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Skerritts View - April 2017
Now BREXIT Really Begins:
Finally Theresa May triggered Article 50 with the presentation of the required letter to Donald Tusk, President of the European Council, who looked suitably sad. This started the two year deadline to when, as things stand, the UK formally leaves the EU. If there’s one thing the media likes, it’s a deadline. Cue clocks appearing on BBC Newsnight, SKY News, or The Daily Telegraph Website, for example, counting down the requisite number of days, hours and minutes.
The initial market response to the news was a weakening in the pound, a modest rise in gilts and little change in equity markets. Sterling should remain the most sensitive UK asset price to the Brexit negotiations and, as we all know, has already depreciated considerably against both the Euro and the US Dollar. Some see this devaluation as providing a positive stimulus to the UK economy with a weaker sterling exchange rate increasing inbound merger and acquisition activity as global companies look to pick up their UK counterparts at a cheaper price.
However this devaluation tailwind may begin to recede next year, putting the brakes on the UK economy. Slower growth in continental Europe and the rest of the world could also exacerbate matters. The severity of the slowdown will hinge on the outcome of Brexit negotiations. On the one hand, the EU has an interest in taking a tough stance to discourage discontent in other member states, particularly in Italy where pro-euro sentiment is tumbling, though in other states such as Austria and Holland, recent elections have shown that this risk may be overstated. On the other hand, the EU still needs the UK as both a trade partner and a geopolitical ally.
There will now be a 27 member EU Brexit summit, likely to take place after the two-round French Presidential Election in April/May. At this Brexit summit, the EU27 will establish its strategy, high-level guidelines and red lines for the Brexit negotiations. The European Council will present these negotiating guidelines to the European Commission. Drawing upon its own legal and policy expertise, the Commission will then draft a mandate which sets out more technical details of each area of negotiation. Next, the Council of the EU2 must approve this draft mandate by qualified majority vote (obviously excluding the UK). Once approved, the European Commission can begin the detailed negotiations with the UK, keeping within the final mandate’s guidelines.
This will be a long winded bureaucratic process and in the near term, investors may therefore be surprised by the relatively muted negotiations that transpire over the coming months. What about over the slightly longer term however?
Well one dominant theme in markets is the expected difference in central bank policy interest rates two years hence. A while ago the Bank of England (BoE) was vying with the US Federal Reserve (Fed) to be the first to hike interest rates in this cycle, while the European Central Bank (ECB) was likely to ease further. But after the Brexit vote and the resulting uncertainty about the UK’s position in the world, the tables have turned. The EU27’s high-level negotiating guidelines and red lines are likely to create more vulnerabilities and uncertainties for the UK than for the euro area.
These vulnerabilities and uncertainties have now been unhelpfully amplified by Scotland First Minister, Nicola Sturgeon, calling for a second referendum on Scottish Independence. For central bank policy, this means that the BoE will have little wiggle room, whereas, if growth continues to pick up in Europe, the ECB can continue to back away from its very loose interest rate policy.
Reality Hits the Trump Trade:
President Trump, a title that still sound strange, came up against political reality recently when US Congress decided not to repeal and replace the Affordable Care Act (known as “Obamacare”).
This failure reminded investors that President Trump will not be sailing smoothly through the murky waters of congressional politics, and has cast doubt in the eyes of many observers about the ability of Congress to pass other parts of Trump’s agenda.
As a consequence, the “Trump Trade” i.e. the markets response to President Trump’s promises of infrastructure spending, and tax cuts, which suggests higher domestic inflation and increased government borrowing, whilst implying better profits for some US corporations, has gone into reverse over the past few weeks, pushing down the dollar and Treasury yields in the process. Markets are again fretting about risks such as gridlock and obstructionism, protectionism, trade wars, and competing nationalisms.
However, the failure to pass an Obamacare replacement may turn out to be a blessing in disguise for the Republicans. According to BCA Research, 24 million people were forecast to lose medical insurance under the new proposals and opinion polls suggest that this would have been a massive own goal for the Republican Party had this gone ahead.
So where does this leave the Trump trade? Well it depends on the direction of travel for the Republican Party. Will they allow the budget deficit to grow, or focus on austerity? Getting the answer to this question right will go a long way in determining whether the impact on nominal GDP growth, inflation expectations, and Fed’s intentions on interest rates, is bullish for the S&P 500 and the US dollar. Throw some infrastructure spending into the mix, and it will not take much for the “Trump Trade” to return with a vengeance.
Moreover, it’s possible that the market’s performance since the US election is based on more than just a bet on Trump and his policies, and BCA Research postulate that US consumer confidence is at its highest level for 16 years. Markets may therefore be responding to this and genuine improvements in the global economic outlook as well.
It’s all gone quiet in Greece, or has it?
Doubts are beginning to surface again about Greece’s ability to meet debt repayments due in July. The terms attached to the emergency loans that have kept the country afloat since 2010 are onerous, yet without meeting them, Greece may not be given the necessary funds to meet the payments due in July. The International Monetary Fund (IMF) backed by Greece’s euro-area creditors, is pushing Athens to save 1.8 billion euros, or 1 percent of gross domestic product, from pension cuts. According to Bloomberg, Greece spends more than 13.3 percent of its GDP on old-age pensions, the highest proportion in the European Union.
Europe has become impatient with Greece as the region prepares for Brexit and the threat from emerging populist movements. The failure to reach an accord stems in part from the conflicting political interests of the two sides. From a Greek perspective, Prime Minister Tsipras doesn’t want to face a scheduled general election in 2019 at the same time as pensioners take a cut of as much as 30 percent in their monthly payments (source Bloomberg). Euro area creditors on the other hand, worry that if the plan is put in place after 2019, a new government that’s not a signatory of the accord might not implement it.
Sources: Bloomberg and BCA Research, March and April 2017