was no “re balancing effect”. We always argued this would be the case. History and empirical observation provides the evidence.

There was no improvement in trade as a result of the exit from the ERM and the subsequent devaluation of 1992, despite allusions of policy makers to the contrary. Check out our chart of the day and the more extensive slide deck below.

Seven reasons why devaluation doesn’t improve the UK balance of payments …

1 Exporters Price to Market…and price in Currency…there is limited pass through effect for major exporters

2 Exporters and importers adopt a balanced portfolio approach via synthetic or natural hedging to offset the currency risks over the long term

3 Traders adopt a medium term view on currency trends better to take the margin boost or hit in the short term….rather than price out the currency move

4  Price Elasticities for imports are lower than for exports…The Marshall Lerner conditions are not satisfied…The price elasticities are too limited to offset the “lost revenue” effect

5  Imports of food, beverages, commodities, energy, oil and semi manufactures are relatively inelastic with regard to price. The price co-efficients are much weaker and almost inelastic with regard to imports

6 Imports form a significant part of exports, either as raw materials, components or semi manufactures. Devaluation increases the costs of exports as a result of devaluation

7 There is limited substitution effect or potential domestic supply side boost

8 Demand co-efficients are dominant

Curiouser and Curiouser – the myth of devaluation continues. The 1992 experience….

“The UK’s trade performance since the onset of the economic downturn in 2008 has been one of the more curious developments in the UK economy” according to a recent report from the Office for National Statistics. “Explanation beyond exchange rates: trends in UK trade since 2007. 

We would argue, it is only curious for those who choose to ignore history. 

Much reference is made to the period 1990 – 1995 when the last “great depreciation led to an improvement in the balance of payments” – allegedly. Analysing the trade in goods data [BOKI] from the ONS own report demonstrates the failure of depreciation to improve the net trade in goods performance in the period 1990 – 1995.

Despite the fall in sterling, the inexorable structural decline in net trade in goods continued throughout. As we have long argued would be the case, in the most recent episode. Demand co-efficients are powerful, the price co-efficients much weaker and almost inelastic with regard to imports. Check out the slide show below for more information. 

The conclusions from the ONS report do not add up. Curiouser and Curiouser, policy makers just like Alice, sometimes choose to believe in as many as six impossible things before breakfast.

A brief history of devaluation from 1925 onwards…. 

The great devaluation of 1931 – 24%

In 1925, the dollar sterling exchange rate was $4.87. Britain had readopted the gold standard. Unfortunately, the relative high value of the pound placed considerable pressure on the trade and capital account, the balance of payments problem developed into a “run on the pound”. The UK left the gold standard in 1931, the floating pound quickly dropped to $3.69, providing an effective devaluation of 24%. The gain, if such it was, could not be sustained. Over the next two years, confidence in the currency returned, the dollar weakened, sterling rallied in value to a level of $5.00 but…Fears of conflict in Europe placed pressure on the sterling. In 1939, with the outbreak of World War II the rate dropped to $3.99 from $4.61. In March, 1940, the British government pegged the value of the pound to the dollar, at $4.03.

The great devaluation of 1949 – 30%

Post war, Britain was heavily indebted to the USA. Despite a soft loan agreement with repayments over fifty years, the pound remained once again under intense pressure In 1949 Stafford Cripps devalued the pound by over 30%, giving a rate of $2.80. 

The great devaluation of 1967 – 14%

In 1967 another “balance of payments” crisis developed in the British economy with a subsequent “run on the pound. Harold Wilson announced, in November 1967, the pound had been devalued by just over 14%, the dollar sterling exchange rate fell to $2.40. This the famous “pound in your pocket” devaluation. Wilson tried to reassure the country by pointing out that the devaluation would not affect the value of money within Britain. 

In 1971, currencies began to float, depreciation not devaluation became the guideline

In 1977, sterling fell against the dollar with pound plummeting to a low of $1.63 in the autumn 1976. Another sterling crisis and a run on the pound. The British government was forced to borrow from the IMF to bridge the capital gap. The princely sum of £2.3 billion was required to restore confidence in the pound.  

By 1981, the pound was trading back at the $2.40 level but not for long. Parity was the pursuit by 1985 as the pound fell in value to a month low of $1.09 in February 1985.

In the late 1980s, Chancellor Lawson was pegging the pound to the Deutsche Mark to establish some form of stability for the currency. In October of 1990, Chancellor Major persuaded Cabinet to enter the ERM, the European Exchange Rate Mechanism. The DM rate was 2.95 to the pound and $1.9454 against the dollar. 

Less than two years later, Britain left the European experiment. 

The strains of holding the currency within the trading band had pushed interest rates to 12% in September, with some suggestions that rates would have to rise to 20% to maintain the peg. 

In September 1992, Chancellor Lamont announced the withdrawal from the ERM. The Pound fell in value against the dollar from $1.94 to $1.43, an effective depreciation of 26%. According to the wider Bank of England Exchange rate the weighted depreciation was 15%. 

The chart below shows GBPUSD since 1953, it doesn’t capture everything mentioned above but it highlights the volatility and terminal decline of the world’s ex-reserve currency:-

Cable since 1953

Source: FX Top

Reform, reform, reform

The UK needs to renegotiate terms with the EU as quickly as possible in order to minimise the damage to UK and global economic growth. I believe there are four options: –

EEA – the Norwegian Option

Pros

  • Maintain access to the Single Market in goods and services and movement of capital.
  • Ability to negotiate own trade deals.
  • Least disruptive alternative to EU membership.

Cons

  • Commitment to free movement of people and the provision of welfare benefits to EU citizens.
  • Accept EU regulation but have no influence over them.
  • Must comply with “rules of origin” – which impose controls on the use of products from outside the EU in goods which are subsequently exported within the EU. The cost of determining the origin of products is estimated to be at least 3.0% – the average tariff on goods from the US and Australia is 2.3% under World Trade Organisation (WTO) rules.
  • Comply with EU rules on employment, consumer protection, environmental protection and competition policy.
  • Pay an annual fee to access the Single Market, although less than for full EU membership.

EFTA – the Swiss Option

Pros

  • Maintain access to the Single Market in goods.
  • Ability to negotiate own trade deals.
  • Greater independence over the direction of social and employment law.

Cons

  • Commitment to free movement of people.
  • Must comply with “rules of origin”.
  • Restricted access to the EU market in services – particularly financial services.

WTO – the Default Option

Pros

  • Subject to Most Favoured Nation tariffs under WTO guidelines. In 2013, the EU’s trade-weighted average MFN tariff was 2.3% for non-agricultural products.
  • Ability to negotiate own trade deals.
  • Independence over legislation.

Cons

  • Tariffs on agricultural products range from 20% to 30%.
  • Tariffs for automobiles are 10%.
  • Services sector would face higher levels of non-tariff barriers such as domestic laws, regulations and supervision. Services made up 37% of total UK exports to the EU in 2014 – the WTO option will be costly.

Bilateral Free-Trade Agreement – the Canadian Option

Pros

  • Negotiate a bilateral trade agreement with the EU – sometimes called the Canada option after the, still unratified, Comprehensive Economic and Trade Agreement (CETA).

Cons

  • Must comply with “rules of origin” – if it mirrors the CETA deal.
  • Services are only partially covered.
  • Negotiations may take years.

The quickest solution would be the WTO default option, the least cathartic would be to join the EEA. I suspect we will end up somewhere between these two extremes; The Peterson Institute – Theresa May—More Merkel than Thatcher? Is of a different opinion:-

To survive politically at home, May must deliver Brexit at almost any cost, suggesting that she might well in the end be compelled to accept a “hard Brexit” that puts the UK entirely outside the internal market. Lacking a public mandate in a fractious party that retains only a slim parliamentary majority, May not surprisingly opposes new general elections, which would focus on Brexit and thus easily cost the Conservatives their majority, along with their new prime minister’s job. Unless the UK suffers substantially additional economic hardship in the coming years, the next UK elections may well occur as late as 2020.

For the financial markets there is a certain elegance in the “hard Brexit” WTO option. Uncertainty is removed, unilateral trade negotiations can be undertaken immediately and the other options remain available in the longer term.

Beyond renegotiation with the EU there is a broader reform agenda. Dust off your copy of Hayek’s The Road to Serfdom, this could see a return to the liberal policies, of smaller government and freer trade, which we last witnessed in the 1980’s. The IEA’s Ryan Bourne wrote an article this week for City AM – Forget populist executive pay curbs: Prime Minister May should embrace these six policies to revitalise growth in which he advocated:-

1) Overhaul property taxation: the government should abolish both council tax and stamp duty entirely and replace them with a single tax on the “consumption” of property – i.e. a tax on imputed rent. It is well known among economists that taxes on transactions like stamp duty are highly damaging, and we have already seen the high top rates significantly slow transactions since April.

2) Abolish corporation tax entirely: profit taxes discourage capital investment by lowering returns, which makes workers less productive and results in lower wage growth. In a globalised world, profits taxation also encourages capital to move elsewhere, both because it makes the UK less attractive as a location for “real” economic activity and because it creates incentives for avoidance through complex business structures. Rather than continuing this goose chase, let’s abolish it entirely and tax dividends at an individual level, as Estonia does.

Read more: Ignore Google’s corporation tax bill and scrap the tax altogether

3) Planning liberalisation: if you ask anyone to name the UK’s main economic problems, you’ll probably hear “poor productivity performance”, “a high cost of living” and “entrenched economic difficulties in some areas”. Constraining development through artificial boundaries and regulations is acknowledged to be a key driver of high house price inflation. Less acknowledged is that, for sectors like childcare, social care, restaurants and even many office-based industries, high rents and property prices raise other prices for consumers, with a dynamic strain on our growth prospects brought about by a reduction in competition and innovation. That’s not to mention the impact on labour mobility. Liberalisation of planning, including greenbelt reform – which May has sadly already seemingly ruled out – is probably the closest thing to a silver bullet as far as productivity improvements are concerned.

