Fathom’s UK Economic Sentiment Indicator (ESI) declined for the seventh month in a row in February, sinking to just 0.1%. The fall in confidence among UK firms and households since last summer has been broad-based, with all but two of the thirteen components heading south. Heightened uncertainty about both the timing and the nature of the UK’s departure from the European Union, captured by our ESI, has already had a measurable impact on economic activity, particularly affecting business investment. Indeed, we estimate that it has added some 300 basis points to the required return to investment projects, which makes it just as contractionary as a 300 basis point policy tightening.
Refresh the chart in your browser | Edit chart in Datastream
With UK lawmakers having voted on Friday 29 March to reject, for a third and final time, Theresa May’s deal, what happens next? In principle, the government could decide to revoke Article 50, and choose to stay in the EU indefinitely. That is possible, but unlikely, which means it is hard to see a rebound in confidence, or economic activity any time soon. The two most likely outcomes now appear to be either that the UK asks for a long extension, in order to negotiate perhaps a softer form of Brexit (a request that may or may not be granted), or that the UK leaves without a deal on 12 April.
To our way of thinking, the risk of a ‘no-deal’ departure is higher now than it has ever been, entering for the first time the realms of ‘too close to call’. And yet this is not reflected in currency markets. GBPUSD has proved to be one of the best indicators of investor sentiment towards the negotiations, moving higher when the news flow favours a soft Brexit, and vice versa. Yet the currency has traded in the range $1.30 to $1.33 through most of March, and the pound is stronger at the time of writing than it was at the start of the year.
Refresh the chart in your browser | Edit chart in Datastream
Want more charts and analysis? Access a pre-built library of charts built by Fathom Consulting via Datastream Chartbook in Eikon.
The prospect of ‘no deal’ is not adequately reflected in current pricing, in our view, and neither are the potential consequences. It is almost universally acknowledged, by ‘Leavers’ and ‘Remainers’ alike, that life in the UK would be difficult in the immediate aftermath of a ‘no-deal’ Brexit. There are likely to be shortages of essential items, (much) higher prices, and perhaps a severe economic contraction. In this environment, the UK government would, of course, seek to blame the EU for the failure of negotiations. But recent polls suggest it may fail in that endeavour.
A no-deal Brexit that led to severe economic pain in the short term must raise the chances of a Labour victory in the next General Election, whether that comes in 2022 as scheduled, or whether, through a breakdown in support for Prime Minister May among sitting Conservative or DUP MPs, that comes much earlier, as betting odds suggest that it might. How might we characterise the consequences of a Labour government?
A complete description of the potential macroeconomic and financial market outcomes is beyond the scope of this article. But if Jeremy Corbyn remains as Leader, and if both history and the stated concerns of Shadow Chancellor John McDonnell are anything to go by, a (very) sharp fall in the pound, accompanied by higher inflation and higher interest rates seems likely.
Refresh the chart in your browser | Edit chart in Datastream
As our final chart makes clear, this possibility is not captured by the co-movement of GBPUSD and gilt yields since the referendum. To our way of thinking, a no-deal Brexit would weaken the pound, but by simultaneously raising the likelihood of a Labour government, it would also raise inflation expectations and with that gilt yields. There is a case for arguing that the correlation between the change in the currency and the change in yields ought to be negative in the present circumstances, rather than the most positive it has ever be
The charts in this article have been created using Chartbook on Datastream. The Chartbook was initially created by Fathom Consulting in 2012 and is now a catalogue of approximately 9000 charts, covering over 170 countries, analysing up-to-date macro and financial data. Whether it is a particular topic, country or variable you are interested in charting, the Chartbook has everything you need. To access Chartbook via Datastream search ‘cbook’.
_____________________________________________________________________
Datastream
Financial time series database which allows you to identify and examine trends, generate and test ideas and develop view points on the market.
Refinitiv offers the world’s most comprehensive historical database for numerical macroeconomic and cross-asset financial data which started in the 1950s and has grown into an indispensable resource for financial professionals. Find out more.
