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All of a sudden we have a new Prime Minister in Number Ten. Yesterday evening we saw the first rate cut in the US for over 10 years, we have sterling dollar hitting two-year lows. No-deal Brexit probability creeping up to circa 40 per cent in some quarters.
In the background, we still have the ongoing trade wars and weaker growth in Europe. And, in a couple of hours’ time, we have the Bank of England coming forward with the UK quarterly inflation report. I think all of that suggests that actually, it’s a very, very important time for clients. I don’t think we underestimate how serious the current situation is, so I’m delighted to sit here with Victoria Clarke today, from our economics team.
And we’ll just go through a few questions and a bit of the detail to hopefully give everyone a little bit more colour on where we’re at.
Before we get onto Brexit, probably the only place to start is actually yesterday evening. There were a few of us here late on, watching what was going on with the Fed and the rhetoric that came from Powell afterwards. So I think the first place would be, Victoria, with the Fed cut last night, first reduction since December 2008, it would be great to hear from you what has the Fed done and why?
Victoria Clarke: Thanks Jon. Yes, it really is a very interesting time, and everything has come together at a critical point. Last night was important; it was important because it’s the Federal Reserve and often what we see from the Federal Reserve can guide central banks across the globe. And markets were geared up for the possibility that the chair of the Federal Reserve, Jerome Powell, was about to indicate that we might be facing a prospect of perhaps a run of interest rate cuts.
And the Fed, as you say, John, did cut rates by 25 basis points, the first move since 2008. So that was big news in itself, but it didn’t match up to market expectations that the chair of the Fed, perhaps under some duress from President Trump, was about to indicate that we were going to get a long run of rate cuts and that we were perhaps moving into a new phase of the economic cycle.
So, instead, we had a one-quarter point reduction in the Federal Fund’s rates. But that was put out there as a Federal Reserve insurance policy.
The head of the Federal Reserve is looking at what President Trump and others are doing or not doing to resolve trade issues, worrying about the global economic backdrop and the weak euro area, and thinking well, I haven’t got a lot of inflation at the moment so I can get away with a rate cut right now.
But that’s disappointed markets, particularly if you look at equity markets; they’ve been backstopped quite a lot lately by the prospect that there were going to be these interest rate cuts, more than one, two, or even three over the next couple of years.
And so we saw the S&P500 one per cent down yesterday and questions now being asked about, well, given the weak global economic backdrop and perhaps monetary policy not being as soft as interest rate markets had hoped for, where the global economy might be headed. So we are at a very critical juncture and, obviously, for currency markets…
There have been some big moves on Brexit this week but obviously, that strength firming in the dollar has added further questions about which way sterling might now be headed if you’ve got a Federal Reserve not being as supportive with policies as it might have done.
So there’s big stuff from the Federal Reserve and it has raised some soul searching in markets, about whether actually, we can’t rely on the central banks to do all the heavy lifting at this point in time.
JP: And as you alluded to, Victoria, do you think market sentiment seems to suggest that it’s one and done from the Fed? How do we see that? What is the likelihood that this could still be one of two or three cuts in the future?
VC: I was watching Jerome Powell last night, as he walked into the press conference, and he looked stressed. He looked like a guy who had probably just had a serious hairdryer from President Trump. He was looking stressed.
He walked up to the mike, he said his rehearsed statement as quickly as he possibly could and then he looked stressed afterwards as well. So he’s getting it in the neck about the fact that he should…In President Trump’s eyes, he should have cut rates by more and Trump took to Twitter to say that he was disappointed.
The economy is doing okay anyway, but he wanted more. And the Fed so far is really holding the line that if you look at the US economy domestically it doesn’t look bad. The unemployment rate is close to 50-year lows, around 50-year lows.
The economy is going to expand above two per cent, possibly around two and a half per cent this year, so it is very much what lies outside the US. And so, typically, when you’ve got the Federal Reserve looking at these sorts of numbers, they’re not going to be looking at the case for rate cuts at easing policy.
So our feeling for a while, actually, has been that the markets have got a little bit carried away and that there was too much priced into interest rate markets. What we think is probably going to happen is something like we saw in the mid-90s; in 1995 you had a similar situation, where the Fed was looking at insurance-type rate reductions, where, in those sorts of scenarios, and in the late-90s, the Fed had moved in three sets of quarter-point reductions.