4) Sensible energy policy: the UK government has gone further than many EU countries on the “green agenda”. But the EU’s framework, with binding targets for renewables, has certainly helped shape policy in the direction of subsidies and subsidy-like obligations and interventions. Even if one accepts the need to reduce carbon emissions, an economist would suggest the implementation of either a straight carbon tax or, less optimally, a cap-and-trade scheme, rather than the current raft of interventions which make energy more expensive than it need be.

5) Agricultural liberalisation: exiting the EU Common Agricultural Policy gives us the opportunity to reassess agricultural policy. The UK should gradually phase out all subsidies, as New Zealand did, opening up the sector to global competition. This improved agricultural productivity in that country significantly. Combined with a policy of unilateral free trade, it would deliver substantially lower food prices for consumers too.

6) Deregulation: in the long term, Britain should extricate itself from the Single Market and May should set up a new Office for Deregulation, tasked with examining all existing EU laws and directives, with the clear aim of removing unnecessary burdens and lowering costs. In particular, this should focus on labour market regulation, financial services, banking and transport

In a departure from my normal focus on the nexus of macroeconomics and financial markets I wrote a reformist article last week for the Cobden Centre – A Plan to Engender Prosperity in Perfidious Albion – from Pariah to Paragon; in it, I made some additional reform proposals:-

Banking Reform: The financialisation of the UK economy has reached a point where productive, long term capital investment is in structural decline. Increasing bank capital requirements by 1% per annum and abolishing a zero weighting for government securities would go a long way to reversing this pernicious trend.

Monetary Reform: The key to long term prosperity is productivity growth. The key to productivity growth is investment in the processes of production. Interest rates (the price of money) in a free market, act as the investment signal. Free banking (a banking system without a lender of last resort) is a concept which all developed countries have rejected. Whilst the adoptions of Free banking is, perhaps, too extreme for credible consideration in the aftermath of Brexit, a move towards the free-market setting of interest rates is desirable to attempt to avert any further malinvestment of capital.

Labour Market Reform: A repeal of the Working Time Directive and the Agency Workers Directive would be a good start but we must resist the temptation to close our borders to immigration. Immigrants, both regional and international, have been essential to the economic prosperity of Britain for centuries. There will always be individual winners and losers from this process, therefore, the strain on public services should be addressed by introducing a contribution-based welfare system that ensures welfare for all – migrants and non-migrants – contingent upon a record of work.

Educational Reform: investment in technology to deliver education more efficiently would yield the greatest productivity gains but a reform of the incentives based on individual choice would also help to improve the quality of provision.

Free Trade Reform: David Ricardo defined the economic law of comparative advantage. In the aftermath of the UK exit from the EU it would be easy for the UK to slide towards introspection, especially if our European trading partners close ranks. We should resist this temptation if at all possible; it will undermine the long term productivity of the economy. We should promote global free trade, unilaterally, through our membership of the World Trade Organisation. In the last 43 years we have lost the art of negotiating trade deals for ourselves. It will take time to reacquire these skills but gradual withdrawal from the EU by way of the EEA/EFTA option would give the UK time to adjust. The EEA might even prove an acceptable longer term solution. I suspect the countries of EFTA will be keen to collaborate with us.

We should apply to rejoin the International Organization for Standardization , the International Electrotechnical Commission , and the International Telecommunication Union (all of which are based in Geneva) and, under the auspices of EFTA, we can rejoin the European Committee for Standardization (CEN), the European Committee for Electrotechnical Standardization (CENELEC), the European Telecommunications Standards Institute (ETSI), and the Institute for Reference Materials and Measurements (IRMM).

Conclusion

Financial markets will remain unsettled for an extended period; domestic capital investment will be delayed, whilst international investment may be cancelled altogether. If growth slows, and I believe it will, further easing of official interest rates and renewed quantitative easing are likely from the BoE. Gilts will trade higher, pension funds and insurance companies will continue to purchase these fixed income assets but the BoE will acquire an ever larger percentage of outstanding issuance. In 2007 Pensions and Insurers held nearly 50%, with Banks and Building Societies accounting for 17% of issuance. By Q3 2014 Pensions and Insurers share had fallen to 29%, Banks and Building Societies to 9%. Over seven years, the BoE had acquired 25% of the entire Gilt issuance.

Companies with foreign earnings will be broadly immune to the vicissitudes of the UK economy, but domestic firms will underperform until there is more clarity about the future of our relationship with Europe and the rest of the world. The UK began trade talks with India last week and South Korea has expressed interest in similar discussions. Many other nations will follow, hoping, no doubt, that a deal with the UK can be agreed swiftly – unlike those with the EU or, indeed, the US. The future could be bright but markets will wait to see the light.

 

What to do if the Brexit hits the fan? Prepare to Invest

400dpiLogo

Macro Letter – Supplemental – No 3 – 17-6-2016

What to do if the Brexit hits the fan? Prepare to Invest

  • Opinion polls suggest that the Brexit camp may win the referendum this month
  • GBPUSD has made new lows on the news
  • UK stocks have fallen to levels last seen in March
  • UK Gilt yields have reached historic lows and credit spreads have widened

Whilst I still think it most likely that we will vote to remain in the EU, if the UK electorate vote to leave the EU on 23rd June, this is what I believe may happen and here is one investment opportunity which might be worth considering:-

Short-term

Sterling will weaken, International capital outflows will hit UK stocks and Gilts. A “technical recession” will ensue.

Medium-term

A weaker currency will cause inflation and exports to rise. Higher yields and a more competitive currency will lead to capital inflows into UK stocks and Gilts. Sterling will recover.

Background

Governor Carney of the Bank of England sees the risk of a “technical recession” should the UK leave the EU. Christine Legarde, MD of the IMF, says she has “not seen anything positive” about Brexit in economic terms, predicting a rebound in growth if the UK remains, but the possibility of a stock and housing market crash if we leave.

Countering these Cassandras’, Iain Mansfield, the director of trade and industry at the British Embassy in Manilla, won the IEA prize for his essay A Blueprint for Britain: Openness not isolation, stating:-

 

The outcome would be to accelerate the shifting pattern of UK’s exports and total trade away from the EU to the emerging markets, where the majority of the world’s growth is located. A more business-friendly regulatory regime and the new security of the City of London from European interference will enhance competitiveness and compensate for the partial loss of access to the European market.

Elsewhere commentators talk of a “Neverendum” even in the event of Brexit.

What to do

The FTSE100 Index is slightly below the middle of its 2,000 point range of the last five years. Despite recent weakness, a Brexit vote will lead to a further weakening of the Sterling Effective Exchange rate. Capital outflows will hit stocks, however, a weaker currency will help the Bank of England to meet its inflation target and exporters will benefit, especially those trading with structurally faster growing economies such as China, India and a number of Commonwealth countries.

Prime Minister Cameron announced the date for the UK referendum on 20th February. The chart below compares the DAX against the FTSE and the S&P500 over the past six months. On the face of it the UK stock market has paid little notice of the vote, although the weakening of Sterling may have been supportive for the more international FTSE companies:-

FTSE SPX DAX 6months

Source: Yahoo Finance

Another interpretation of the price action in financial markets suggests that the markets expect the UK to remain. Similar price action proved more reliable than the opinion polls both during the Scottish Referendum of 2014 and the Quebec Referendum of 1995. Cable (GBPUSD) dipped in March but has since recovered, partly spurred on by initial polls predicting that UK voters would choose to remain, lately it has weakened once more. The charts below are from Wednesday 15th, the Sterling has weakened further since:-

GBPUSD 6 months

Source: Barchart.com

EURGBP has been weakening over the past year:-

EURGBP 1 yr

Source: Tradingview.com

When viewed over the past ten years, however, the nature of the price move appears less remarkable. Eurozone (EZ) growth has been improving after a period of protracted weakness. Could an improvement in sentiment towards the EZ be the catalyst rather than expectations of the demise of Sterling?

EURGBP Monthly since 2007

Source: Tradingview.com

Once the initial turmoil of Brexit subsides, fears about the stability of the Eurozone will return; during the last decade the UK witnessed “safe haven” investment flows from Europe, especially into real estate. Inflows will resume as the European political landscape polarizes further. The UK construction sector will benefit. Reform of planning legislation, more likely once the UK has regained control of its borders, could substantially increase the attractiveness of the building sector. In many ways the housing sector represents an each-way bet. Should the UK electorate vote to remain deferred demand for property is likely to resume.

The UK stock market dividend yield is around 4%: by other metrics, including the Cyclically Adjusted Price Earnings ratio, the market is not overly expensive either. A Brexit decline may provide an excellent buying opportunity. Prepare to invest.

What are the prospects for UK financial markets in 2016?

400dpiLogo

Macro Letter – No 47 – 04-12-2015

What are the prospects for UK financial markets in 2016?

  • The EU referendum may take place as early at as June next year
  • Financial markets appear to be ignoring the vote at present
  • The tightening of bank capital requirements is almost over
  • Higher tax receipts have tempered the pace of fiscal tightening

In assessing the prospects for UK financial markets next year I will focus on three areas, the EU referendum, the stability of the financial system and the state of government finances.

