01 Jul 2020
Investec's UK economic mid-year review 2020
At the halfway point of a tumultuous year, Investec experts speak in an exclusive webinar about the current state of the economy, Brexit, currency markets, the retail industry and supply chains. They also examine the outlook as the UK negotiates a trade deal with the European Union and the risk of a resurgence in the coronavirus pandemic hangs over the recovery.
Watch the full replay by clicking below:
- Philip Shaw: Brexit and the outlook for a UK-EU trade deal: 2:22-11:54
- Victoria Clarke: the economy, Covid-19, the risk of a second wave: 11:54-22:57
- Kiran Russell: currencies, Covid-19 and the outlook for the pound: 22:57-33:06
- Kate Calvert: the outlook for the retail industry and physical stores: 33:06-43:12
- Paul Rablen: logistics, supply chains and key risks facing the sector: 43:12-53:12
- Q&A: a V-shaped recovery, retail winners, localising supply chains: 53:12-59:58
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As Investec’s panel of experts explains, the UK economy faces two significant challenges – the current Brexit negotiations and the management of the coronavirus pandemic. Below is a summary of their discussion on where we are now and the path ahead at this crucial juncture.
The Brexit backdrop
After leaving the European Union (EU) in January, the UK finds itself in a transition period until the end of the year. Before 30 June, the UK could have extended this period by up to two years but chose not to do this. The clock is now ticking for the two sides to reach a new trading relationship or default to World Trade Organisation (WTO) rules.
The UK's current approach indicates that Prime Minister Boris Johnson wants to establish a looser trading relationship with the EU than his predecessor, Theresa May, according to Philip Shaw, Chief Economist at Investec.
"Boris Johnson is seeking to strike a bespoke free trade deal with the EU, several deals with third-party countries such as the US, Japan and Australia, and to diverge from EU rules. This is clearly a mountain to achieve in a short space of time,” Shaw said.
The question is then - why not extend the EU transition period?
Shaw explained that there are two reasons. The first is that the UK would need to pay in the region of £10 billion per year. The second is a belief in government that an extension would be kicking the can down the road.
Against this complex backdrop, Shaw believes the critical outcome is whether we get a free trade agreement, maybe similar to the EU-Canada arrangement, or the two sides fail to reach an agreement.
The economic impact
If there is no deal, Shaw sees two key economic impacts.
"Firstly, exports to the EU would be subject to its WTO tariffs, which are particularly onerous in certain sectors, particularly food. The second is around shipments, which would be subject to checks at the point of entry, bringing unwelcome lengthy hold-ups."
Mr Johnson has indicated he would like to see a trade deal struck in July, but Shaw believes this is extremely optimistic.
"Trade experts are now determining whether a deal can be struck by the end of the year. The sticking point is around the so-called level playing field, related to EU standards around government subsidies, animal welfare, climate change and workers' rights.
"Primarily, the EU is concerned about a competitor lying on its doorstep gaining advantage through lowering domestic costs and cheap imports. The good news is pandemic-induced economic uncertainty will focus minds on both sides to get something over the line that will diminish the economic impact.
"A sensible base case is that the UK and the EU agree on a broad set of parameters in time, and they both agree on a light touch to product checks until all the fine print is settled and more infrastructure at the ports is ready."
Metrics such as electricity consumption and transportation volumes help us understand the impact. For example, during the peak of the pandemic, electricity fell 40%, and while it is coming back, it remains far below normal.
The shape of the recovery
If Brexit wasn't enough to be dealing with, the global outbreak this year of the coronavirus known as Covid-19 initially pushed Brexit concerns into the background. Due to the pandemic's sudden impact, the UK economy contracted by 2.2% in the first quarter, the biggest decline since 1979.
"This was a disappointing number," said Victoria Clarke, an economist at Investec. "But we have already seen the impact of the full weight of lockdown in April's figure – a record drop of 20%."
While high-frequency data is showing a resumption in economic activity, it is "far from business as usual", Clarke said.
"Metrics such as electricity consumption and transportation volumes help us understand the impact. For example, during the peak of the pandemic, electricity fell 40%, and while it is coming back, it remains far below normal patterns."
Clarke said she sees a slow, grinding recovery slowly bringing the economy back to pre-Covid-19 levels. Also, concerns about job losses when government stimulus ends and the risk of a second wave in the pandemic are creating uncertainty.
"We are already seeing worrying signs from the US and localised outbreaks in the UK. Medical data, such as the government's ability to suppress the R number, treatments, and the newsflow around potential vaccines, will be critical in directing forecasts."