So it looks as if there probably will be another move and, as I say, particularly given the amount of pressure he’s facing from the President.
There’s probably going to be another reduction and possibly another one in early 2020 because the Fed’s looking at its policy framework. And, as I say, it hasn’t got a lot of inflation to worry about. But, yes, I am hesitant to say it’s the start of a persistent easing cycle when, to an extent, was kind of surprised by the extent of the shock to sentiment that you saw after the Fed meeting last night.
Because, for me, looking at the data and being a very purist economist and looking at how the economy’s fundamentals were, it just didn’t look as if a whole run of rate cuts were warranted at all. So, yes, it’s insurance cuts, and probably a couple more, but not more than that.
JP: Interesting; so you talk about relatively strong fundamentals, you talk about low inflation, and you talk about obviously global factors being a play for the Fed’s move. We are a couple of hours away from the Bank of England decision, what’s your view on how the Bank of England will react? And do you think it’s possible they could go a similar way to the Fed?
VC: Well, the difference is that the Federal Reserve’s gone a bit further in its what we’d call normalisation of interest rates, basically getting them back towards where it might feel comfortable with them being in the long-term neutral rates. And the Fed was further down that road.
And the Bank of England hasn’t got very far; we’ve got bank rates still at three-quarters of a per cent, because of Brexit. Brexit has left the Bank of England sitting tight, waiting for those uncertainties to pass and they haven’t yet.
So there is, on the one hand, a weaker global backdrop which the Bank of England will clearly take note of, but, equally, because it hasn’t moved policy so much over recent years, it still feels that much more of a pull to try and lift interest rates a bit more.
But it’s got clearly one very big question, which is what path are we going to see the UK economy take through Brexit over the next year or longer? And how is the global backdrop going to evolve? If it gets Brexit uncertainties out of the way, then it will want to continue gradually, and to a limited extent, that’s the buzzword that the BoE likes to use, bring interest rates up.
But it needs those two things to get out of the way, and it needs to make sure that those trade risks aren’t bigger. So the short answer is it’s going to do its own thing and what that thing is will depend on Brexit.
And it’s got a horrible job today, because it’s got to try and present a new set of inflation forecasts which set out what it might do under various different states of the world, depending on Brexit, without diving into a big bubbling saucepan of boiling Brexit political wars, which it clearly wants to stay right out of. So, in short, it’s all about Brexit.
JP: Okay, so let’s go into more detail about that; obviously the main reason for the call, and I’m sure what everyone wants to hear about. What, six weeks ago, sterling-dollar close to 130 and actually market sentiment was pretty positive towards the potential of Boris coming into power.
Yet we sit here today with sterling-dollar at 121, 120, and sterling-euro in the 109s. It would be great to hear from you about your view of what’s happened in the last few weeks.
VC: There was a real period of quiet through the political contest to see who the Tory leader was going to be. Actually, everybody was seeing everything Boris Johnson and Jeremy Hunt, and others were staying on no-deal Brexit as kind of campaign talk. And then obviously we had the result of the leadership race, Boris Johnson was announced as the new Prime Minister.
And, at that point, the penny dropped, because he appointed his cabinet. It was a huge night of sackings, a huge evening of sackings; I can’t remember the last time we’ve seen that many senior cabinet ministers moved aside.
And a very strongly Brexit cabinet brought in with the likes of Dominic Cummings from Leave UK pulled in as one of the key advisors. Stephen Barclay is still the Brexit Adviser, but he was told he couldn’t have as a key advisor someone who wasn’t Brexity enough.
So there has been a concern from the markets who were worried about no-deal Brexit risks that the people Boris is surrounding himself with were more strongly Brexit-focused than had been concerned.
And the other critical element that’s come through is just how hard-line Boris Johnson has been on two things; one, that we will leave on the 31st October come what may and, secondly, that he is not having the backstop. The backstop has to go. And on that last point, Brussels isn’t talking until the UK agrees to be a bit more flexible on the backstop. Boris Johnson’s government’s narrative is Brussels is being stubborn, and there are concerns therefore that they’re heading in the direction of a no-deal and that they’re going to try and make the narrative work so that they can blame Brussels for that.