The EU Referedum

As we head into 2016 political and economic commentators are beginning to focus on the potential impact of a UK exit from the EU would have on the British economy. Given the size and importance of the financial services sector to the economy, I want to investigate claims that a UK exit would be damaging to growth and lead to a rise in unemployment. For a more general overview of the referendum please see my July 3rd post – Which way now – FTSE, Gilts, Sterling and the EU referendum?

In February a report by the UK Parliament – Financial Services: contribution to the UK economy opened with the following statement:-

In 2014, financial and insurance services contributed £126.9 billion in gross value added (GVA) to the UK economy, 8.0% of the UK’s total GVA. London accounted for 50.5% of the total financial and insurance sector GVA in the UK in 2012. The sector’s contribution to UK jobs is around 3.4%. Trade in financial services makes up a substantial proportion of the UK’s trade surplus in services. In 2013/14, the banking sector alone contributed £21.4 billion to UK tax receipts in corporation tax, income tax, national insurance and through the bank levy.

The GVA was down from a 2009 high of 9.3%. For London the GVA was 18.6%. In international terms the UK ranks fourth, behind Luxembourg, Australia and the Netherlands in terms of the size of its financial services sector. As at September 2014, 1.1mln people were employed in the sector. According to research by PWC financial services accounted for £65.6bln or 11.5% of total government tax receipts in 2013-14.

Last week the Evening Standard – ‘Brexit’ would lead to loss of 100,000 bank jobs, says City – cited senior banking figures warning of the potential impact of the UK leaving the EU:-

Mark Boleat, policy chairman at the City of London Corporation, said: “If as a country we were to vote to leave, then London’s position as a leading financial centre would remain but without doubt there would be an impact on our relative size and the jobs we support.”

Confidential client research from analysts at US investment bank Morgan Stanley, seen by the Standard, warned that “firms for whom the EU market is important” would need to “adjust their footprint” in London if the Eurosceptic cause was victorious.

Sir Mike Rake, deputy chair of Barclays and chairman of BT, said: “It is extremely difficult to quantify the number of jobs that would be lost and the time frame over which that might happen but leaving the EU would severely damage London’s competitiveness and our financial services sector.”

There have been growing hints from financial institutions that they are starting to plan for Britain quitting the 28 member club.

Both HSBC, which announced a review of the location of its global headquarters in April, and JP Morgan are reportedly in talks about moving sections of their businesses to Luxembourg in part because of the threat of Brexit.

Deutsche Bank, which employs 9,000 people in Britain, has set up a working group to review whether to move parts of its business from Britain in the event of a UK withdrawal. 

US asset management group Vanguard, which has a City office, has admitted that Brexit would have a “significant impact” on its operation across Europe and has already started planning for it.

Many senior bankers are concerned that they would lose the financial services “passporting” rights enjoyed by fellow EU members.

A fascinating historic assessment of the opinion of the UK electorate towards the EU is contained in this week’s Deloitte – Monday Briefing, they  anticipate a referendum date of either June or September 2016, in order to avoid coinciding with a French (March/April) or German (September) election in 2017:-

Since Ipsos MORI started polling on this issue in 1977 on average 53% of voters in a simple yes/no poll have supported membership and 47% have opposed it. The yes vote reached a low of 26% in 1980 rising, over the following decade, to a peak of 63% in 1991, shortly before the pound’s ejection from the European Exchange Rate Mechanism.

In June of this year Ipsos MORI showed UK public support for the EU, again on a straight yes/no poll, at an all-time peak of 75%. Since then it has fallen away in parallel with heightened UK public concerns about immigration. The most recent Ipsos MORI poll, from mid-October, showed the yes vote at 59%.

More recent polls suggest a further narrowing of the yes lead. Across eight polls carried out in November the yes vote averaged 52% and the no vote 48%.  

The yes vote is, by and large, younger and more affluent than the no. Opposition to the EU rises sharply among the over 40s, an important consideration given that voter turnout is higher among older voters. Conservative voters tend to be more eurosceptic than Labour voters; white voters tend to be more sceptical than non-white voters.

… “don’t knows” averaged around 15% of all voters, more than enough to tip the vote decisively.  

The last referendum on UK membership of what was then the European Economic Community (EEC) was held in 1975, just two years after the UK joined the EEC. The vote was an overwhelming victory for EEC membership, with the electorate voting by 67.2% to 32.8% to stay in.

… In an intriguing paper economists David Bowers and Richard Mylles of Absolute Strategies Research (ASR) outline how the political landscape has shifted in the last 40 years.

… in 1975 the debate was about membership of a trading bloc, the Common Market. For sure, the commitment to “ever closer union” was in the Treaty of Rome, but in 1975 few in the UK, especially in the yes campaign, paid much attention to it. Since then the EU has grown from 9 to 28 members, expanded into Central and Eastern Europe, created the Single Currency and acquired more characteristics of a federal union.

…In 1975 the UK economy was in a shambles, slipping into the role of sick man of Europe. In the previous three years the UK had endured a recession, double digit inflation, endemic industrial unrest and the imposition of a three-day working week to save scarce energy supplies. British voters in 1975 looked enviously to the prosperity and stability of Germany. Today the UK is seeing decent growth, while the euro area grapples with the migration crisis, sluggish activity and the difficulties of building a durable monetary union. On a relative basis the performance of the UK economy looks, for now at least, pretty good.

…The Maastricht Treaty of 1992 established the right of people to live and work anywhere in the EU, but… it was EU enlargement into Central and Eastern Europe in 2004 that caused immigration into the UK to rise markedly, pushing migration up the list of UK voter concerns. More recent migration from North Africa and the Middle East, and the growing problems facing the Schengen nations, have added new concerns.  

The final factor…was the enthusiasm of the majority of the press for the Common Market in 1975. The press gave the then Prime Minister, Harold Wilson, largely uncritical coverage of his negotiations for a “better deal” in Britain’s relationship with the Community. (Historians tend to the view that Wilson actually achieved little in his negotiations with the Community; but he deftly turned meagre result into a public relations triumph). The lone dissenting voice in a general mood of press enthusiasm for the EEC was the Communist Morning Star. This time round it seems likely that a number of major papers will take a euro sceptic line.

The most recent poll, published by ORB last week in the wake of the Paris attacks, found 52% in favour of exit.

Financial Stability

This week saw the release of the Bank of England – Financial Stability Report – December 2015 – it suggests that the UK economy has moved beyond the post-crisis phase, the risks are, once again, external in nature:-

The global macroeconomic environment remains challenging. Risks in relation to Greece and its financing needs have fallen from their acute level at the time of the publication of the July 2015 Report. But, as set out in July, risks arising from the global environment have rotated in origin from advanced economies to emerging market economies. Since July, there have been further downward revisions to emerging market economy growth forecasts. In global financial markets, asset prices remain vulnerable to a crystallisation of risks in emerging market economies. More broadly, asset prices are currently underpinned by the continued low level of long-term real interest rates, which may in part reflect unusually compressed term premia. As a consequence, they remain vulnerable to a sharp increase in market interest rates. The impact of such an increase could be magnified, at least temporarily, by fragile market liquidity.

Domestically, the FPC judges that the financial system has moved out of the post-crisis period. Some domestic risks remain elevated. Buy-to-let and commercial real estate activity are strengthening. The United Kingdom’s current account deficit remains high by historical and international standards, and household indebtedness is still high.

Against these elevated risks some others remain subdued, albeit less so than in the post-crisis period to date. Comparing credit indicators to the past alone cannot provide a full risk assessment of the level of risk today, but can be informative. Aggregate credit growth, though modest compared to pre-crisis growth, is rising and is close to nominal GDP growth. Spreads between mortgage lending rates and risk-free rates have fallen back from elevated levels.

They go on to note that the Tier 1 capital position of major UK banks was 13% of risk-weighted assets in September 2015, below the levels advocated by the Vicker’s Commission but above Basel requirements. The Financial Policy Committee (FPC) are expected to impose a 1% counter-cyclical capital buffer in the near future, but otherwise the fiscal tightening, which has been in train since the aftermath of the financial crisis has finally run its course.

The other risks which concern the Bank are cyber-risks of varying types and, of course, the uncertainty surrounding the EU referendum.

Autumn Statement and Spending Review

Last week saw the publication of the UK Chancellor’s Autumn Statement and Spending Review. Mr Osborne was fortunate; the OBR found an additional £27bln in tax receipts which allowed him to reverse some of the more unpopular spending cuts previously announced. He still hopes to balance the government budget by 2020/2021. Public spending will rise from £757bln this year to £857bln in 2020/21. Assuming the economy grows as forecast, public spending to GDP ratio should fall from 39.7% to 36.5%.

Writing in the Telegraph Mark Littlewood of the IEA said:-

George Osborne has today made a one-way bet. His announcements are based on two predictions: continually low interest rates and sustained strong economic growth, making our debt repayments lower than anticipated and tax revenues higher than expected. These are not unrealistic assumptions, but if either go off course, the savings announced today will not go nearly far enough.

Market Performance

Stocks

Financial markets abhor uncertainty. Concern about collapsing FDI and Scottish devolution due to Brexit, will hang over the markets until the outcome of the vote is known: meanwhile rising rhetoric will discourage investment. Regardless of economic performance UK stocks are likely to underperform.

Back in July I believed the uncertainty about the UK position on the EU would have minimal effect:-

Unless the UK joins the EZ, currency fluctuations will continue whether they stay or go. Gilt yields will continue to reflect inflation expectations and estimates of credit worthiness; being outside the EU might impose greater fiscal discipline on subsequent UK governments – in this respect the benefits of EU membership seem minimal. The UK stock market will remain diverse and the success of UK stocks will be dependent on their individual businesses and the degree to which the regulatory environment is benign.

