PMI measures in Britain were sharply down in July in the immediate aftermath of the Brexit vote as if a harbinger spoke of darker days on the immediate horizon. Yet, the months of August and September appeared to shake off much of the immediate shock value of the vote much like a prizefighter shaking off a well-landed blow to the head as economic fundamentals and local markets appeared to stabilize. It was a point articulated at great length by the May government at the Tory Autumn Conference in Birmingham in the opening days of October.
The multinational-heavy FTSE-100 index is up almost 11% since the vote to an all-time high of 7013.55 through yesterday's market close (14 October) with the earnings of some of Britain's biggest multinational companies being the driving force behind the market surge. Two divergent trends are at play here: Companies with broad foreign reaches captured strong tailwinds on the pound's decline as the laws of comparative advantage produced a Godsend that has bolstered the bottom lines and stock prices of Britain's largest international conglomerates.
The second play at work is companies that otherwise tie directly into the domestic market with little foreign revenue exposure-insurers, regional banks, homebuilders, retail outlets. Few of these companies have fared well in the wake of the vote. The headwinds of rising prices on imported raw materials priced in dollars have hit manufacturers quickly and hard, while imported goods priced outside the UK have increased sharply and in proportion to the fall of the pound on world currency markets. Import prices rose 9.3% in August year over year. Consumer spending has pulled back as a result. Meanwhile, the domestically-oriented FTSE-250 is down almost 13% in dollar terms but has risen 4% in pound terms since the referendum vote. (see Figure 1, above)
Unsurprisingly, industrial production in Britain fell 0.4% in August month-over-month after eking out a 0.1% gain in August. Production indices for total industry both calendar and seasonally adjusted in the UK are now back to 2010 levels through the end of August. Capital investment appears on hold as corporate decision makers await clearer signals on government policy toward forging a new trade relationship with the behemoth market across the Channel responsible for 44% of total UK exports in 2015. Consumer spending has pulled back as price inflation that was once pegged at an annualized rate of 0.6% only in August is now expected to reach a gut-wrenching annual pace of 2% in the early months of next year according to the latest BOE projections.
The dynamic that has changed is the extent that markets continue to pummel British asset values. In the short period of time since PM May's outlining speech during the Tory autumn conference, the pound has dropped from $1.2976 on the 30th of September to $1.2155 through today's market close (14 October) - a drop of 6.33%. The 10-year gilt posted a yield of 0.651% on the 30th of September is now posting a yield of 1.065% - an increase of 63.59% over the same period. Why?
The most direct answer to this question ties to the triggering of Article 50 by March of next year, duly announced by PM May in her opening speech at the Tory Annual Conference in Birmingham. The announcement turned the probability of a full Brexit from a process that would take years - if it took place at all - into an overnight real-world countdown that has proved disconcerting to investors and business alike to say the least. While Mrs. May's seeming willingness to sacrifice the broadest access possible to the single market in order to unleash some romantic notion of British entrepreneurial animal spirits free of EU rules and oversight was well received by Brexit sympathizers within the party ranks, the real meaning of the speech lurked well beneath the surface.
As with many countries of the developed world, the financial crisis hit the British economy hard. Similarly, the resulting recovery has been tortuously slow, widening the economic chasm between the haves and the have-nots across the British economy. Addressing this divide became the muddied rallying cry of the Brexit campaign. The demonization of immigrants, of experts and by inference the EU as somehow thwarting the unleashing of British economic knowhow of yesteryear served the political purposes of the moment was captured by the call to take back control - of the borders, of the country's sovereignty, of addressing the long seething economic divide between Londoners and the rest of the country that the financial crisis bequeathed. Wrapped in this argument is a fundamental shift in British politics - the Labor Party under Jeremy Corbyn has decidedly staked out a socialist response to the growing quagmire leaving in the lurch a wide swath of political turf for Mrs. May to gather, encapsulated by her outward claim to be the protector of worker rights at the national level.
The task of meshing such disparate notions of preserving free trade with the insistence on controlling the borders and reasserting British sovereignty appears curiously unworkable, a position that clearly has investors worried. Lacking detail, investors' response has come in the form of rising borrowing costs and falling market values of British assets as government policy appears to be lurching in a decidedly inward, protectionist direction. On a trade-weighted basis, the new level for the pound exceeds that attained during the financial crisis. It exceeds Britain's falling out of the European Rate Mechanism in 1992. The pound is being priced by the market for a hard Brexit.
Beyond the question of Brexit and the low investor confidence levels in future growth of the economy, other factors are at work applying downward pressure on the pound. Britain's current account deficit stands at 5.9% of GDP. This means the British economy remains dependent on foreigners to buy its assets to make up the trade difference. This dependence on the goodwill of foreigners becomes problematic as the country's assets weaken in value. The impact is twofold: The pound weakens further and debt service becomes proportionately more expensive as the dichotomy of government policy squeezes the economy further. Meanwhile, British borrowing costs as we have seen are on the rise. With the precipitous decline in the pound since the Brexit vote that now just over 18% through Friday's (14 October) market close coupled with increased prices on imported goods and services, the BOE is unlikely to cut its main lending rate any further.
The devaluing pound acted - and continues to act - as an important shock absorber as the British economy adjusts to the new reality after the vote. So too did the quick reaction by the BOE in easing monetary policy in the immediate wake of the referendum vote. Two more absorbing factors were also at play - the expedited appointment of Theresa May as prime minister in early July and the decision not to seek a personal mandate by staging early national elections did much to curb the heightened level political uncertainty that hung like a shroud over both the country and the economy.
Having your own currency and control over your monetary policy are the two elements that set Britain far apart from the likes of Greece, Ireland, Portugal and Spain at the peak of the financial crisis. In Britain, the pound bore the weight of capital flows out of the country as investors sought out safe harbor investment vehicles, with a goodly portion flowing into dollar-based assets. British stock and bond markets were mixed as companies with foreign exposure enjoyed outsized gains in market share, while domestically-oriented companies experienced sharp declines in demand from consumers, while the cost of raw materials priced in foreign currencies soared. The BOE cut its main lending rate in August, which kept the pricing of financial assets from spiraling out of control - at least thus far. The four program countries in the euro-zone had no such national control over currency or interest matters, which precipitated the crash of both its equity and bond markets while interest rates - not to mention unemployment rates - soared. Banks were left dangerously short of liquidity and capital flight ran rampant. All four countries required international bailouts to right their troubled economies.
That said, Britain continues to face down one of the biggest economic challenges in generations. The two-minute "flash crash" of 7 October sent the pound tumbling from $1.26 against the dollar to about $1.18 in early morning trading in Asia remains a constant market threat. While likely caused by a computer glitch, markets are clearly on edge in regard to the pound and British assets in general that future such moves cannot be ruled out. Carlos Ghosn, the head of Renault-Nissan auto group, has publicly stated that future investment in the giant Sunderland plant is on hold until the terms of the UK-EU relationship solidifies. The Sunderland plant employs about 7,000 and supports an estimated 20,000 in the supply chain. The plant makes about 500,000 cars a year which is nearly a third of the UK total auto output. An estimated two-thirds of that production is sold into the EU. While the May government appears willing to ride roughshod over some highly paid and likely foreign investment bankers long encamped in London's financial district, losing Sunderland - given the government's most recent political tilt - is another matter.
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