And therefore nobody is really talking because both sides are saying: "Well, I’m not talking to you until you say you’ll talk a bit more about the backstop; you’ve seen the agreement, that’s what’s on the table." And Boris is saying: "Well, we’ve told you; we’re not keeping the backstop. There’s nothing to talk about until that point."
And markets are concerned, there’s no real-time to move on this. So if he is adamant he’s leaving on the 31st October and he needs a new deal which has no backstop, he hasn’t got much time to do that.
We calculated that by the time the government comes back from recess on the 3rd September, they’ve got 21 parliamentary days, 21 days, to try and get a deal and associated legislation through parliament because you’ve got conference recesses within parliament. Brussels is out for most of the summer so, as I say, the penny has dropped; we are still doing what we can to try and look through the noise, the hype, the negotiating talk, of which much of that focus on the backstop will be.
That’s been one of May’s main criticisms, that she just wasn’t tough enough. By actually saying the backstop has to go, that is a negotiating positing in itself. And while they’re not talking that clearly is Boris’ negotiating. So you have to try and look through all of that; that’s what I’ve been trying to say, you have to try and work out what’s negotiating bluster and what’s not.
And therefore our central position is still that more likely than not there will be a deal. But we are feeling nervous because there isn’t much time and there’s a risk things can go wrong.
And Boris has still got the same old problem Theresa May had, which is parliamentary majorities and people aren’t voting down parliamentary lines anyway. People are voting whether they remain or Brexit or whether they want a harder or a softer type of deal. So if you look at the three votes May had, Boris is a new face, he’ll try and get changes, if he can, on the backstop, and try and get rid of it if possible.
But he’s still got to get something through parliament. And his majority now is down to two, and we’ve got a by-election in Wales, in Brecon and Radnorshire; if that goes the wrong way for the Tories at least, and the Lib Dems take that, the government’s majority is down to one. So he really has nothing to play for.
The other element is this chat, that there’s been lots said about prorogation, so the idea that parliament could be suspended to force a no-deal Brexit through.
Steps have been taken to try and limit the risk of that; there was a Northern Ireland Executive Formation Bill that had something attached to it that means that parliament has to come and debate things in October, to try and reduce the limit. But there’s lots of things being put in place that just have felt to market as if that no-deal prospect has been edged up and edged up materially.
For us, as I say, we’re trying to work out how much is bluster and how much is not and are probably slightly less nervous than market pricing would imply the market is about no-deal. But, nevertheless, certainly not sitting our laurels, reassured that there’s no chance the UK is heading for that whatsoever.
JP: I think that’s interesting; you talk about the hype and the bluster and the noise and I think that, from afar, I think it’s probably quite difficult for ourselves and actually for clients as well, to cut through that, to really understand the true position. It would be good to hear from you, what do you think Boris is really trying to achieve? What’s the result here that you think he’s going for?
VC: Boris is Boris, he’s a politician and the number one goal for him will be to do what he needs to do to try and shore up and settle back the troubles the Tory party is facing. As I said just a second ago, you’ve got a majority of just one at the moment, so he needs to work out what he needs to do to bring the Tory party together.
The polling just a few weeks ago was showing the Brexit Party, the Tories, Labour, and Liberal Democrats all polling neck and neck, which is quite phenomenal, four major parties in the UK, rather than two or even possibly three at points.
But this is the focus for him and to achieve that focus he has to either deliver on Brexit in the way that he has so that he can bring some of his support that’s drifted over to the Brexit Party back to the Tories. Or there is some speculation that he could go for an early general election and try and do that just with some of his fighting talk on Brexit, which might try and get him some numbers to get a Brexit deal through early.
So I think at the top of it all it’s politics, as it always is; underneath that, obviously, he needs to try and achieve something specific on Brexit.
Either a no-deal Brexit but that, in itself, would come with some severe political risks. On our numbers, on the IMF numbers, on the Bank of England numbers, that’s not a nice, if I can put it that way, outcome for the UK economy. So, politically, it’s not going to be great news for him. You think even with some of his advisers, they’re going to be looking, thinking, actually, the risks of going for a no-deal Brexit are too severe. So he wants a deal; I genuinely believe that Boris Johnson does want to find a deal.
