22 June 2017

The Conservative Party’s failure to gain a majority of Parliamentary seats in the June 8 snap election has shifted the landscape on key policy issues.  In particular, Prime Minister Teresa May had asked the British electorate for a mandate to adopt an aggressive stance in upcoming Brexit negotiations, including walking away if she could not achieve a deal to her liking.  As a starting point, the logic of her strategy was flawed.  To be sure, a landslide victory may have helped her domestically, but EU leaders announced regularly that the outcome of the UK election would not deter them from pursuing their interests.

Indeed, what has confused European leaders so far is the failure of the UK to express “what they want”.  And, while European negotiators have suggested they do not intend to seek revenge or punish the UK for leaving the EU, Ms May’s failed strategy calls into question her judgement, and leaves the UK in a weaker negotiating position. Indeed, after months of tough talk, David Davis quickly acquiesced to the EU’s position that substantial progress on the issues of the Irish border, the divorce settlement, and citizens’ rights must precede any discussions of a future trade deal (which may not begin until the Autumn).

Despite efforts to paper over the cracks, at the onset of EU negotiations and even after a referendum and general election, both the Conservative and the Labour parties remain deeply divide internally about their Brexit strategy.  To be sure, reflecting the wish of their electoral base to leave the EU, Labour did adopt a pro-Brexit manifesto position. But, both the party and leader Jeremy Corbyn (albeit reluctantly) had both campaigned to Remain. Likewise, Ms May, pressured by hardliners within her Cabinet, became the poster-girl for “hard” Brexit, despite supporting (albeit quietly) Remain initially.  Unfortunately, even though the Tories have been divided over Europe for decades, they have struggled to find a common position.  As in the United States, where after complaining for 7 years about Obamacare, one would have thought the Republican Party would have a replacement ready to go.

Fortunately, however, the election has succeeded in eliminating the possibility of more extreme versions of Brexit; hopefully, beginning the process of building a national consensus. The poor electoral performance of both the Liberal Democrats and the SNP – including losses by heavyweights Nick Clegg and Alex Salmond – virtually eliminates any possibility of back tracking on the referendum’s Brexit verdict.  On the other extreme, the demise of UKIP appears to reflect the public’s rejection of their extreme views.  Interestingly, UKIP’s lost share of the vote appears to have been split equally by the Tories and Labour, suggesting that UKIP support had come from members of both major parties unhappy with the position taken on the EU (and immigration more specifically).  Now, with the Conservatives and Labour both pledging to leave the EU, UKIP’s appears to be a spent force.  I trust, however, Nigel Farage will grace the air waves again soon, if the government concedes too much during Brexit talks.

The impressive electoral showing by the Conservatives in Scotland has made Prime Minister May dependent on the region’s support. Scotland, of course, voted to Remain, and Ruth Davidson will insist that Scotland play a role in shaping the government’s EU policy, Similarly, the decisive role Northern Ireland’s DUP will play also reduces further the possibility of extreme Brexit outcomes (read on), as NI voted decisively to Remain.

After months of using undefined terms like Hard/Soft Brexit, the nascent consensus emerging is that the UK will leave the EU, the Single Market, and the Customs Union, reflecting the outcome of the referendum.  The UK will negotiate a Free Trade Agreement with the European Union, which will allow for a new immigration regime.  Sounds simple, all is left is to agree (both domestically and more importantly with the EU) the thousands of potentially extremely divisive details.  Don’t book holidays, put on the coffee, and get started — the clock is ticking (653 days)!!

To limit the uncertainty and the downside economic risks during the negotiations, it is imperative a transitional arrangement is agreed without delay.  Negotiating trade deals takes time. Indeed, the recently concluded EU-Canada deal required 8 years of talks.  And, while the EU-UK FTA may be quicker, still 4-5 years is likely.

As tariffs on manufactured goods are already low, the UK focus in the new FTA negotiations should be on services, which account for nearly 50% of UK exports and 80% of UK employment. The UK enjoys a comparative advantage in this area, especially financial services, and non-tariff barriers impede trade significantly.  This is a complex topic, but here’s an illustration. Currently, trade in services with non-EU nations represents roughly 50% of overall transactions with these countries.  With EU nations, on the other hand, services exports represent less than 40% of overall sales with the region.  If service exports to the EU rose to 50% of overall trade with those nations, overall UK exports of goods and services would gain £40bn – adding over 2% to GDP!  EU non-tariff barriers in services are formidable, and other countries will applaud success in liberalising trade in this area. Likewise, if the UK succeeds in persuading Germany to increase spending/imports and reducing its bloated current account surplus, the world will celebrate!

Outside the EU, will the UK remain a party to EU FTAs with third countries? Pro-Brexiters look forward to new FTAs with third parties.  However, while negotiations can start now, deals will be years in the making (and cannot be concluded while still in the Customs Union).  Moreover, it is quite possible, third countries will not even begin negotiations until the UK’s future status in the WTO is clarified.  Currently, as an EU member, the UK uses the EU’s tariff schedule on imports from non-EU countries. Once outside the EU, the UK must outline its own WTO tariff fees on imports, which may be the same or indeed lower than those currently used.  Third parties, however, are likely to want to know the UK’s new schedule prior to engaging in bilateral trade talks.

The election outcome impacted more than Brexit.  The SNP’s poor showing indicates disinterest in another independence referendum, and I believe this question is now resolved for a generation.  Sadly, Nicola Sturgeon’s prominence on the national stage will decline – a great loss as she is a formidable, effective politician.

