Brexit Is Here

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On Wednesday March 29th UK Prime Minister Theresa May will send a letter to Donald Tusk the President of the European Council signalling the triggering of Article 50 and starting the two year process for the UK to leave the European Union.

This heralds another period of uncertainty for both the UK and the EU. The perceived wisdom has been that this will mean a move lower for sterling similar in speed but not magnitude to the move that we saw last June. However, although there will be some selling of sterling in expectations of a difficult time to come for the UK economy, an immediate large move lower may well not occur. Why could this be?

The vote last June was a real surprise for the markets and this made the move lower in sterling quick and aggressive. This time the market knows that the Brexit process will start on March 29^th and in anticipation of this has already sold a record amount of sterling. The (Bloomberg) chart below shows the IMM (International Monetary Market) futures positions this week. It shows the market has sold £6.7 billion of sterling futures in anticipation of Wednesday March 29th. In true “sell the rumour, buy the fact” market behaviour there will be much less reason for speculators to hold these positions and they will probably look to buy them back.

Surely the UK economy must be suffering with all of the Brexit uncertainty? Before the Brexit vote last June the UK economy did slow down to register an annual +1.6% GDP growth rate but after the vote the economy picked up steam and accelerated to 2%. At the end of last year the UK economy had the highest GDP growth rate in the G7 group of countries. The UK consumer makes up 62% of UK GDP and certainly retail sales data has been volatile falling 1.9% in January but bouncing back nicely +1.4% in March. What is clear is that the UK economy has not abruptly stopped after the Brexit vote.

What about foreign direct investment? The UK has a large current account deficit, currently £25.5 billion quarter on quarter and needs overseas investors to fund this deficit. According to research provider Trading Economics, foreign direct investment was £25.2 billion in the third quarter of 2016. This was lower than the two previous quarters, which averaged £37.4 billion, but not a catastrophe.

How about the UK economy’s future after March 29^th? It seems like small and medium size (SME) businesses are continuing to try and build their businesses. The latest Agent report from the Bank of England showed that SME investment intentions had picked up in February and were expected to grow spending moderately. However, the report showed different expectations for the consumer as inflation is now 2.3% and climbing whilst average earnings are 2.2%. This could easily put the brakes on consumer spending but as explained above this is anything but a certainty.

Putting all of this together the logical market reaction to next Wednesday could well be an initial dip lower for sterling before it rallies higher. The European Union has publicly said that it will respond to the triggering of Article 50 within 48 hours and will hold a Brexit summit on April 29^th. At this summit they could easily decide to start negotiations with the UK in June 2017 which leaves only 22 of the 24 negotiating months remaining. If the EU wants to punish the UK the easiest way to do this would be to delay negotiations, leaving the UK with the option of either agreeing a hurried and improperly prepared trade deal or walking away and trading under WTO rules. This series of events could easily slow down the UK economy. Sir Stephen Wall a former UK Ambassador to the EU recently commented that “The first twelve months of the negotiations will probably be mostly posturing, with the second twelve months being all about panicking to get the deal done.”

If this view does become reality it is in the medium term that the UK economy could stumble and we could then easily see sterling fall to at least test and then probably exceed last year’s lows