But as I set out with regards to your earlier question, there are various limits, things that make it difficult for him to do that, like the lack of time. He’s promised himself, he’s promised everybody that he’ll do that by the end of October. The backstop is difficult; how much will Brussels stick to the line that the deal is the deal and the backstop stays in?
Is there a chance that they could shift away from that position? Boris and his advisors are saying that there’s flexibility on the backstop, we don’t need to sort it out now. Others ideas have been written, none particularly easy solutions, but there are things out there.
So I think, on balance, and it’s a nervous 'on balance', but on balance I think that Boris is working towards getting some sort of deal. And the political noises that we’re seeing, the amount of cash that’s going out of the door for no-deal Brexit preparations is really there to reinforce the credibility of their position with Brussels. Which is we’ll go for no-deal if we have to, try and push us in that direction; if you do, we’ll take the eurozone economy down with us and you won’t get your Brexit cash.
Those two things, the threat of no-deal and the cash that the UK has, potentially, to put on the line for the EU budget, are our two main negotiating chips.
JP: Okay. So I guess that despite all of that, sterling, in particular, is certainly feeling the result of that increased concern and probability of a no-deal, probably to a point where we…I think the common theme is still that sterling probably is undervalued yet it continues to fall. What is your view on what this all means for sterling?
VC: So in terms of our expected case, we have worked for a while on the assumption that there will be a deal, and that remains in the numbers, but a deal, and I’ll come on to this in a second, and no-deal can come in lots of various and different ways. I think on balance the team’s view is that even though Boris is saying I’ll exit on the 31st October come what may, there’s still a decent chance of a small extension.
So our expected case numbers are predicated on those two things; one, that there is a deal of sorts and, two, that that deal is probably pushed into the new year. There’s been lots written, lots said, about how disruptive it would be, even under a managed deal, to exit around the October, run-up to Christmas period.
It’s difficult for businesses if negotiations are still running, up to that 31st October deadline, to plan how to operate, how to manage business stock flows, for example, in the run-up to Christmas. So there’s a case made for that being pushed into the new year.
But those are the kinds of assumptions, really, that underpin our expected case. So, in short, we see sterling struggling through the summer because it’s going to be negotiating fighting talk from the UK administration. There probably isn’t going to be too much happening because, as I said, Brussels is on holiday. Much of parliament is away. You’ll have some of the cabinet around but, in general, there really isn’t going to be much progress. In September, there’s still going to be speculation about whether no-deal is on the table.
Parliament is going to come back, you’ve got the Tory Party conference, so you’ve got a very nervous run-up to the end of October. And then, potentially, Boris Johnson needs to find a face-saver as to why he can push this back, finding himself a little bit of time to agree a deal. But after that, so the pound is still under pressure as those negotiations continue to year-end. And then as you get into Q1, if the deal is reached, the pound moves up. But it doesn’t move up to the extent that we’re back at the pre-referendum levels.
The pound is still under pressure because you’ve then got to probably sort out what your future trading arrangements are going to be in a transition period which has been dramatically shortened. Because, originally, they were going to have the remainder of this year and next year as the transitional phase to get a deal for future arrangements sorted out by the end of 2020. If you don’t push that back and there’s no sign that they’re planning to at this point, then the uncertainty continues.
So in terms of our numbers, we’ve got the pound rising to 123 against the dollar by the end of this year, 129, so that’s if the deal is done, by the end of the first quarter. And then 131 by the end of next year, so it is clearly drifting up. Under a no-deal, it’s a different kettle of fish completely but there are lots of different variants of no-deal. I can’t really stress that enough; there is clearly the very disorderly no deal, the planes don’t fly, the ports are completely blockaded. In that sort of situation, and the Bank of England has done quite a lot of modelling on that, the sterling implications are very severe, there’s no two ways about it.
And then there’s a much more managed no deal which I think, in reality, if this government decides to push us in that direction, it would be in its interests and the UE administration’s interests to come to a much more managed no-deal Brexit which could be with a transition, it could be with a series of mini deals. And then sterling, it’s not going to be supported but that would cap the downside. And we’ve put some suggested numbers around on how sterling performs under these different variants of no-deal and there is huge uncertainty around that.