Labour – and specifically Jeremy Corbyn– outperformed low expectations.  Bear in mind, despite the celebrations, Labour did not improve upon Gordon Brown’s disastrous 2010 result.  Mr Corbyn, however, did resonate with a nation weary of austerity. Real incomes have declined 7% since 2007, and government spending has declined 4% of GDP from its peak.  Reflecting this mood, Chancellor Philip Hammond has curbed previous deficit reduction plans already.  Spending demands will inevitably grow, but as outlays/GDP remain above the pre-crisis levels, the Chancellor has limited flexibility.  In this regard, the tragedy at Grenfell Tower contributes to the disquiet about skewed income inequality (especially in London/RBKC).  And, while a full investigation will take place, concerns have been expressed that local government spending cuts may have played a role. All in all, I suspect deficits/borrowings will rise in coming years.

The Coalition of Chaos: Two Years Max!

Having failed to achieve an outright parliamentary majority, the Conservatives will need to rely on the Norther Irish Democratic Unionist Party.  The UK’s recent history with minority governments does not bode well.  In the 1970s, the Liberal-Labour alliance lasted less than two years.  Likewise, the duration of John Major’s link with the Ulster Unionists after the 1992 election was similar.  Both episodes were followed by crushing electoral defeats of the incumbents.  While the more recent Conservative/LDP coalition lasted five years, the LDP paid a large price for the collaboration – a fact not wasted on the DUP.

I suspect the duration of this government will be similar.  Implementing the divisive agenda outlined in the Queen’s speech will require diplomacy and consensus building, as each individual piece of legislation will be an opportunity to test the weak minority government.  Criticism of Prime Minister May’s performance on the election trail – relying on only a small cadre of now-sacked advisors, accepting poor campaigning advice (e.g. not participating in  debates, speaking in platitudes, focusing on personalities and not issues),  and including poorly designed policies in her manifesto – have called into question her leadership of a fragile government.  Despite her successful career as a government minister, many doubt whether she has the authority or the personal skills needed to ward off challenges from both the opposition parties and even within the Tory clan.

Furthermore, the proposed link with the DUP raises numerous specific issues.  Under the Good Friday Accord, the UK government must maintain an impartial stance towards the devolved NI Assembly.  Many doubt that would be possible – or perceived to be possible by the individual parties in the region — if the Tories are reliant on DUP support.  This is especially important now, as talks to restore the Stormont Assembly are set to begin soon.

Likewise, the DUP appears to be looking for up to £1 billion in additional regional funding for their support.  How would other UK regions react, especially Scotland where Ms May’s government is even more dependent on support from local Conservatives.  In addition, the UK regions receive currently £4bn annually of development funding from the EU, of which about 20% goes to Northern Ireland. DUP leader Arlene Foster will want reassurances that these funds will continue after Brexit.  Wales, who receive twice NI’s share on a per capita basis, will look for similar pledges.

Brexit, of course, raises particularly important issues for Northern Ireland.  First of all, the NI economy is more linked to the EU than the UK overall: nearly 60% of exports are sold to the region compared to 45% by the UK.  Additionally, as 70% of NI exports are destined for the Republic of Ireland, both sides of the island will want continued frictionless trade, especially if the UK leaves the customs union as planned.  To be sure, Norway (non-EU) and Sweden share a land border, but despite their best efforts, long customs delays can occur at the border. Moreover, many of the measures used to deal with this problem (e.g. customs officials of each country can operate within 15km on either side of the border) would not be acceptable in Ireland’s case.

Likewise, with over 30,000 people commuting across the border every day, maintaining the freedom of movement in Ireland will be crucial post-Brexit.  Switzerland and Norway are both Schengen members so this is not a problem.  How will the UK limit EU immigration with a soft Irish border?

Irish farming will create potentially explosive problems for the Tory-DUP link.  Agricultural products now represent about 20% of Northern Irish exports — roughly 3% of GDP – with much of these sales within supply chains with agri-businesses south of the border. After leaving the EU, will these sales be subjected to the EU’s CAP tariffs, which can be as high as 50% for dairy products and 25% for animals? This could wreak havoc in rural communities on both sides of the border. To be sure, this can be addressed in the future UK-EU FTA, but agriculture products are not included in EU trade deals with Norway, Switzerland, or Turkey.

Strategic Implications

Despite the political turmoil, my strategic conclusions are similar to those in my April blog “Navigating the Brexit Swamp” (see brianvmullaney.com).

• The BOE is focused on Brexit-related downside economic risks, not above-target inflation. Despite some division within the MPC, the base rate will remain unchanged this year (euro-sterling indicates markets attach a 70% probability to one hike this year). Over the next two years, however, markets expect less than 2 rate hikes. Unless Brexit negotiations go very badly, even a dovish BOE is likely to tighten a bit more than that.
• Additional fiscal demands, a dovish MPC, and above-target inflation will steepen the yield curve somewhat.
• Sterling is undervalued. Political and policy concerns will impact Euro/£ mostly, which could decline up to 5%.  Eventually, $/£ will head towards 1.40, but could test 1.20 near term (much will depend on $/Euro) at the outset of Brexit talks.
• With the extreme versions of Brexit abandoned, the FTSE will head higher: outperforming the S&P, but underperforming European markets.