It has been almost four months since the EU Referendum and financial markets now largely recognise that we have entered a period of prolonged uncertainty in the economic and policy environment.
While the IMF’s prediction of an immediate post-referendum recession in the UK has not materialised, the consequences are beginning to be felt as markets digest the prospect of this prolonged period of uncertainty, with sharp decreases in Sterling and rising gilt yields over the past week.
For many firms, there is now a huge uncertainty premium, with a significant number of investment decisions being postponed. Notably, both US and Japanese investors are expressing caution around investment decisions. These may not show up in current economic indicators but they will have a very real impact on the economy. Added to this we face the prospect of a ‘hard Brexit’ and the loss of single market membership – a fundamental concern for UK business. This further drives increasing levels of fear and volatility on the markets, exemplified the ‘flash crash’ in Sterling two weeks ago.
On the positive side, and contrary to some predictions about a political vacuum opening up after the referendum vote, a new stable UK government has now been established. Theresa May has quickly established herself as an authoritative Prime Minister and leader of the Conservative Party. The extent of her authority should be noted – she has no current obvious political opponents within her own Party or within Parliament who can effectively challenge her premiership or policy agenda, though we watch with interest the cohesion or otherwise of her Cabinet (tensions are already emerging between the Chancellor and ‘Brexiteers’ in the Cabinet).
May’s speech at Conservative Party Conference two weeks ago displayed a new and clear sense of direction for the UK Government, one which recognises the disengagement and sense of inequality that is widely thought to have underpinned the Brexit vote. While there were few specific policy proposals, she gave a clear indication of her priorities for Brexit negotiations as well on macro-economic policy. Many commentators have suggested that this represents a seismic shift in UK policy making. It is now, therefore, pertinent to ask – what does this fundamental change mean for banking and risk?
Macro-economic, fiscal and monetary policy
At a macro-policy level, May has signalled that the Government is prepared to take a more interventionist approach in the economy, noting that ‘where markets are dysfunctional, we should be prepared to intervene’. May has attacked certain aspects of corporate behaviour, such as companies exploiting the failures of the market and where consumer choice is inhibited by ‘complex pricing structures’. This rhetoric has led some to believe that Mrs May is adopting an aggressive anti-business stance as well as rejecting many aspects of economic liberalism.
It is unclear at this stage how this approach will manifest itself in specific policies and regulatory interventions, but those hoping for a lighter and simpler regulatory framework are likely to be disappointed. What does seem clear is that the PM is not being swayed by the business lobby, let alone The City, at this juncture.
Along with indications given by the Chancellor, Philip Hammond, there are clear signals from May that there will be a loosening of Government fiscal policy. The previous commitment, given by George Osborne, to achieve a surplus by 2020 has been abandoned in favour of increased public borrowing and increased spending, with pledges for the state to play a greater role in building infrastructure, raising productivity and rebalancing the economy. The extent of this change is likely to become clearer after next month’s Autumn Statement, where the Chancellor will provide more detailed plans on public borrowing and spending. If there is a significant change in fiscal policy, then it may represent the first time that it will have been used as an active tool for driving economic growth in a long time, after years of austerity.
One of the more intriguing announcements from the new Prime Minister was her pledge to change current monetary policy. May argued that super‑low interest rates and quantitative easing has caused negative side-effects to the economy and has allowed those with assets to get richer, while those without them to suffer. It is unclear at this stage how the Government can effectively deliver this change without removing or undermining the independence of the Bank of England. In any case, it is arguable that a change to monetary policy is overdue. As a vehicle for stimulating the economy, monetary policy may have run its course – we see evidence for this in many jurisdictions around the world. Low interest rates and quantitative easing have boosted asset values and share prices, but May is being advised that such policies will have little incremental impact moving forward.
With the massive dose of QE, BoE/Treasury acquisition of toxic assets and a potential to shift to negative rates, monetary policy is at a dead end. The economy is stuck in a liquidity trap – banks are sitting on their reserves with little appetite to expand lending to SMEs and large corporations do not have confidence to invest in real capital formation – some estimates say there is as much as US$10 trillion on corporate balance sheets globally.
Ultimately there is little confidence in the economy and consequently banks are reluctant to lend to one another, leading to a rapid decline in liquidity and market making. Any gains in the stock market are very different to the pre-crisis gains in nature. Brexit has enabled multinationals to repatriate foreign denominated revenues at a massive premium given the shift in exchange rates. Share buy backs are also up equity prices. Key indicators of economic health such as the FTSE 100 are therefore not offering a true reflection of underlying growth. For the UK economy to really boom, there needs to be real capital formation.
In one of her first formal statements as Prime Minister, Theresa May stated that she will not provide a ‘running commentary’ on Brexit negotiations. Over the past few weeks, however, there have been clear signals given about her approach to how the UK would leave the European Union and negotiate its future relationship with the trading bloc.
Firstly, May has now set a deadline of March 2017 for the UK to invoke Article 50 – the mechanism for withdrawal and the starting point of formal negotiations with EU institutions and its member states. Secondly, she gave an indication that she would prioritise controls on immigration over single market membership. There are few details on how new UK immigration controls would work in practice, although the Chancellor appeared to suggest a focus on limiting the numbers of low skilled migrants, rather than placing controls on ‘highly skilled and highly paid bankers, brain surgeons and software engineers.’ Nevertheless, any restrictions to immigration and labour will likely represent a challenge for business and impact the economy.
Perhaps more importantly, by stating that UK control of its own borders is effectively a ‘red line’ in negotiations, the Prime Minister will be seen by EU counterparts as opting out of one of the ‘four freedoms’ which are required for single market membership. With this in mind, the future status of trade with the continent is now largely dependent on what the EU and its remaining member states are prepared to offer by way of concession to these freedoms. This posturing has led many to believe that the UK now faces ‘hard Brexit’ and will leave the EU on less favourable trading terms than those in place today. It is possible that the UK will exit without bilateral agreements and therefore be reliant on WTO rules.
For the financial services sector, there are some who are becoming increasingly pessimistic about the City of London’s ability to retain passporting rights and list or trade euro denominated instruments. At this stage, however, it does not appear that the UK Government has a settled view on the UK’s future trading relationship with the EU. This is reflected in the recent reported disagreements at Cabinet-level between the Chancellor and the more hard-line ‘Brexiteers’ on a variety of issues, including the role of the financial services industry, UK contributions to the EU budget and participation in the EU customs union.
In reality, there are likely to be compromises made during negotiations. These could include a transition deal in place before a permanent deal is struck, or agreements made for single market trading in individual sectors and industries. There are, however, no guarantees of a favourable outcome and the transition period will present very real risks for UK business and financial services in particular. Indeed, the Chancellor himself has stated that the UK can expect ‘a couple of years, or perhaps even longer’ of turbulence and uncertainty and that business confidence will be on ‘a roller-coaster’.
From a banking perspective, this prolonged period of uncertainty and volatility may become the defining feature of Theresa May’s premiership. The future role of London as a Global Financial Centre is most definitely at risk.