So that’s clearly important to say. Now, under the no-deal, we’ve got the pound against the dollar at around 108 under a more disorderly scenario, so that’s a big move even after the sell-off that we’ve seen this week, where we’ve seen the pound coming down to about 121. And under a more managed no-deal, you could see a much smaller slide, but that would be a very managed no-deal, perhaps to around 118.
And then the pound against the euro, equivalent lows seen around perhaps one euro seven under a disorderly, 93 pence the other away around. Sorry, in the disorderly, around parity, and in the more managed situation, around 107. So big moves there; as I say, I’m talking about parity under a very disorderly situation.
So a whole range of possibilities, but it’s difficult to see governments on both sides pushing for a very disruptive outcome. You would expect that even if they’ve fallen out and had a really torturous negotiation in the run-up to the 31st October, there would be some significant mitigations in place.
And quite a lot of them have been put there, actually; there have been lots of talks between the Bank of England, between the authorities, to try and work out what could be put in place to try and limit some of that downside.
So it’s not impossible that we end up at the lower of those ranges, and I’m talking about euro-sterling at parity, but I think more likely probably that you’re a bit above that with those mitigations in place.
JP: Thanks, Victoria. I think it would be great to move on to some questions, and just remind everyone that you’re more than welcome to submit those. We’ve already got a couple if I can move on to those to start with. One question here, actually, regarding the second referendum; how likely is that? And, on the back of that, what’s your view of the chances of Brexit being reversed?
VC: So a few months ago we would have said a second referendum was still quite low but increasing in likelihood because it felt like when May still was struggling to make any traction through parliament, that it was potentially the only way to get things resolved.
And I think now, given the shift in the political dynamics, the focus is not so much on a second referendum at this point, but more on a general election. And there was some chat yesterday that Boris might even try and squeeze a general election in before 31 October, which might be the get out of jail clause he would need, to get the extension.
Come what may, except perhaps if there’s a general election and I haven’t had the time to do it. So I would, at this point in time, see a general election as more likely, though clearly, a general election could be a precursor to having a second referendum. Now the polls at the moment have shifted; you’ve got the Boris honeymoon bounce, effectively.
So the polls have shifted to give Boris seven points up, ten points up, off the back of recent developments. And that looks to increase the chances of the Tory Party coming out as the largest party in any general election. If they didn’t, if we shift back to where we were, then let’s say Labour were the largest party, then you’ve got more talk about Labour perhaps coming together with other factions, with the Liberal Democrats, with others, and that might increase the chance of a second referendum.
Labour have been quite opaque on what would push them for a second referendum, but they all agree that they would like to see one on what they’ve called a bad deal.
So I think the chances of a second referendum are still relatively low. As I say, I think a general election is the more relevant question at this point in time. If parliament gets stuck again then maybe, eventually, they throw it back to the people and have a vote.
But it would have to be more specific than oh, let’s re-run the referendum; that would be hugely divisive. It would have to be this is the form of Brexit you’re being offered, do you want to take that, or no-deal, or perhaps a third option of remain. It’s complicated; they’d have to phrase the questioning very carefully. But, yes, I still see it as a fairly low likelihood at this point.
JP: The next question, Victoria, is just in relation to sterling-euro; sterling-dollar in a very disorderly no-deal being down at around that 110 level, that makes some sense. US superpower, it’s independent, the dollar will prosper in that scenario.
It would be interesting to get your thoughts about how the euro would be affected in a messy no-deal scenario. Because surely there will be repercussions for the eurozone and the single currency
VC: Yes, yes. That’s the case, definitely. When we work through what the economic implications are for the different geographies and follow that through to the views on interest rates and foreign exchange, that’s definitely been our thoughts as well. So clearly if you look the US economy is going to be the least affected, the Fed has mentioned it, but the US is a fairly closed economy anyway so it seems that the impact on the States would be relatively limited.
So yes, big sterling moves against the dollar because that’s mainly on the move. Against the euro, you’re right; the eurozone economy is going to be suffering as well, quite clearly, particularly Ireland. Everybody’s seen the numbers that have been put together on the UK, but the hit to the Irish economy, on various estimates, is not too dissimilar.
The rest of the zone, there will be some countries more affected than others; Germany, the car industry there has been singled out as a particularly vulnerable area. So there would be some significant squeeze on the eurozone.
