Post-Brexit living

Key points

  • Trade guerrilla: moving fronts
  • ŸUK Tory contest: Temporary suspension of gravity
  • ŸWhat’s not in the limelight: Oil’s silent support (so far)
  • What the Street is saying: Believe in the European Central Bank

Trade guerrilla: moving fronts

We made the point last week that we do not expect “one stroke” trade deals but a succession of “skirmishes” bringing neither full resolution nor proper escalation, keeping the market on its toes and continuing to erode global confidence. Since last Friday we had good news on Mexico… but immediately afterwards the US President mentioned the possibility of “sanctions” against Germany for its involvement in the Nordstream 2 pipeline project. This does not necessarily bode well for the trade negotiations between the EU and the US which are due to re-start this autumn. We note also that even the deal with Mexico is possibly shakier than initially thought, since the presentation of its content by the Mexican government differs from that of the US administration.

Beyond the day to day gyrations in the news-flow, we point our readers to a very interesting note from the Peterson Institute (Trade and Investment Policy Watch by Bown, Jung and Zhang released on 12 June) showing that while Beijing has significantly raised tariffs on US products, it has at the same time lowered them for products coming from the rest of the world from 8.0 to 6.7%.

The ensuing re-allocation of Chinese demand away from the US is unlikely to offset much of the overall cost of the trade war(s) for Europe in the short term. Indeed, if EU products are becoming more competitive on the Chinese market, the ongoing slowdown in Chinese growth and the generic uncertainty brought about by the “trade guerrilla” trump this for now. But it is another reminder that the EU and the US interests are definitely not aligned on these issues.

UK Tory contest: Temporary suspension of gravity

The leadership contest to find a successor to Theresa May by the end of July has started in earnest. Boris Johnson is the race’s favourite, winning 114 votes out of the 313 Tory MPs in the first round within the parliamentary group. Given his willingness to toy with the idea of a “no deal Brexit” and his pledge to withhold the payment of the UK’s GBP39bn liabilities to the EU until he gets a better deal from Brussels, odds of a “hard Brexit” come 31 October mechanically rise. In addition, the motion tabled by the Opposition in parliament aiming to prevent the next PM to pursue a “no deal” strategy failed by nine votes the previous day: support from some Tory remainers was more than offset by dissent from Labour leavers.

Still, there will be other occasions to stop such a scary scenario. More profoundly, beyond the complex mechanics of the UK’s unwritten Constitution, the biggest hurdle towards a “hard Brexit” is simply the difficulty for any party to sell to public opinion a consistent strategy making such a drastic outcome economically manageable.

In the referendum campaign, Johnson stood up for the free market wing of the Brexiteers. The idea was that free from the “EU’s shackles” the UK would thrive by pursuing a staunch de-regulationist, ultra-competitive strategy (low tax, low employment protection). Unsurprisingly, Boris Johnson’s main proposal in the economic field in his leadership bid is a rise in the threshold beyond which the higher income tax rate kicks in.

A snag is that in the referendum campaign, the Brexiters’ assumption was that the EU would ultimately grant the UK a very high quality of access to the single market without the corresponding limitations to sovereignty. Now that this illusion has dissipated, the de-regulationist approach no longer is what would bring the UK an acceleration in growth, but more what could offer some measure of compensation for the long-term decline in economic growth brought about by either a low quality deal with the EU (the one negotiated by T. May) or no-deal at all.

We note that all the other top contenders in the race propose some sort of tax reform (J. Hunt wants to cut the corporate tax by 1/3, M. Gove wants to dispose of VAT and move to a US-style sales tax). The crucial question for British policy-makers is whether such compensatory strategy is economically and politically feasible. We don’t think so.

UK trend GDP growth has exceeded that of the euro area (1.7% on average over the last 10 years against 1.4%), but this does not mean the British economy is more efficient. Productivity has slowed down everywhere after the Great Recession, but it has completely stalled in the UK while at least it has remained on an upward trend in the US and the euro area (Exhibit 1).

If productivity has stalled but growth remains decent, this means that the UK is simply pouring more labour and capital in the system. Working age population continues to grow in the UK while it has stalled in the Euro area, in an almost perfect mirror image of the productivity pattern (Exhibit 2). A lot of this divergence comes down to immigration. The UK economy has been a clear beneficiary of migrations brought about by the inclusion of the Eastern European countries in the EU.

Exhibit 1


Exhibit 2


Maintaining the same growth model while putting free circulation of labour between the UK and the EU to an end – one of the key motives behind the victory of “leave” in the referendum – or opening wide the doors to non-EU immigration is thus very difficult.

The same holds for the supply of capital in the UK economy. In the 1990s and the first years of this century the UK managed to attract more Foreign Direct Investment relative to the size of its economy than the euro area, supporting the build-up in domestic capital. This reversed just before the Great Recession (Exhibit 3) and the uncertainty around Brexit is now weighing on foreign investment decisions. If, looking ahead, access to the EU’s market from the UK is curtailed, then using the UK as an entry point into Europe won’t be such an interesting proposition for non-EU investors.

