Mark Carney and the Forecast That Wasn't a Forecast

Sigh. The language in the Bank of England’s 88-page dissertation on Brexit’s potential economic impact couldn’t have been clearer: The incredibly dire “no deal no transition” Brexit scenario they cooked up—the one where GDP drops -8% in a single year and overnight interest rates shoot to 5.5%—wasn’t a forecast. It was a sanity check for this year’s stress tests, which the BoE happened to release the same day (all banks passed). It even stated that, “The ‘disruptive’ and ‘disorderly’ Brexit scenarios are therefore not forecasts for the economy in the event that the UK leaves the EU with no deal and no transition period.” (Boldface ours.) Unfortunately, this didn’t stop headlines going hog wild over “Project Hysteria,” as one lawmaker dubbed it, claiming the BoE was forecasting a shock worse than 2008’s Financial Crisis or the Great Depression if Parliament rejects PM Theresa May’s Brexit deal and the UK leaves without a trade deal next March. To us, the reaction sums up sentiment toward Brexit, supporting our view that just getting on with Brexit—whatever it looks like—should bring stocks some measure of relief.

It is tempting to say what the BoE has here is a failure to communicate, but we read the paper and don’t think it is unclear. It marked the ugly scenarios as most relevant for its regulatory arm, not economic policymakers. It said they weren’t forecasts. It spent pages explaining that any form of Brexit is basically impossible to model because there is no good precedent. To us, it recalls Star Trek IV, when Spock was doing the calculations for the trip back from 1986 to the 23^rd century, and Admiral Kirk asked if he had adjusted for the added mass of water and whales, and Spock explained Scotty couldn’t give him exact numbers so he had to guess. This is 88 pages of central bank guessing. The only way they could have been clearer is if every page had a red watermark saying “THIS IS ONLY A GUESS!” So, we guess this is another case of sensationalist headlines competing for readers. Because, face it, Carney Sees Carnage or No Deal Brexit Worse Than Great Depression will get more eyeballs than Central Bank Warns Modeling Is Hard or Brexit Impact Inconclusive, Depends on Numerous Unknowns.

Although the BoE’s missive isn’t a forecast, even its more sane-looking models carried the flaws typifying long-term forecasts: straight-line math and no consideration of unknown variables. The baseline scenarios simply projected May 2016 (before the referendum) and November 2018 GDP trends in a straight line through 2023, with no volatility or recession between now and then. Scenarios modeling close post-Brexit EU trade ties also used straight-line math, concluding growth would be just a bit weaker than the lost no-Brexit future. Only the disruptive scenarios included a recession, giving the casual reader the impression that only Brexit could cause a UK recession in the next five years. That is … weird? The entirety of British economic history argues against it. You don’t need a systemic shock to get a recession. Many recessions start off boring, with the yield curve inverting and no one noticing. The probability of that happening in the next five years and causing a recession even if Brexit never happened is high. THIS ISN’T A FORECAST! Just a statement about how economic cycles, money markets and central banks have historically worked.

We aren’t saying all would be peachy keen if a no-deal Brexit happened. There would probably be some hiccups, to say the least. But the BoE’s worst-case hypothetical scenario seems unlikely. It assumes no monetary or fiscal stimulus, yet the likelihood the Treasury does nothing while the BoE hikes rates to 5.5% is exceedingly low. The UK isn’t a highly indebted, bailed-out eurozone nation, where stimulus could be “blocked” by a supranational body.^[i] It assumes there is no transition period, but the UK and EU have already agreed on one that lasts through 2020. It assumes the UK loses access to most extant trade deals, but the WTO has already agreed to grandfather in a Brexited UK. WTO terms may not be great, but they at least provide a fallback to keep goods and services moving. New customs hassles aren’t good news, but India dealt with similar last year when its new goods and services tax took effect. The long queues and confusion took a bite out of growth, but it was temporary, and India’s economy didn’t shrink. Again, we aren’t trying to bash the BoE. They wouldn’t be doing their job if they didn’t consider all possible scenarios. But it is important to distinguish between possibilities and probabilities.

On the bright side, this backlash ensures yet more worst-case scenarios are baked into expectations. Markets move most on surprises—good and bad. If everyone were expecting Brexit to go swimmingly, we would be worried, because hiccups would qualify as a negative surprise. But with nearly everyone expecting an awful Brexit, anything less than awful would be a happy surprise. An -8% annual GDP drop is ludicrous—about double what the country experienced during the financial crisis. But now it is part of the zeitgeist, which should render even a small contraction following a possible no-deal Brexit a positive surprise for the global economy.

Plus, let us take a moment to consider what a no-deal Brexit could mean. If May’s deal passes and the UK stays in the EU’s customs union, it can’t sign free-trade deals with other nations. If Parliament rejects it and the UK reverts to WTO rules, then it can sign new deals—another potential positive surprise. The UK and its major EU trading partners are in the process of hiring a few thousand new border agents, which would help ease those dreaded customs tie-ups. UK and EU leaders could decide pretty quickly to accept each other’s regulatory standards for manufacturing equipment, vehicle safety and other items companies depend on. As politicians, they would have every incentive to do so. So the economic pneumonia many fear could turn out to be a cold or even a few messy sneezes. Not catastrophic.

In our view, UK stocks have struggled lately not because a no-deal Brexit would be awful, but because all the talk about an awful outcome is dragging on sentiment. Meanwhile, the uncertainty of what Brexit actually looks like delays risk-taking and investment. You can’t execute a plan until you know what, exactly, you are planning for. Businesses still don’t know. Perhaps they will find out on December 11, if Parliament approves May’s deal. If they don’t, then it could take a few more weeks. But come what may, at some point, businesses will finally know what they are dealing with. Simply knowing the outcome helps remove uncertainty, enabling them to finally get on with life.

We think this is the thing for investors to watch for—clarity, in any form. Not dire not-forecasts. Not politicians grandstanding. Noise can distract stocks in the short term, but over time, fading uncertainty should prove more powerful.