This article was originally published in Nikkei Veritas on 17th July 2018.
In a world currently under a cloud of uncertainty over the trade policies being pursued by President Trump there was some welcome positive news recently with the signing of the Japan-EU free trade agreement on 17th July. Agreed late last year and likely to become active in 2019 once ratified in Japan and the EU, officials estimate the deal will boost Japan's GDP by 1.0%, add 290,000 jobs and remove approximately EUR 1bn of duties currently paid by EU exporters annually.
Unfortunately, one other major source of uncertainty in terms of global trade is getting worse. The UK referendum result was over two years ago but only this month did we get a formal detailed plan by the UK government on its vision of the UK's post-Brexit trading relationship with the EU. The plan (the White Paper) failed to unite divisions in parliament in London and has only reinforced the level of uncertainty ahead. This trading relationship is significant. While Japan MoF data revealed that Japan-EU trade totalled EUR 124bn (GBP118bn) in 2017, official UK statistics indicated that UK-EU trade totalled GBP 615bn last year. From a global perspective, the outcome of the Brexit negotiations is far more important.
What is remarkable of late has been the very limited moves in GBP in response to the escalation of Brexit uncertainty. The White Paper agreement reached by PM May's cabinet was followed by two senior cabinet resignations – David Davis and Boris Johnson. At the time of writing and since the White Paper was agreed, there have been 10 resignations from government over Brexit. This is an unprecedented period of political turmoil yet the BoE GBP TWI has remained around the 78.000 level since the start of May.
We are not confident that this low level of volatility can continue. Parliament is now in summer recess but even more political turmoil and increased Brexit uncertainty likely lies ahead. But Parliament is essentially gridlocked on one of the most important decisions that will determine the future of the UK for generations to come.
We see this increased political turmoil as raising the prospect of 1) a delay in the Article 50 deadline of 29th March 2019; 2) a 2nd referendum; and 3) a cliff-edge Brexit. This is simply down to the fact that time is fast running out. When parliament returns after the summer recess on 4th September there will only be just over 6 weeks to the EU summit on 18th-19th October that Michel Barnier has set as the deadline for finalising the withdrawal Agreement to allow the time required for countries to legislate in parliaments. This is a very tight timeline.
There is one other scenario here – a positive end to the turmoil. In this scenario the White Paper does indeed form the basis for UK-EU negotiations to proceed. The EU does not demand significant changes to the document that would undoubtedly create additional turmoil in London. Some EU leaders have given the White Paper cautious support. In this scenario then, a deal is in fact reached by 18th-19th October. To be honest though, this scenario is currently looking the least likely.
We believe one of the reasons for the lack of volatility for the pound during this increased turmoil is that fact that the economic data news flow has been positive. After the slowdown in Q1, the economy is rebounding with a sharp recovery in consumer spending. This means the BoE is still likely to raise interest rates on 2nd August. However, beyond this action, downside risks due to Brexit uncertainties are increasing and a lack of clarity over what lies beyond 29th March 2019 will become a bigger negative for the real economy the longer it takes to reach a deal on Brexit. A delay in leaving the EU, a 2nd Brexit referendum, a cliff-edge Brexit, a leadership challenge for PM May and even another general election are all plausible possibilities that lie ahead and all of them point to increased GBP volatility ahead.
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