The recent fall in GBPUSD may look like more Brexit-related losses for the pound, but in reality the decline from around 1.32 at the beginning of February to 1.2900 this week has been mostly driven by the US dollar.
Broader measures of sterling have remained flat along with EURGBP since the general election, despite the modest green shoots that are beginning to emerge in the UK data picture. EURGBP, for example, has traded in a 3% range since December, a time period that included the election.
Recent data indicates a considerable improvement in the growth outlook, however, and we believe the right approach is to look through the Q4 growth freeze.
2019 ended badly for the UK economy, as political uncertainty greatly hampered growth.
We continue to expect sterling strength through to the end of the year, driven by a modest pickup in investment growth and the ultimate resolution of Brexit. Incoming data suggest that Q1 will see a marked pickup in growth, removing the chances of a rate cut from the BoE and giving sterling room to rally further.
Our base case for sterling assumes a free trade deal covering goods is agreed between the EU and UK by the end of the year.
This will have an unknown long-term effect on sterling, the nature of which will depend on if the Government can lift trend GDP growth, and productivity growth in particular. Regardless of the long term effects of these new arrangements, simply reaching an agreement will, in our view, be sufficient to support a rally in sterling through to the end of the year.
The UK economy is recovering after a dismal end to 2019
Political uncertainty due to Brexit and the general election took a significant toll on the UK economy at the end of 2019. This manifested as a serious slowdown in high frequency growth data, accompanied by a crash in business sentiment surveys.
January saw a spree of poor data releases due to the lagged nature of hard data.
GDP and labour market data released in January wouldn’t have been representative of the real economy post-election for this reason. Soft survey data, as well as January’s retail sales figures, suggests the economic recovery may have already begun in a robust fashion.
UK data offers a mixed picture, but we think there are reasons for optimism:
- Gross domestic product growth slowed to just above zero in the fourth quarter, down from 0.4% in Q3. Although the dominant services sector remained in expansion, a contraction in industrial output meant that the economy grew at a rounded 0.0% in Q4. Real spending by households rose only 0.1% on the quarter, the smallest increase in four years, despite healthy income growth.
- However, monthly GDP data combined with the latest business surveys suggest the Q4 slowdown was followed by a recovery. GDP rose by 0.3% in December, after contracting sharply in November.
- Survey data suggests that the Q4 decline was due to political uncertainty that has now diminished. Purchasing Managers’ Indices showed a strong bounce in January, while anecdotal reports made it clear that lower political uncertainty was the driver behind the improvement. Other survey data, such as the Bank of England’s Decision Maker Panel survey, also supports the idea that there has been a material reduction in uncertainty in recent months.
- With the labour market still delivering steady real wage gains, consumer spending is likely to remain well supported through to the rest of the year. Combined with an increase in investment, UK GDP growth is likely to improve as a whole over the course of the year.
Chart: UK Composite PMI Output vs UK GDP MoM
MPC not persuaded by “insurance” rate cuts
The January meeting was an important litmus test for the Monetary Policy Committee. It showed the balance of opinion is still averse to “insurance” rate cuts of the sort advocated by Michael Saunders, and enacted elsewhere by central banks such as the RBA and RBNZ.
Speaking on January 15th, Saunders argued that in the current low-rate environment, if easing was likely to be necessary, it should be “relatively prompt and aggressive”.
In this argument, with rates close to the zero lower bound, policymakers face asymmetric risks: cut rates early, and the risk of an inflationary overshoot is minimal, but cut rates too late and the economy may risk falling into a low-inflation morass of the sort seen in the eurozone and Japan.
Arguments similar to this one have featured prominently in global central banking. The Fed’s recent rate cut cycle was broadly viewed as “insurance”, both by observers and policymakers.
Moreover, the mix of bad macro data from Q4 provided further reasons for caution. Faced with poor output data from Q4 on one hand, and the prospect of an improvement in growth in 2020 due to reduced political uncertainty on the other, the MPC chose to hold rates.
This suggests that the MPC’s reaction function remains quite insensitive to short-term data volatility and that the bar for easing in 2020 is therefore set quite high.
With incoming data still supporting the MPC’s hopes for a growth pickup in Q1 and through to the end of 2020, we believe rate cuts from the BoE are unlikely this year, although the coronavirus outbreak represents a wild-card risk to global growth in general that will merit careful monitoring.
Chart: Markets continue to expect BoE easing
Brexit outcomes come into focus
At first glance it may seem that the initial negotiating positions set out by the EU and UK in early February are very far apart. However, given the UK is likely to be willing to settle for a relatively narrow “Canada” style agreement and the asymmetric leverage the two sides bring to the negotiating table, a deal by the end of the year remains the most likely outcome in our view.
The UK’s position is less clear than the EU’s, but the key quote from Boris Johnson’s speech in Greenwich on the 3rd of February called for a “free trade agreement, which opens up markets and avoids the full panoply of EU regulation, like the Canada deal”. Johnson went on:
There is no need for a free trade agreement to involve accepting EU rules on competition policy, subsidies, social protection, the environment, or anything similar any more than the EU should be obliged to accept UK rules… The UK will maintain the highest standards in these areas – better, in many respects, than those of the EU – without the compulsion of a treaty….
Michel Barnier revealed a negotiating mandate that offered the UK a broad free trade deal. The key passage from the negotiating mandate reads:
The envisaged agreement should uphold the common high standards in the areas of state aid, competition, state-owned enterprises, social and employment standards, environmental standards, climate change, and relevant tax matters.
Based off these initial positions, and Boris’s own comments, it seems the range of likely outcomes has collapsed.
The ultimate outcome now looks likely to fall between a “Canada” style agreement covering mostly goods trade and a far less ambitious “Australia” deal where only certain sectors are covered by narrow tariff reduction agreements. Although exactly where in this range talks will ultimately end is unknown, a “no-deal” end to the transition period looks unlikely.
The bar for a Canada style agreement covering most goods trade is lower than it may initially seem when looking at the two parties’ opening positions. When viewed in the context of existing UK alignment with the EU, as well as the relatively narrow scope of a likely deal on goods, a deal starts to look more plausible.
EU standards on taxation, for instance, are not extensive beyond general OECD commitments. The UK is unlikely to deviate from general principles of human rights. Most notably, the EU mandate does not appear to explicitly require “dynamic alignment” with EU standards.
At a bare minimum the UK could commit to maintaining existing rules on state aid, while accepting the EU will have the unilateral ability to impose tariffs if standards are lowered.
Given both sides are broadly in agreement on their desire to achieve tariff free goods trade, this outcome is our base case.
Author: Ranko Berich, Head of Market Analysis at Monex Europe.