Brexit Grinds on, but the UK Economy Grinds Higher

Whilst many people see the summer as the “doldrums”—an idle period featuring beaches, heat waves, umbrella drinks and air conditioning—this summer is off to quite a newsy start. Last week was no exception, and we aren’t just talking about the Three Lions’ heartbreak against Croatia or Serena Williams’ astounding run at the All England Lawn Tennis and Croquet Club. Here is our attempt to round up some biggies—the cabinet resignations, Brexit back-and-forth and some cheery economic data.

Checking in on Chequers

After 6 July’s all-hands cabinet meeting at Chequers yielded an agreement on an alleged “soft Brexit,” the following week brought lots more political news. Foreign Minister Boris Johnson and Brexit Minister David Davis (along with a handful of junior ministers) can now add the word “former” to their titles, as both resigned in protest. The now-former ministers favoured a sharper break with the EU, with Johnson colourfully calling the plan, “a polished turd.” We think this highlights the continued and persistent divide among May’s Conservative Party on the issue, which likely adds to Britain’s extremely gridlocked government.

It also leads many political observers to speculate a leadership challenge is in store for May. It would take only 48 of the Conservative’s 317 MPs to call a confidence vote—a total hard-Brexit Tories likely could achieve. Many think Johnson has ambitions to take May’s place. Whilst that is certainly possible, there are reasons to be sceptical, in our opinion. Consider: May’s minority government depends on support from Northern Ireland’s Democratic Unionist Party (DUP) in order to retain power. They favour May’s plan due to their shared border with EU-member Ireland. A harder Brexit could mean a physical border, putting the Good Friday Agreement that brought peace to Northern Ireland at risk. Therefore, we think the likelihood they support a Conservative government targeting a hard Brexit is low. So ironically, the Conservatives’ poor showing in the snap election May called in 2017 could actually preserve her government.

Brexit White Paper Roils the Papers

Following the resignations, after patching her cabinet and receiving a standing ovation at a meeting with Tory backbench MPs, May pressed forward with the Brexit plan agreed at Chequers, releasing a 104-page government white paper outlining the proposal’s details. In matters relating to the economy, it proposed establishing a new “free trade area for goods” between the UK and EU, in which trade in goods would be tariff-free and not require customs or regulatory checks. To achieve this, May volunteered to accept EU regulatory standards for food, chemicals, aviation safety and medicines—and make financial contributions to the ongoing operations of the relevant regulatory agencies. She also pressed for free trade in services, including digital services and finance, that would enable UK financial services firms to continue serving EU clients whilst remaining physically based in Britain.

Politicians’ reactions were mixed. The EU’s Brexit negotiator, Michel Barnier, tweeted that the EU would offer an “ambitious” free-trade agreement and that he looked forward to continued negotiations, though unnamed EU officials told The Guardian May’s proposal may cross the EU’s red lines on customs arrangements. Meanwhile, high-profile UK politicians favouring a “hard Brexit,” in which the UK regains full sovereignty over regulatory matters, decried the plan for accepting a “common rulebook” with the EU. Most coverage we saw of The City’s reaction was rather dour, too, as the paper bases financial services’ firms access to the EU on “regulatory equivalence”—which they claim subjects them to rules set from afar. Catherine McGuiness, policy chairman for the City of London Corporation, further noted the EU can unilaterally revoke equivalency, a scenario potentially discouraging cross-channel investment. But in our view, whether that proves accurate likely hinges on how a trade agreement ultimately looks, which is unknowable today.

Despite the heightened rhetoric, in our view, little shifted meaningfully in the Brexit saga this week. May’s cabinet has been divided between the “hard” and “soft” Brexit camps since she became PM. UK and EU negotiators have wrangled over regulations and customs arrangements since talks began. The UK has sought an agreement that would preserve free trade with the EU whilst enabling it to sign bespoke trade deals with non-EU nations of its own choosing. And it has long been uncertain whether everyone involved would get everything they wanted. But we have also long suspected the end result would be some sort of compromise—and compromises have a way of pleasing no one, as it is generally human nature to bemoan any concessions one must make to reach an agreement. The white paper strikes us as just that sort of compromise.

We think this saga highlights why the actual Brexit, when it takes effect, needn’t automatically be a material market driver. It gave investors and business owners more information on potential Brexit outcomes—a sort of sneak peek that they can loosely start planning for more than two years before the post-Brexit transition period expires on 31 December 2020. We think this reduces the likelihood of a sudden shock when the calendar page turns to 1 January 2021. As the very public back-and-forth between Westminster and Brussels continues, uncertainty should gradually fall, enabling markets to “get on with it,” proverbially, well before Brexit becomes official.

Meanwhile, in the Realm of Economic Data

As the Brexit saga churned, the Office for National Statistics released new economic data showing growth has sped in recent months, providing some evidence that the lingering uncertainty hasn’t weighed on the economy to the extent many feared earlier this year, when economic growth slowed.

In the first quarter of 2018, Gross Domestic Product (GDP), a government-produced measure of economic output, grew just 0.2% from the fourth quarter of 2017, one of the slowest increases in years. When business surveys covering services and manufacturing didn’t improve significantly in April, some media observers warned the first quarter’s weakness wasn’t due to the “Beast From the East” chilling economic activity—if warmer weather didn’t boost growth, some surmised, deeper problems may be at work. Yet more recent data have seemingly dispelled this notion. After falling in March, retail sales rose 1.8% month-on-month in April and another 1.2% in May.^[i] The Index of Services, which measures output across the UK’s many service-based industries (including finance and hospitality) rose 0.4% month-on-month in April—its fastest rise since December 2016—and 0.3% in May.^[ii]  Perhaps most interestingly, the ONS’s inaugural estimate of monthly GDP, released on 10 July, pegged growth at 0.2% in the three months through May, up from 0% in the three months through April.^[iii]

We think equity markets are forward-looking, meaning most of these economic results’ impact should already be factored into equity market performance. However, we think they do illustrate that broad sentiment toward the UK economy has been too weak. Overall and on average, we think the gap between investors’ expectations and feelings about the economy—or investor sentiment, in other words—and the economy’s actual performance is a big influence on share prices. If economic growth continues surprising investors in a positive way, we think it should be a tailwind for markets, much as we suspect it was throughout Q2 2018, when UK shares outperformed the global equity market.^[iv]