Here’s how the markets have evolved since the summer. Firstly the FTSE100 vs EuroStox50 and S&P500 – six month chart, at first blush, I was wrong, the FTSE  has underperformed EutoStoxx and the S&P:-

FTSE vs STOX vs SPX 6month

Source: Yahoo Finance

However, the FTSE250 tells a different story:-

FTSE100 vs 250 - 6m

Source: Yahoo Finance

This divergence has been in place for several years as the five year chart below shows:-

FTSE100 vs 250 - 5 yr

Source: Yahoo Finance

Here is the FTSE250 compared to EuroStox50 and the S&P500 – over the same five year period. The mid cap Index has followed the S&P, although in US$ terms its performance has been less impressive:-

FTSE250 vs EurStox and S&P - 5yr

Source: Yahoo Finance

Gilts and Bunds

During the period since the beginning of July the spread between 10yr Gilts and Bunds has ranged between 112bp and 145bp reaching its narrowest during the fall in equity markets in August and widening amid concerns about European growth last month. UK Inflation expectations remain subdued; this is how the MPC – November Inflation Report described it:-

All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.

Sterling

The Sterling Effective Exchange Rate has traded in a relatively narrow range (please excuse the date axis, vagaries of the Bank of England’s data format – this is a one year chart):-

GiltBund JulNov

Source: Bank of England

During  stock market weakness in the summer Sterling strengthened. After weakening in October it rebounded, following the US$, in November.

Back in July I anticipated a weakening of Sterling:-

Ahead of the referendum, uncertainty will lead to weakness in Sterling, higher Gilt yields and relative underperformance of UK stocks. If the UK electorate decide to remain in the EU, there will be a relief rally before long-term trends resume. If the UK leaves the EU, Sterling will fall, inflation will rise, Gilt yields will rise in response and the FTSE will decline. GDP growth will slow somewhat, until an export led recovery kicks in as a result of the lower value of Sterling. The real cost to the UK is in policy uncertainty.

It may be that capital outflows are about to begin in earnest but I start to question my assumptions – the market seems to be caught between the uncertainty surrounding UK membership of the EU and doubts about the longevity of the “European Experiment” as a whole.

Conclusion

Gilts remain below their long run average spread over Bunds but the interest rate environment is exceptionally benign, making any pick up in yield attractive. The FTSE250 index appears to be ignoring concerns about collapsing commodities, slowing emerging markets – especially China – and the prospect of Brexit, but it may struggle to remain detached for much longer. Sterling also appears to have ignored the referendum debate so far. Or perhaps, the UK market is a relative “safe haven” offering exposure to European markets without the angst of Euro membership – either way I remain cautious until the political uncertainties dissipate.

Which way now – FTSE, Gilts, Sterling and the EU referendum?

400dpiLogo

Macro Letter – No 39 – 03-07-2015

Which way now – FTSE, Gilts, Sterling and the EU referendum?

  • Uncertainty is bad for business and the UK will struggle ahead of the referendum
  • Gilt yields have been around 150bps higher than Bunds over the last 25yrs
  • The DAX has substantially outperformed FTSE over the same period
  • Higher productivity is key to UK growth but, in the long run, demographics will help

Last week the UK Prime Minister began to debate EU treaty reform with his European counterparts. He has a long way to go. The deadline for a UK referendum on EU membership is the end of 2017 but an up-hill battle is likely because all EU countries must ratify treaty changes – the referendum will come before EU treaty changes have been agreed. In this letter I will review the history of UKs, uncomfortable, membership of the EU and previous renegotiations, compared with today’s proposals. I will then go on to consider the implications for Sterling, Gilts and UK Stocks should the UK decide to stay or go.

A brief history of the UK and the EU

The last time the UK voted on EU, or as it was then called, European Economic Community (EEC) membership, was in 1975. At that time the “yes” vote won by 67.5%. This took place only two years after first joining, previous attempts to join in 1961 and 1967 having been vetoed by French President de Gaulle.

British scepticism about the political ambitions of the Schuman declaration of May 1950 meant the UK failed to join the European Coal and Steel Community – established at the Treaty of Paris in 1951 – but spent much of the decade debating EEC membership. When the EEC was finally established in 1958, the UK opted out for two principal reasons: concern about its relationship with the Commonwealth and other international alliances, and its preference for free-trade over economic organisation and sectoral policies. At that time the UK was torn between two foreign policy strategies, one focused on the European Free Trade Area, the other on the General Agreement on Tariffs and Trades – the predecessor to the World Trade Organisation (WTO).

The 1974 treaty renegotiation, just a year after joining the EEC, was driven by three factors: free-trade versus political integration, the effects of the collapse of Bretton Woods and subsequent inflation on the UK economy – Sterling had been considered a quasi-reserve currency up to this point – and the size of UK contributions to the EEC budget which the UK government considered to be excessive.

The table below lists the 1974 UK government demands for renegotiation and the outcomes:-

DEMAND OUTCOME
Changes to CAP so as not to undermine free-trade None
Fairer financing of EEC budget Correcting mechanism
Withdrawal of UK from EMU Accepted
Retention of UK powers over regional, industrial and fiscal policy Creation of Regional Development fund supported by Ireland and Italy
Agreement on capital movement to protect UK jobs and balance of payments None
No harmonisation of VAT Never planned anyway
Access to Commonwealth goods Minor concessions

The next major test of the UK relationship with the EU came during Margaret Thatcher’s first Conservative government (1979-1983) although an agreement with the EEC was not reached until her second term in 1984. On this occasion the issue was simply a question of how much the UK was paying in to the EU budget given that 80% of that budget was then spent on maintaining the Common Agricultural policy (CAP). The UK “rebate” was sanctioned because at that time the UK was the second poorest of the ten member EEC.

UK demands for treaty change 2015

The current UK renegotiation of EU membership is concerned with the following issues:-

Restrictions to freedom of movement within the EU
Sovereignty of Sterling
Structural reform of the EU bureaucracy
Reclaiming of powers from Brussels to protect UK interests

On the latter point, this takes two principal forms: the ability to block EU legislation where it may be detrimental to UK interests and the ending of a commitment to “ever closer union” in respect of UK membership.

The Sovereignty of Sterling is a relatively uncontentious issue, whilst structural reform of the EU bureaucracy is an ideal to which all European governments will accede, at least in principal; the problems arise over restrictions on free-movement of people – enshrined in Article 48 of the Treaty of Rome:-

1.Freedom of movement for workers shall be secured within the Community by the end of the transitional period at the latest. 2. Such freedom of movement shall entail the abolition of any discrimination based on nationality between workers of the Member States as regards employment, remuneration and other conditions of work and employment. 3. It shall entail the right, subject to limitations justified on grounds of public policy, public security or public health: (a) to accept offers of employment actually made; (b) to move freely within the territory of Member States for this purpose; (c) to stay in a Member State for the purpose of employment in accordance with the provisions governing the employment of nationals of that State laid down by law, regulation or administrative action; (d) to remain in the territory of a Member State after having been employed in that State, subject to conditions which shall be embodied in implementing regulations to be drawn up by the Commission. 4. The provisions of this Article shall not apply to employment in the public service.

This leaves, the reclaiming of powers from Brussels. “Ever closer union” is probably negotiable since EU member states have always moved at different rates, both economically and culturally. Allowing the UK to pick and choose which aspects of EU legislation it accepts, however, is like joining an exclusive club and then ignoring the rules. Under normal circumstances you’d be asked to leave.

One of the associated problems for the EU – that of, when to stop expanding – is discussed in this essay by Tim Price – Let’s Stick Together. He reviews the work of Leopold Kohr, in particular his seminal work “The Breakdown of Nations”:-

It all comes down to scale. As Kirkpatrick Sale puts it in his foreword to ‘The Breakdown of Nations’,

“What matters in the affairs of a nation, just as in the affairs of a building, say, is the size of the unit. A building is too big when it can no longer provide its dwellers with the services they expect – running water, waste disposal, heat, electricity, elevators and the like – without these taking up so much room that there is not enough left over for living space, a phenomenon that actually begins to happen in a building over about ninety or a hundred floors. A nation becomes too big when it can no longer provide its citizens with the services they expect – defence, roads, post, health, coins, courts and the like – without amassing such complex institutions and bureaucracies that they actually end up preventing the very ends they are intending to achieve, a phenomenon that is now commonplace in the modern industrialized world. It is not the character of the building or the nation that matters, nor is it the virtue of the agents or leaders that matters, but rather the size of the unit: even saints asked to administer a building of 400 floors or a nation of 200 million people would find the job impossible.”

Kohr showed that there are unavoidable limits to the growth of societies:

“..social problems have the unfortunate tendency to grow at a geometric ratio with the growth of an organism of which they are a part, while the ability of man to cope with them, if it can be extended at all, grows only at an arithmetic ratio.”

In the real world, there are finite limits beyond which it does not make sense to grow. Kohr argued that only small states can have true democracies, because only in small states can the citizen have some direct influence over the governing authorities.

What’s in it for the UK

In the interests of levity I’ve included a link to this summation of UK foreign policy with regard to Europe from the satirical TV programme Yes, Minister – this episode was first aired in 1980.

In the intervening 35 years, trying to decipher what is best for the UK has not become any easier. I’ve chosen just two organisations to represent the views for and against EU membership: Business for New Europe and Better off Out. Here’s how Business for New Europe make the case for staying in:-

As a member of the European Union, our companies can sell, without barriers, to a market of 500 million people. The Single Market means that exporters only need to abide by one set of European regulations, instead of 28 national ones. Europe is our biggest trading partner- it buys 45% of our exports. If we left the EU, companies would face tariffs and regulatory barriers to trade.