And it is, therefore, our view that the impact that you see sterling versus dollar is much larger than it is against the euro because the euro is being dragged alongside. And in terms of what that means for euro-dollar, yes, you’ve got a slightly weaker euro against the dollar over the period as well, so euro-dollar is also being affected.
JP: Changing tone a little bit, and trying to, certainly for importers or those selling sterling; say that we get a deal, what does it look like for sterling? What could the positives be for the UK economy that will actually prompt sterling to rally and have a very good 12 months ahead?
VC: Well there’s been so much uncertainty in there already, for such a long period now, since the 2016 referendum; you look at any of the breakdowns of UK GDP, business investment has been hit very, very clearly. More anecdotally, all of the surveys that come through for the Bank of England and other institutions are pointing to businesses just being reluctant to add the extra unit of capital.
If you’re a footloose organisation looking to put another operation in place, it’s not going into the UK. And if you’re servicing business contracts in places, people are finding and looking at other supply chains.
So the removal of all of those factors should see a clear bounce-back for the UK economy. Sterling clearly moves up but, at the same point, UK-focused exporters are also having that sort of foot-up from the weaker pound removed as well. So that makes the export picture a little bit more difficult. It’s difficult to say precisely because, as I said earlier, it very much depends on how any future deal is constructed, whether there’s a transition phase.
And I think it’s very likely that whatever gets agreed in the near-term is not an outcome that completely removes all the uncertainty from the picture at one point in time.
So, sure, you get a big relief rally in the pound as soon as there’s news of a deal of some sort but, as I indicated, it’s difficult to see a return to the fair value levels for sterling that we would expect longer time. And the 1.55, 1.56 is still seen pretty far away, even if it prompts Bank of England to move with some interest rate increases. When other central banks are easing I think it’s still going to be a gradual grind higher.
Yes, and initial relief move, but then the reality will set in that it’s a long road ahead and trade deals take a long time to do. And you’ve got the prospect of a 2022 general election coming through also.
JP: Just another question that’s come through here, Victoria, probably just flitting back across the pond; we’ve got the Presidential election coming up in 2020, how do you see that influencing not just sterling-dollar, but I guess financial markets in general?
VC: The Presidential election is big; the big link for us at this present point in time is trying to work out how that shifts the dial on trade relations and how tough Trump is going to play it with China-US trade talks over the next few months. How tough he is going to play things with the EU. And there’s talk about more car tariffs coming through later this year.
So I think for global markets, that’s the big one. At the moment, Trump is benefiting, at least among Republican voters who are, in the most, enjoying his tough trade rhetoric.
I would think, though, and there are more and more signs that it’s finding its way back to the US economy, particularly the US manufacturing sector, that as time goes on President Trump is a bit more cautious in the way that he plays his trade cards. Because at the end of it all, in a US election year, he’s got to have his big focus on getting a strong economy next year. So that will hopefully temper the way that we see Trump playing the trade talks.
It looks also, as we know from discussions over the debt ceiling and the two-year funding plan, to mean more fiscal spending next year as well. So that’s another key support. So in the context where we’re looking at a global economy where there are a number of downside risks circling, actually, the 2020 election is not unhelpful at all in [unclear] the global backdrop.
And we talked about the Federal Reserve at the start of this session, I think that that will be another factor that the Federal Reserve will be thinking about, is look, we’ve potentially got a bit more loosening coming from fiscal policy.
This might persuade Mr Trump to be a little bit more cautious and less combative on the trade front. And so the States might be one of the key developed market economies that’s actually on a relatively decent run next year. So we talked about sterling and its potential performance and that is primarily driven by our view over Brexit, where you get a deal come through and then some creep upwards from there.
But the offset there, and the fact that limits some of the recovery that you see in the pound is the fact that that would, should, lend some support to the US dollar through next year.
JP: Brilliant. Thank you so much, Victoria. I think we’re probably done there, so I just wanted to take the opportunity to thank everyone very much for joining us.
Also, just to highlight that for ongoing updates and insights from our economics team and our trading team, please make sure you visit focus.investec.com. And please also make sure that for any clients, any prospective clients, make sure you’re connecting into your relationship managers, your salespeople so that we can hand hold you through anything that’s going on and give you live updates as we go. But thank you very much again, and have a great day.
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