It would then take very aggressive supply-side measures to keep the UK attractive post-Brexit, but there is very little room for manoeuvre left. Cutting tax deeply without re-opening a significant fiscal deficit would entail another round of cuts to a level of public spending which is already very low by European standards (Exhibit 4). Indeed, after bringing government expenditure closer to the Euro area average than to the US by the end of the Blair/Brown years, the UK has been converging back to US levels. Given the popular attachment to what remains of the “big items” on the list of British public services – in particular the National Health Service – we think for the UK to engage on a “tax competition” with Europe would be politically unrealistic. We find it interesting that according to the British Survey of Social Attitudes, it is in 2016 – the year of the referendum – that for the first time in 10 years the share of those calling for more tax and more spending exceeded those preferring a stable level of tax and expenditure.

Exhibit 3


Exhibit 4


The same applies to further de-regulate the labour market. According to the OECD’s synthetic indicator of employment protection legislation, the UK is already well below the levels seen in the rest of the EU (1.59 against 2.82 in France and 2.83 in Germany), and already closer to the US (1.17). There are no “low hanging fruits” to pick up there. Again, given the general shift in public opinion in the UK over the last few years away from deregulation, such policies would be unsellable.

The reaction of the EU also matters. Even after a “no deal Brexit” and possibly a phase of physical disruption to trade, the two partners will need to re-engage. The more the UK will pursue aggressive competition policies on regulation and tax, the less the EU would be ready to make progress towards even a minimal free trade agreement.

For now, the extension until 31 October allows British politicians another few months of discussing abstractions, especially since the discussion is for now for the benefit of the 120,000 members of the Tory party who ultimately get to choose the next PM. As we get closer to the deadline, the laws of gravity should apply again, if only because the conservative majority in parliament hangs by a thread and early elections are on the cards. When time comes for actual policy implementation, reality will make a comeback. 

True, given the UK electoral system in which the party commanding the “biggest minority” can win a decent majority in parliament, even in the case of early elections adventurous options cannot be ruled out, but when the debate moves away from the ruling party alone and move to the wider spectrum of opinion, we still believe on balance that a further extension and ultimately a softer form of Brexit is the most reasonable scenario. The summer will be scary though, when the final two candidates selected by the parliamentary group will start touring the local party associations. This will present many occasions for them to lay out extreme scenarios.

What’s not in the limelight: Oil prices, the silent supporter (so far)

While the ripples of the trade wars are the Euro area’s number one headwind at the moment, in the second half of last year a softness in domestic demand, and particularly consumption, also appeared, surprisingly so given the strength of the labour market. The rebound in oil prices towards a peak at USD86 /barrel (bbl) in October had a significant impact on purchasing power. At the end of last year energy prices shaved 0.7 percentage point (pp) off real wage yoy growth (Exhibit 5).

Exhibit 5


Symmetrically, some of the surprisingly resilient dataflow in the first half of 2019 in the Euro area can be traced back to the decline in oil prices towards USD60/bbl. To some extent this an illustration of a stabilising effect of oil: when global demand for energy falls because the economy is softening, the ensuing decline in oil prices dampens spurs spending in the consumer countries.

But a supply-side driven spike in oil prices would come at exactly the wrong time. This is why we monitor quite closely the risks in the Persian Gulf. Investors have tended to focus less on this aspect of US foreign policy than on trade wars, but tension flaring up with Iran could become very relevant for the global cycle. Mike Pompeo’s announcement on Thursday that he could trace back the recent fires on tankers to Iran deserves attention. 

What the Street is saying: believe in the ECB

We were not thoroughly impressed by the ECB’s press conference last week, since for us the explicit hints at potential further action on policy rates and QE did not offset the fact that the actual announcements were underwhelming. We were thus intrigued by Citi’s Arnaud Mares very positive take on the latest communication from the European Central Bank (ECB) – his “Yes we can” weekly on 7 June.

Arnaud is a subtle and experienced monetary policy analyst and his views must be taken seriously. His main point is that there is power in the ECB’s hints that a fairly precise conversation has started on re-engaging with asset purchases and that Draghi’s point on the European Court of Justice rulings is a way to signal the central bank would not necessarily be constrained by their self-imposed limits (e.g. not taking more than a third of eligible debt from a single issuer).

We don’t disagree with that and we do not doubt that resuming Quantitative Easing (QE) is a scenario under exploration. Our concerns focus more on the political feasibility of such an approach. Even if QE falls squarely within the realm of monetary policy, a number of political conditions had to be met first. QE was ultimately a consequence of a push towards stronger Euro area institutions (e.g. European Stability Mechanism) from 2012 onward combined with a commitment to structural reforms at the national level. As we wrote last week, this consensus and the sense of progress on the Euro area institutional set up has waned, as Italy has moved away on policy while the smaller Northern European countries organized under the “New hanseatic League” refuse further integration without strong conditionality.

Exhibit 6


This suggests that QE 2.0 could be a solution of last resort, triggered only once the macroeconomic conditions have significantly soured further. This would be a late, reactive approach and not a pre-emptive one. We find the market reaction since last Thursday quite interesting actually. Inflation expectations have continued to decline. This means either that investors do not believe that more action is actually coming from the ECB, or, which may actually be worse, that they don’t think that, if and when It is implemented, it will be enough to bring inflation back to target.

This will undoubtedly rank high in the discussions in Sintra next week. Watch this space for our takeaways next Friday.

All data sourced by AXA IM as at 7 June 2019

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