The free movement of capital means that EU companies can invest here in Britain freely. This investment, by companies like Siemens, creates jobs and grows our economy. 46% of all the foreign investment in Britain came from EU countries.

The EU provides funding for businesses to all regions of Britain, particularly those with the greatest need. From 2014 until 2020, £8 billion of EU money will go from Brussels to the UK. The biggest winners from this process are Cornwall, Wales, the Scottish Highlands, Northern Ireland and the North of England.

EU research funding helps universities and firms innovate to create the technologies of the future. Britain will receive £7 billion from the EU’s Horizon 2020 fund, and our small businesses receive more funding for hi-tech research than those of any other EU country. EU membership is vital to rebalancing the British economy.  

Better off Out – sponsored by the Freedom Association – counter thus:-

10 Reasons to Leave

1.Freedom to make stronger trade deals with other nations. 2. Freedom to spend UK resources presently through EU membership in the UK to the advantage of our citizens. 3. Freedom to control our national borders. 4. Freedom to restore Britain’s special legal system. 5. Freedom to deregulate the EU’s costly mass of laws. 6. Freedom to make major savings for British consumers. 7. Freedom to improve the British economy and generate more jobs. 8. Freedom to regenerate Britain’s fisheries. 9. Freedom to save the NHS from EU threats to undermine it by harmonising healthcare across the EU, and to reduce welfare payments to non-UK EU citizens. 10. Freedom to restore British customs and traditions.

They go on to highlight 10 Myths about the risk of leaving – not all are economic so I’ve paraphrased their opinions below;-

Britain would lose 3mln jobs if we left the EU – Under the terms of the Lisbon Treaty the UK would enter into an FTA with the EU. The WTO obliges them to do so too. Of more importance the UK trade balance will the EU is in increasing deficit – the other member states have more to lose.

Britain will be excluded from trade with the EU by Tariff Barriers – EU has FTAs with 53 countries with a further 74 countries pending. In 2009 UK charged customs duty of just 1.76% on non-EU imports. The EU Common Market is basically redundant already.

Britain cannot survive economically outside the EU in a world of trading blocs – Japan does and it’s not a member. The EU’s share of world GDP is forecast to be 15% in 2020, down from 26% in 1980. Norway and Switzerland export more, per capita, to the EU than the UK does. Britain’s best trading relationships are with the USA and Switzerland. The largest investor in the UK is US.

The EU is moving towards the UK’s position on cutting regulation and bureaucracy – EU directives are subject to a ‘rachet’ effect – once in place they are unlikely to be reformed or repealed. 80% of the UK’s GDP is generated within the UK so should not be subject to EU laws. In 2010, Open Europe estimated EU regulation had cost Britain £124 billion since 1998.

If we leave, Britain will have to pay billions to the EU and implement all its regulations without having a say – The UK has 8.4% of votes. The Lisbon Treaty ensured the loss of Britain’s veto in many more policy areas.

Swiss Case Study: The Swiss pay the EU less than CHF600mln a year for access to the EU market. They estimate the cost of full membership would be CHF3.4bln.

Norway Case Study: In 2009 Norway’s total financial contributions to the EEA (European Economic Area) agreement was Eur340mln Britain pays £18.4bln per annum.

The EU has a positive impact on the British Economy – Fishing (115,000 jobs lost) farming, postal services and manufacturing have been devastated by EU membership. Unnecessary red tape, aid contributions, inflated consumer prices (due to CAP etc.) are indirect costs.

Britain will lose vital foreign investment as a consequence of leaving the EU – The 2010 Ernst and Young survey on UK’s attractiveness to foreign investors, found Britain still the number one Foreign Direct Investment (FDI) destination in Europe owing largely to the City of London and the UK’s close corporate relationship with the US. Key factors, in order of importance:-

Culture and values, English language, Telecommunications infrastructure, Quality of life, Stable social environment, Transport and logistics infrastructure.

Britain will lose all influence in the world by being outside the EU – Britain has a substantial ‘portfolio of power’ including membership of the G20 and G8, a permanent seat on the UN Security Council and seats on the IMF and WTO. The British Commonwealth has 54 nations which is being discriminated against by EU policy. London is the financial capital of the world and Britain has the sixth largest economy. The UK is also in the top ten manufacturing nations in the world.

Legally, Britain cannot leave the EU – A single clause Bill passed at Westminster can repeal the European Communities Act 1972 and its attendant Amendment Acts.

Having dealt with the main arguments for remaining in the EU, Better off Out do point out that creating an FTA with the EU may take time.

Greenland established a precedent when it left the EEC in 1985, this followed a referendum in 1982 and the signing of the Greenland Treaty in 1984. It had joined, as part of Denmark in 1973 but after it had achieved home rule in 1979 the importance of its fishing industry became a major economic incentive for it to leave the forerunner to the EU.

Greece may leave as early as next week and, as this March 2015 article from ECFR – The British problem and what it means for Europe makes clear, a Brexit will not be good for the EU either:-

An EU without Britain would be smaller, poorer, and less influential on the world stage. The UK makes up nearly 12.5 percent of the EU’s population, 14.8 percent of its economy, and 19.4 percent of its exports (excluding intra-EU trade). Furthermore, it runs a trade deficit of £28 billion, is home to around two million other EU citizens, and remains one of the largest net contributors to the EU budget (responsible for 12 percent of the budget in total).

Meanwhile the Confederation of British Industry claim that being a member of the EU is worth £3,000 per household whilst Business for Britain estimate that the UK would save £933 per person from cheaper food if they left. In a report last week S&P chimed in, saying 30% of foreign direct investment (FDI) into the UK – representing 17% of GDP – was directed to financial services and insurance. 50% of this FDI emanated from other EU countries – this could be at risk if the UK should leave. So the debate rumbles on.

How is the UK economy evolving?

UK manufacturing has been in decline since the start of the millennium, whilst this decline was initially a reaction to the strength of Sterling it has yet to benefit from the subsequent weakness of the currency:-

UK_Effective_Exchange_Rate_and_Manufacturing

Source: ERC, IMF, UN

Total factor productivity is near the heart of this conundrum:-

UK_TFP_vs_G7

Source: ERC, ONS

The UK is lying 6th out of the G7 in terms of output per hours worked, and since 2007, has underperformed the G7 average. The dotted line shows where productivity would have been had the recession not hit. The UK had been lagging its peers during the 1990’s so the predicted outperformance would merely have brought it back into the fold.

In a speech given last week the BoE’s Sir John Cunliffe – Pay and productivity: the next phase made a number of observations about the future:-

Between 2000 and 2007, the average worker in the UK automotive manufacturing industry produced 7.7 vehicles a year. Over the past seven years he/she averaged 9.8 vehicles a year. Productivity – output per worker – in car manufacturing has increased by 30% since the onset of the great financial crisis. Britain has become the fourth-biggest vehicle maker in the EU and is more efficient than bigger producers such as Germany and France.

Unfortunately productivity in the UK has not followed the lead of the car industry. Indeed, the opposite is true. In 2014 labour productivity in the UK was actually slightly lower than its 2007 level. In the seven years between 2000 and 2007 labour productivity grew at an average annual rate of about 2% a year. In the seven years that followed, our annual productivity growth averaged just below zero.

Or to look at it another way, the level of labour productivity – output per hour worked – in the UK economy is now 15% below where it would have been if pre-crisis trends had continued.

…It is true that the average output per hour of the rest of the G7 advanced economies is only around 5% above its pre-crisis level. But as I have noted, in the UK it has not even recovered to that level. And in 2013 output per hour in the UK was 17 percentage points below the average for the rest of the G7 – the widest gap since 1992.

In the 10 years prior to the crisis, growth in the hours worked in the UK economy, accounted for 23% of the UK’s overall economic growth. The mainstay of our economic growth, the other 77%, came from growth in productivity. Since 2013 only 9% of our annual economic growth has come from productivity improvement. The remaining 91% has come from the increase in the total hours worked.

As a result, employment in the UK is now around its highest rate since comparable records began in 1971. Over 73% of people aged 16-64 are working. There are now over 31 million people in work in the UK.   Unemployment has fallen at among its fastest rate for 40 years and is now very close to its pre-crisis level – over the past two years over 1 million jobs have been created.

Productivity growth can be divided into two sorts of change: the change in productivity inside individual firms and the changes between firms. The first, the changes within firms, happens as firms increase their efficiency. The second happens as labour and capital are reallocated between firms, from the less productive ones to the more productive.

After collapsing in the crisis, productivity began to increase again within firms two years ago. We expect that to continue. As the economy grows, spare capacity is used up. The real cost of labour increases relative to the cost of investment. Firms have a greater incentive to find efficiency gains and to switch away from more labour-intensive forms of production. This should boost productivity.

In contrast, productivity growth due to the reallocation of resources in the economy remains weak. We can see this in the divergence of rates of returns across firms which remain remarkably and unusually high and the change in capital across sectors which has been particularly low. When the reallocation mechanism is working, the transfer of capital and labour from the less productive to the more productive pulls up the level of productivity in the economy and reduces the divergence between firms. The high degree of divergence between firms at present implies that this reallocation mechanism is working significantly less powerfully now than before the crisis. This can also be seen in the proportion of loss-making firms which stands at around 20% higher than its long-run average. Company liquidations also remain low. So there is still more than a hint of ‘zombiness’ in the corporate sector.

For more on productivity issue this working paper BoE – The UK productivity puzzle 2008–13: evidence from British businesses is full of interesting insights.