Analysing currency markets
After the Brexit-induced turbulence in currency markets last year, Covid-19 arrived just as a sense of normality had returned, according to Kiran Russell, a director of Corporate FX Sales at Investec. "The rule book had to be torn up again," he said.
What surprised markets was the sheer speed of the impact, he explained. As the UK government was criticised for delaying its response, currency markets descended into chaos.
"One-month implied volatility in the sterling-dollar options market went up from 5.5% in mid-February to 26% a month later. Sterling plummeted against the dollar before Boris Johnson had a chance to announce the lockdown."
The crisis saw us enter a new world, where risk-on, risk-off investor sentiment drives currency markets, according to Russell.
"While some analysts have said sterling has behaved like an emerging-market currency, this price behaviour is more a function of distressed markets. In this environment, as markets correlate, investors move out of riskier assets and into safe havens, such as the Japanese yen, Swiss franc and US dollar."
We will continue to exist in a risk-on, risk-off environment, as the coronavirus continues to dominate the newsflow. However, the macro picture won't take a back seat forever; further ahead, it's important to keep an eye on the US election and the US-China trade war too.
What's next for foreign-exchange?
Russell said when currency volatility spikes and foreign-exchange markets correlate, it changes the hedging landscape for corporates.
"Firms that adopt portfolio hedging strategies find certain hedging solutions look more attractive in a high-volatile environment than a low-volatile environment, and vice versa."
The easing of the UK lockdown has reduced implied volatility and put the pound on a firmer footing. But uncertainty remains. Russell said two key events in July are critical to sterling's fortunes.
"The approach of the government in containing any second wave of the virus is the first. Secondly, its ability to secure a free trade agreement with the EU, which many traders believe is underpriced, could provide a boost to sterling.
"More broadly, we will continue to exist in a risk-on, risk-off environment, as the coronavirus continues to dominate the newsflow. However, the macro picture won't take a back seat forever; further ahead, it's important to keep an eye on the US election and the US-China trade war too."
How will retail recover?
Another sector in the spotlight amid the twin challenges of Brexit and Covid-19 is the consumer industry. Kate Calvert, Head of Retail in Investec's Equity Research business, said 2020 would be remembered as "the lost year for retail". However, she explained that a challenging environment is nothing new for the sector, which has already had to evolve with the structural shift online.
She explained that online sales during lockdown have not been enough to mitigate lost sales instore, resulting in a collapse in profits. Short-term winners have been e-commerce retailers, such as Amazon and Argos. Sectors such as DIY, electrical, fitness and children-related retailers have also done well.
Big-ticket items, such as cars and furniture, have felt the pain. Landlords of retail premises have also suffered, with just 20 percent of rents due at the 24 June quarterly rent day expected to be collected.
From a corporate perspective, the mantra has been to batten down the hatches, cut costs and capital expenditure and focus cash preservation. Retailers are also accessing banking facilities and tapping equity markets.
The next hurdle for retail is the re-opening of stores. Most non-food retailers are expecting sales to be down between 40 percent and 60 percent initially.
"If it weren't for government support, many good businesses would have gone under. Already we have seen household names, such as Laura Ashley, go into administration – but many of these companies were struggling with high leverage and weak competitive positions.
"The next hurdle for retail is the re-opening of stores. Most non-food retailers are expecting sales to be down between 40 percent and 60 percent initially. Online demand is falling back, as more sales return to the physical channel, but penetration levels are unlikely to return to pre-Covid-19 levels.
"The macro picture is challenging and the removal of job support will be critical. That said, companies should never let a good crisis go to waste. Retail is continually evolving, and there will be opportunities in the months ahead."
Covid-19 shakes up supply chains
A sector tied to the fortunes of the retail industry and the broader economy is logistics and supply chains, and Covid-19 has had an enormous impact on the transportation of goods, said Paul Rablen, a director in Investec's Growth and Leveraged Finance business.
"Logistical trends, such as e-commerce growth and just-in-time management, have been accelerated and impacted respectively, putting more pressure on constituents within supply chains. Initially, we saw a supply-side shock when trade from China dried up, but now, as we see global demand impacted, warehouses are filling up, while deliveries are reduced comparatively."
Rablen sees volumes returning, but the crisis has revealed inherent inflexibility in the supply chain.
"While some operators have richly benefitted from being plugged into the Amazon or e-commerce network, some niche operators have been effectively locked out as their customers closed temporarily.
"We have, however, begun to see a lot of lateral thought, the use of subcontractors and collaboration between players, with asset-light networks the clear winners, in the vein of the Uber model. That is encouraging and we hope this will be a positive legacy within supply chains post-crisis."