The UK service sector continues to grow, although its share of exports to the EU remains smaller than that of goods – 37% vs 49%. Services exports to the rest of the world are the driver of UK export growth.

Conclusion and Investment Opportunities

Sterling

In search of a surrogate for the uncertainty surrounding the UK referendum, the chart below shows the impact on Sterling of the sudden realization that the Scottish might vote to leave the Union in 2014:-

GBP_vs_USD_and_EUR_-_Scottish_Vote_2014

Source: Oanda and ERC

Should the population of the UK vote to forsake the EU, the relative stability of the GBPEUR exchange rate is likely to become structurally more volatile, the move against the USD from 1.72 to 1.61 is but a foretaste of what we should anticipate. However, the 40% appreciation in the UK effective exchange rate between 1995 and 2000 – see the earlier chart above – and reversal between 2000 and 2009, suggests that membership of the EU has not led to the stability in exchange rates one might have expected.

Between the breakdown of Bretton Woods in March 1973 and the establishment of the European Exchange Rate Mechanism (ERM) In March 1979 (which the UK chose not to join until October 1990) was a period of intense currency volatility – exacerbated by significant interest rate differentials. During this period the GBP effective exchange rate actually moved less than it has since 2000. Nonetheless, higher daily volatility will impose a modicum of additional cost on UK businesses. This 2004 paper from the FRBSF – Measuring the Costs of Exchange Rate Volatility looks at the subject in more detail:-

The main quantitative finding is that the welfare effects of exchange rate volatility are likely to be very small for many countries. When numbers are chosen to permit the model to reproduce basic characteristics of the U.S. economy, the model indicates that the loss of utility is equal in size to only about 0.1% of annual consumption; that is, people would be willing to exchange only about 0.1% of their annual consumption level to eliminate the exchange rate volatility in the economy.

Gilts

The UK has exhibited structurally higher inflation than much of the Eurozone (EZ) since the collapse of Bretton Woods. That, combined with the relative asynchronicity of the UK and German economic cycles, made it difficult for the UK to operate inside the ERM – it lasted less than two years, from October 1990 to September 1992. The chart below shows German and UK 10yr Government bond yields during this period, Bunds, with lower yields, on the right hand scale:-

united-kingdom-and german government-bond-yield 1990 - 1992

Source: Trading Economics

Germany was struggling during this period and the Hartz labour market reforms occurred shortly thereafter.

germany-UK-government-bond-yield 1990 - 2015

Source: Trading Economics

As the chart above shows UK Gilts have traded at a higher yield than German Bunds for most of last 25 years. I think it would be reasonable to assume Gilt yields, had the UK remained in the ERM and joined the Euro, would have been between those of Germany and France during this period. In other words, the cost of UK government financing has been around 150bp higher than it might have achieved had it joined the EZ.

UK inflation over the same period has been significantly higher than Germany’s, in real-terms Bunds have offered vastly superior returns. This differential may also be due to the UK government running a substantially larger budget deficit during the period. I regret the data in the chart below only goes back to 1996. The UK balance is shown on the right hand scale:-

germany-UK government-budget 1996-2015

Source: Trading Economics

Stocks

The chart below shows the relative performance of the FTSE100 vs Germany’s DAX40 since 1990. The German market (right hand scale) has increased from 2,000 to 12,000 whilst the UK market has risen from 2,000 to 7,000. Germany has been the clear winner of this race:-

united-kingdom-German stock-market 1990-2015

Source: Trading Economics

Would the UK stock market have fared better inside the EZ and would the UK departure from the EU be detrimental or positive to stock performance going forward? Here is the 1990-2015 comparison between FTSE100 and the French CAC40 index:-

united-kingdom-france stock-market

Source: Trading Economics

Germany appears to be something of an exception, France, Italy and the Netherlands have underperformed the UK during the same period: although Spain has delivered German-like returns. It is worth mentioning that Germany has run a balance of trade surplus for the entire period 1990 – 2015 whilst, excepting a brief period between 1991 and 1997, the UK has run a continuous trade deficit.

I don’t believe UK membership of the EU has much influence over the value of UK stocks in aggregate. Certain companies benefit from access to Europe, others are disadvantaged.

Unless the UK joins the EZ, currency fluctuations will continue whether they stay or go. Gilt yields will continue to reflect inflation expectations and estimates of credit worthiness; being outside the EU might impose greater fiscal discipline on subsequent UK governments – in this respect the benefits of EU membership seem minimal. The UK stock market will remain diverse and the success of UK stocks will be dependent on their individual businesses and the degree to which the regulatory environment is benign. The chart below shows UK GDP by sector since 2008. Services stand out both in terms of their resilience to the effects of the recession and continued growth in its aftermath, it is now 8.5% higher than before the recession, all the remaining sectors languish below their 2008 levels. Improving total factor productivity is key:-

UK_GDP_by_sector_ECR_ONS

Source: ERC and ONS

Ahead of the referendum, uncertainty will lead to weakness in Sterling, higher Gilt yields and relative underperformance of UK stocks. If the UK electorate decide to remain in the EU there will be a relief rally before long-term trends resume. If the UK leaves the EU, Sterling will fall, inflation will rise, Gilt yields will rise in response and the FTSE will decline. GDP growth will slow somewhat, until an export led recovery kicks in as a result of the lower value of Sterling. The real cost to the UK is in policy uncertainty.

Longer term the demographic divergence between the UK and other countries of Europe will become evident. By 2060 the working age population of the UK is projected to increase from 37.8mln (2013) to 41.8mln whilst in Germany the same population will decline from 49.7mln to 35.4mln. The EC – Ageing Report 2015 – has more details. The UK can benefit from staying in the EU and continuously negotiating. However, it must become much more involved in the future of the EU project, including “ever closer union”. It can also benefit from “Brexit”, directly flattering the government’s bottom line. The worst of both worlds is to remain, as the UK has since 1950, sitting on the fence –decisiveness is good for financial markets and the wider economy.

The Scotian experiment and European fragmentation

400dpiLogo

Macro Letter – No 21 – 10-10-2014

The Scotian experiment and European fragmentation

  • Scotland voted to remain part of the Union but the devolution debate doesn’t end there
  • Further European integration risks breaking the European Union
  • Economic growth in the UK and Eurozone will be damaged by long-term uncertainty

The Scottish decision to remain part of the Union, by such a slim margin – 55% to 45% on an 85% turnout – caught me by surprise. On reflection it should not have been unexpected – it was as much about the “hearts” as the “minds” of the Scottish electorate. Now that the dust has settled, I wonder what this vote means for the United Kingdom and for other regions of Europe.

In this month’s issue of The World Today, Chatham House – A result that resolves little Malcolm Chambers – Research Director at the Royal United Services Institute (RUSI) made the following observations: –

The Scottish referendum was supposed to settle the UK’s constitutional uncertainties, but the result has raised more questions than it answers. How Britain addresses the devolution issue and the question mark over its commitment to Europe will shape perceptions of its ability to wield influence and hard power abroad for years to come.

Britain’s 2010 National Security Strategy, published shortly after the coalition government took office, was entitled ‘A Strong Britain in an Age of Uncertainty’. It made no mention of the two existential challenges – the possible secession of Scotland from the United Kingdom, and the risk of a British withdrawal from the European Union. Yet either event would be a fundamental transformation in the very nature of the British state, with profound impact on its foreign and security policy.

The article goes on to discuss the promises made to Scotland by Westminster’s political elite, from all the main parties, which may now create the conditions for eventual independence: –

Devolution max could have a similar effect, making the final step from ‘devo-max’ to ‘indy-light’ appear less traumatic, even as it still allows Westminster to be blamed for any ills that remain. If a further referendum is to be avoided five or ten years from now, it will not be enough to make constitutional changes.

Prime Minister Cameron took the opportunity to raise the issue of Scottish MPs voting on English issues; whilst this was politically expedient, it sows the seeds for regional calls for devolution of power to the poorer areas of Britain: –

Yet growing awareness of the constitutional imbalances created by devolution to Scotland – and, to a lesser extent, to Wales and Northern Ireland – is creating a series of shockwaves that will not dissipate easily. The UK, as a result, could now see a long period of constitutional experimentation and controversy, with profound effects on the governance of the country as a whole.

Chambers then turns to investigate the “European Question”. Here he sees a parallel between the UKs relationship with the EU and the Scottish desire for independence: –

Britain’s relationship with the European Union is similar, in important respects, to Scotland’s position in the United Kingdom. It has a special financial arrangement, involving a rebate of most of its net contribution, that is not available to other member states. It retains its own currency and border controls, and has a permanent exemption from the common currency and passport-free travel to which other states have agreed. As in Scotland, there is strong political pressure for the UK to be allowed special treatment in further areas, such as immigration controls. In both cases, attempts to construct ‘variable geometry’ governance frameworks are made more difficult by the asymmetry in size between the opting-out nation and the political union as a whole.

From the Brussels’ perspective the issue of devolution is not just restricted to the “Sceptred Isle”: –

While the nature of the Britain’s constitutional crises is unique, they are part of a wider crisis of European politics. Over the past five years, the eurozone has faced successive crises as it has sought to find a way to reconcile vast differences in economic interest and viewpoint between its member states. Relations between Germany and the southern states have worsened as the former takes on a more openly hegemonic role.

Without further significant sharing of political sovereignty – for example through a banking union – the risk that one or more member states could leave the eurozone will remain very substantial. Yet further political integration could bring its own challenges, with powerful nationalistic parties in northern Europe already pushing against those who argue that all the answers must come from Brussels. One of the reasons that Britain’s European allies were so worried about the Scotland vote was precisely their concern as to the example that a Yes vote could have sent to separatist movements in Spain, Belgium, Italy or Bosnia. This concern will not have been entirely dissipated, both because of the precedent set by London’s willingness to hold the vote, and by the closeness of the margin.

In conclusion Chambers states: –

It is still far from likely that the United Kingdom will perish, or that it will abandon its commitment to the European Union. But the possibility of one or both of these separations taking place seems set to be a central part of British politics for a decade or more.

The impact on Sterling

Sterling is still some way below its longer-term average on a trade weighted basis as this chart of the Sterling Effective Exchange Rate (ERI) Index shows, however, it’s worth noting that the average between 1994 and 2013 is around 90: –

GBP Effective Exchange rate - BoE

Source: Bank of England

Uncertainty always undermines the stability of ones currency and the Scottish referendum was no different, although its impact proved relatively minor. In a recent speech, Bank of England – The economic impact of sterling’s recent moves: more than a midsummer night’s dream – Kristin Forbes – MPC member, downplayed what could have been a dramatic decline in the value of the GBP:-

There has been some volatility in sterling recently, especially around the time of the Scottish referendum, but sterling is currently only 1% weaker than its recent peak in July 2014.

In her conclusion she points to the appreciation of the GBP since the Great Recession and cautions those who fail to anticipate the negative inflationary consequences of a weaker exchange rate: –

Where sterling’s recent moves may have had the greatest economic impact is on prices and inflation. A “top down” analysis estimating the pass-through from exchange rate movements to prices suggests that the lagged effect of sterling’s appreciation during 2013 and early 2014 may have acted as a powerful dampening effect on inflation. Although model simulations may be overestimating the magnitude of the effect, sterling’s past moves have reduced the risk of inflation increasing sharply, despite the strong growth in employment and the overall economy.

This dampening effect of sterling’s past appreciation, however, will peak at the end of 2014 and then begin to fade. As a result, it is becoming increasingly important to monitor trends in domestically-generated inflation – and especially unit labour costs – so that monetary policy can be adjusted appropriately and also be allowed to work through the economy with its own set of lags. Unfortunately, understanding recent trends in the domestic component of inflation – especially the slow growth in wages – has been challenging. A “bottom up” analysis of inflation that focuses on current measures of domestically-generated inflation (which attempt to minimize the dampening effect of sterling’s moves) show price pressures that are well contained and little evidence of imminent inflationary risks.

These “bottom up” indicators present a very different story then the “top down” estimates of inflation after adjusting for sterling’s recent appreciation. Has sterling’s appreciation had less of a dampening effect on prices than has traditionally occurred – perhaps due to structural changes in the UK or global economy? Or are the measures of domestic inflation understating current inflationary risks – perhaps due to the long lags before timely data is available? To answer these questions, it is critically important to monitor measures of prospective inflation to determine the appropriate path for monetary policy.

If concern about political devolution of power to the regions, at the expense of the power-house of the UK’s South East, and expectation of rising Euro-scepticism, are destined to be the pre-eminent political issues for the next decade, then an appreciation in the value of Sterling is likely to be tempered. Since the UK economy is closely integrated to Europe this persistent undervaluation will be less obvious in the GBP/EUR exchange rate but hopes of the trade weighted value of GBP rising like the USD due to structurally stronger growth will be muted.

In the aftermath of the referendum RUSI – Never the Same Again – What the Referendum Means for the UK and the Worldobserved:-

Having, for the first time, looked at what a ‘yes’ vote might mean for them, private investors and businesses are now more sensitised than ever before to the risks that a further referendum could pose. If some of them were to begin to hedge their bets accordingly, there could be a risk of an extended period of underinvestment in Scotland, with serious consequences for its prosperity.

Better together?

The campaign slogan of the Westminster elite was “Better Together” but, setting aside the rhetoric of power hungry politicians, what are the pros and cons of devolution versus Union? Writing ahead of the referendum Adam Posen of the Peterson Institute – The Huge Costs of Scotland Getting Small made a valiant case for continued integration: –

When is it ever a good idea for a small nation to set up on its own? Leaving aside cases of colonization and outright oppression, there is little good reason ever to shrink on the world scene by leaving a larger unit. The internal politics of democracies always get better deals for regions within them than small sovereigns can elicit from identity-ignoring market forces. The few small nations that did gain in welfare by seceding from transnational entities are those that escaped failed autocratic systems. The Baltic countries escaping the former Soviet Union’s dominance can be seen in this light. But setting out on your own is only beneficial when the system left behind has directly constrained your nation’s human potential. Whatever else, that cannot be said of the current Scottish situation in the United Kingdom.

It is a fact of life in today’s world that a small economy on its own is always buffeted by the forces of the global economy more than a region within a larger union. Even well-run small states like Singapore and Estonia are subject to huge swings in their economy resulting from capricious capital flows in and out. These swings disrupt employment, investment, and competitiveness via real exchange rate fluctuations. More important, small economies are fundamentally undiversified because of their small scale, and they risk their specializations falling out of favor in world markets. Events beyond their control can overwhelm the small nation’s high value-added industries, no matter how good it is at those things, be they oil extraction or banking or whisky distilling. Scottish independence in form will instead mean increased vulnerability in fact, because, inherently, smaller means more exposure when the markets turn—and turn they will.

…The economic debate over independence has tended to focus on the one-time transfer costs: setting up a new government administration, apportioning the accumulated public debt, grabbing as much oil as possible. But these issues are of minimal importance, however one chooses to measure them, compared to the ongoing costs of permanently greater insecurity to households and businesses. Even if an independent Scotland were to start out with the Scottish National Party (SNP) fantasy of relatively low public debt and a relatively high share of remaining oil revenues, it would have to save more, pay higher interest rates, and keep more space in its budget for self-insurance, hampered by a narrow tax base, in order to cope with the vicissitudes of the global economy on its own.

When one looks at the economic austerity foisted on the population of Greece and at the hopeless prospects much of the unemployed youth of Europe I wonder whether there is an alternative to the “integrationist” approach.

Looking for an answer I went back to the forging of the United Kingdom. This is how John Lancaster describes the events which led to the Act of Union in 1707:-

During the 17th century, Scottish investors had noticed with envy the gigantic profits being made in trade with Asia and Africa by the English charter companies, especially the East India Company. They decided that they wanted a piece of the action and in 1694 set up the Company of Scotland, which in 1695 was granted a monopoly of Scottish trade with Africa, Asia and the Americas. The Company then bet its shirt on a new colony in Darien – that’s Panama to us – and lost. The resulting crash is estimated to have wiped out a quarter of the liquid assets in the country, and was a powerful force in impelling Scotland towards the 1707 Act of Union with its larger and better capitalised neighbour to the south. The Act of Union offered compensation to shareholders who had been cleaned out by the collapse of the Company; a body called the Equivalent Society was set up to look after their interests. It was the Equivalent Society, renamed the Equivalent Company, which a couple of decades later decided to move into banking, and was incorporated as the Royal Bank of Scotland. In other words, RBS had its origins in a failed speculation, a bail-out, and a financial crash so big it helped destroy Scotland’s status as a separate nation.”

The above passage, taken from Lancaster’s 2009 book It’s Finished, is quoted near the opening of a recent article by Tim Price – Let’s Stick Together in which he refers to Leopold Kohr – The Breakdown of Nations. The forward by Kirkpatrick Sale describes the problem of size when nation building: –

What matters in the affairs of a nation, just as in the affairs of a building, say, is the size of the unit. A building is too big when it can no longer provide its dwellers with the services they expect – running water, waste disposal, heat, electricity, elevators and the like – without these taking up so much room that there is not enough left over for living space, a phenomenon that actually begins to happen in a building over about ninety or a hundred floors. A nation becomes too big when it can no longer provide its citizens with the services they expect – defence, roads, post, health, coins, courts and the like – without amassing such complex institutions and bureaucracies that they actually end up preventing the very ends they are intending to achieve, a phenomenon that is now commonplace in the modern industrialized world. It is not the character of the building or the nation that matters, nor is it the virtue of the agents or leaders that matters, but rather the size of the unit: even saints asked to administer a building of 400 floors or a nation of 200 million people would find the job impossible.

Kohr grew up in a small village which may have helped him to recognise one of the intrinsic weaknesses of democracy: that it works best on a small scale.

Taking this theme further and applying it to an independent Scotland, John Butler – From bravery to prosperity: A six-year plan to make Scotland the wealthiest Anglosphere region of all makes the case for a smaller more flexible approach. Here is an abbreviated version of his six point plan:-

Debt Repayment

The Scots’ legendary bravery is equalled by legendary parsimony, the first essential element of success. There is no growth without investment and no sustainable investment without savings. It stands to reason that you aren’t a parsimonious society if you carry around a massive, accumulating national debt. Debt service is also a drag on future growth. Thus if the Scots want to prosper long-term, they are going to need to pay down their share of the UK national debt.

Tax Reduction

There are several policies that would quickly create an investment boom. Most important, Scotland should do better than celtic rival Ireland, with a low corporate tax rate, and abolish the corporate income tax altogether. Yes, you read that right: The effective corporate income tax in many countries now approaches zero anyway, due to all manner of creative cross-border accounting.

Human Capital

Developing human capital, at which the Scots excelled in the 19th century, is the third element. Consider which industries are most likely to relocate to Scotland: Those requiring neither natural resources nor extensive industrial infrastructure, that is, those comprised primarily of human capital. Although financial services comes to mind, there is tremendous overcapacity in this area in England and Ireland, including in unproductive yet risky activities, so that is better left to the English and Irish for now. Better would be to concentrate on health care, for example, an industry faced with soaring costs and stifling regulation in much of the world.

Scotland could, inside of six years, become the world’s premier desination for so-called ‘healthcare tourism’. Scotland lies directly under some of the world’s busiest airline routes, an ideal location.

Sound Banking

A fourth essential element to success is to implement Scottish Enlightenment principles for sound banking. This is of utmost importance due to the potential monetary and financial instability of the UK and much of the broader Anglosphere.

As a first step, Scotland should forbid any bank from conducting business in Scotland if they receive any direct financial assistance from the Bank of England or from the UK government. In turn, Scotland should make clear to Westminster that Scottish residents will not contribute to any taxpayer bail out of any UK financial institution. No ‘lender of last resort’ function will exist for financial activities in Scotland, unless such action, if formally requested by a bank, is approved by the Scots in a referendum. (Taxpayers are always on the hook for bailouts one way or the other; why not make this explicit?)

Self-Reliance

The fifth element reaches particularly deep into Scottish history: Self-Reliance. Peoples that inhabit relatively inhospitable or infertile lands tend to establish cultures with self-reliance at the core. No, this does not make them culturally backward, but it does tend to contribute to a distrust of foreign or central authority. The Scots, while brave, were frequently disunited in their opposition to English rule, something that had unfortunate consequences for many, not just William Wallace.

Scottish Presbyterianism

Finally, there is the sixth element: the collective cultural traditions of Scottish Presbyterianism. There are few religions in the world that hold not only faith, but hard work, thrift and charity in such high regard as that of traditional Presbyterianism. Yes, as with most all Europeans, the Scots have become more secular in recent decades. But the same could be said of the Germans, who nevertheless cling to their own, solid Protestant work ethic and associated legal and moral anti-corruption traditions.

To be fair to Adam Posen of the Peterson Institute, none of the arguments for a non-integrated Scotland solve the problems of vulnerability to external shocks. The crux of the issue is whether a larger, more integrated unit, is more effective than a smaller more flexible one.

The Politics of Empires

“Power tends to corrupt, and absolute power corrupts absolutely. Great men are almost always bad men.”  Lord Acton – 1834-1902.

Throughout history successful nations have grown through expansion and integration. The process is cyclical, however, and success sows the seeds of its own demise. Europe emerged from the dark ages to conquer much of the known world. Since then it has imploded during two world wars and may now be embarking on a further wave of integration. Or, perhaps, this is the last attempt to assimilate a multitude of disparate cultures before the “long withdrawing breath” into smaller, more dynamic, self-reliant units.

In the opening chapter of Edward Gibbon’s “Decline and Fall of the Roman Empire” he says:-

…but it was reserved for Augustus (who became Caesar in BC 44) to relinquish the ambitious design of subduing the whole earth and to introduce a spirit of moderation into the public councils.

However, I believe the seeds of destruction, which eventually created the conditions for the establishment of A NEW Europe, stem from Diocletian’s introduction of the Tetrarchy in AD 284. It divided the Roman Empire in four regions.

Diocletian’s son, Constantine attempted to slow this fragmentation by adopting Christianity as the official religion of the empire, however, his decision to move the seat of government from Rome to Byzantium in AD 324 set the stage for the final schism into the Eastern and Western Empires which occurred in AD395 on the demise of Theodosius.

The Western Empire sustained continuous assaults from Vandals, Alans, Suebis and Visigoths leading to the second sack of Rome in AD 410 by Alaric. The Western Empire finally collapsed in AD 476 when the Germanic Roman general Odoacer deposed the last emperor, Romulus . Europe had descended into a “dark age” of constant wars between rival tribes. The sole pan-European administrative organization after the fall of the Western Empire was the Catholic Church, which adopted the remnants of its infrastructure.

The creation of the Europe we recognise today began with the conversion to Christianity of Clovis – King of the Franks – in AD 498, but it was not until the re-uniting of the Frankish kingdoms in AD 751 under Pepin The Short and the subsequent appointment of his son Charlemagne as Holy Roman Emperor in AD 800 that the idea of a Christian “Western Europe” began to emerge. When viewed from this long historical perspective the current development of the EU is still in its infancy.

In the East, Constantinople remained the administrative center of the Byzantine Empire. Under Emperor Justinian in AD 526 the Empire expanded. Challenges from the Lombards in AD 568 saw the loss of Northern Italy, but the rise of Islam after AD 623 proved a more terminal event. Although Byzantium went into decline, due to many assailants – not least the Western Empire – it limped on until 1453 when it to finally succumbed to the Ottoman Turks.

Why the history lesson? The spark of the industrial revolution was kindled in Europe. It developed out of the chaotic collapse of the Western Roman Empire, the warring between a plethora of tribes and the rise of independent city states. It was built on the fragmented polity of petty fiefdoms and the desire to trade despite national borders and political restrictions on the movement of labour and goods. The renaissance began in Italy where the competition between small city states stimulated “animal spirits”. The flowering of art and culture that this democratisation of prosperity set in motion goes some way to support the idea that “small is beautiful”.

During the dark ages the concept of “Nationhood” was fluid, as exemplified by the Dukes of Normandy’s fealty after 1066 to the King of France, but only in respect of their French domains. As nation states began to coalesce international trade developed further. Nations waxed and waned, alliances were made and broken but no single nation succeeded in dominating the whole region. Demographic growth encouraged voyages of discovery. Colonisation followed, and finally the conditions were propitious for the birth of the industrial revolution from which we continue to benefit today.

These processes were gradual, running their course over many generations. I believe Europe is now fragmenting once more; painful for our own time but filled with promise for future generations. Calls for self-government from many regions within the EU will increase. The more Brussels attempts to make its citizens feel European the more its citizens will yearn for self-determination.

This trend will be driven by a number of factors aside from the declining effectiveness of central government. Bruegal – The Economics of big cities articulates one of these economic paradoxes, how globalisation has made the world more local: –

Local economies in the age of globalization

Enrico Moretti writes that the growing divergence between cities with a well-educated labor force and innovative employers and the rest of world points to one of the most intriguing paradoxes of our age: our global economy is becoming increasingly local. At the same time that goods and information travel at faster and faster speeds to all corners of the globe, we are witnessing an inverse gravitational pull toward certain key urban centers. We live in a world where economic success depends more than ever on location. Despite all the hype about exploding connectivity and the death of distance, economic research shows that cities are not just a collection of individuals but are complex, interrelated environments that foster the generation of new ideas and new ways of doing business.

Enrico Moretti writes that, historically, there have always been prosperous communities and struggling communities. But the difference was small until the 1980’s. The sheer size of the geographical differences within a country is now staggering, often exceeding the differences between countries. The mounting economic divide between American communities – arguably one of the most important developments in the history of the United States of the past half a century – is not an accident, but reflects a structural change in the American economy. Sixty years ago, the best predictor of a community’s economic success was physical capital. With the shift from traditional manufacturing to innovation and knowledge, the best predictor of a community’s economic success is human capital.

Human Capital may be defined as “the skills, knowledge, and experience possessed by an individual or population”. In the internet age this resource can be located almost anywhere and need not be isolated due to email, telephone or video conference technology, however, the advantages of physical proximity and social interaction favour cities.

Another, and related, issue is the increasingly disruptive effect of technology on employment. Bruegal – 54% of EU jobs at risk of computerisationhighlights one of the greatest economic challenges to the social fabric of the EU, but this is a global phenomenon: –

Based on a European application of Frey & Osborne (2013)’s data on the probability of job automation across occupations, the proportion of the EU work force predicted to be impacted significantly by advances in technology over the coming decades ranges from the mid-40% range (similar to the US) up to well over 60%.

Those authors expect that key technological advances – particular in machine learning, artificial intelligence, and mobile robotics – will impact primarily upon low-wage, low-skill sectors traditionally immune from automation. As such, based on our application it is unsurprising that wealthy, northern EU countries are projected to be less affected than their peripheral neighbours.

European governments are caught between the competing needs of an aging population and a younger generation who have little prospect of finding gainful full-time employment. Meanwhile city workers are paying for the regions where unemployment is highest. The tension between “wealth makers” and “wealth takers” are destined to increase.

Conclusion

Scotland voted to remain part of the Union. The Independence campaign was ill prepared failing to consider such issues as what currency they would use or how they would avoid a run on their banking system. The next time the Scots vote – and there will be a next time – I believe they will leave the Union because these questions will have been addressed. Other regions around the UK and Europe have taken note – the spirit of devolution is abroad. Prosperous regions, such as Catalunya and Northern Italy – Padania as it is sometimes called – crave independence from their poorer neighbours. Poorer regions resent the straight jacket of a single currency – be it the GBP for regions like the North East of England or the EUR for Greece and Portugal. To the poorer regions, the flexibility of a floating exchange rate is beguiling; as the EU stumbles through an era of debt laden low growth devolution pressures will increase.

For the GBP and EUR the Scottish “No” vote will fail to diminish the potential for social and political tension. The value of these currencies will reflect that uncertainty. Longer-term foreign direct investment will be lower. This will place an additional burden on EU budgets. A larger percentage of central government spending will be directed to regions where calls for devolution are highest rather than to economically productive projects in more prosperous areas.

European and UK equities are likely to under-perform in this environment whilst the increased indebtedness of EU governments is likely to increase their real borrowing costs.

Will this happen soon and will it be possible to measure? I think it is already happening but, given the very long-term nature of the fragmentation of nations, it will be difficult to measure except during constitutional crises. The shorter-term business cycles will still exist. Trading and investment opportunities will continue to arise. For the investor, however, it is essential to be aware of the risks and rewards which this fragmentation process will present.