For Britons, Brexit Is Now More Fear Than Hope

Mar 29, 2017

Nine months after they voted for it, the British finally got their wish of tipping over the European applecart today. Two years from today, the U.K. will cease to be a member of the European Union, making it the first country in 60 years to reverse a generally consistent trend of integration since World War II.

Do they regret getting what they wanted yet? It depends who you ask. According to polling firm YouGov, there's been no real shift in people's views since last June.

Source: YouGov 

But IHS Markit, whose business confidence surveys are trusted by markets around the world, came to a very different conclusion this week. It reckons a much larger majority of Britons now thinks the U.K.'s economic prospects look worse as a result of Brexit.

Source: IHS Markit 

Even the old and the poor, two groups whose votes decided the referendum, are markedly more pessimistic. This is particularly important because consumer confidence and spending was the largest factor behind the U.K. economy's surprising strength in the second half of last year, according to Azad Zangana, senior European economist with fund manager Schroders in London.

There's no telling precisely what's behind that shift in sentiment, but a fair bet is that the pound's exchange rate is a big factor. The trade-weighted sterling index is down 18% from last June, making the price of everything from foreign holidays to iPhone apps and Swiss chocolate more expensive. That has helped push inflation to a three-year high. And, given that exchange rate fluctuations take time to reach Main St., inflation will get worse before it gets better. The Bank of England sees it peaking at 2.8% in 2018.

But while exchange rates ultimately reflect economic fundamentals, in the short term they are prone to sharp shifts in sentiment driven by news headlines, which have been overwhelmingly negative in recent weeks. How to avoid a sense of imminent doom when lawmakers in Westminster are getting upset that the Act of Parliament taking the U.K. out of the EU won't be printed on goatskin like in the good old days of Henry VIII? Or when, more seriously, the minister responsible for negotiating Brexit admits he "hadn't yet looked into" the economic impacts of leaving the EU without a trade deal in place?

Right now, pessimists like Deutsche Bank say the pound could lose another 15% against both the dollar and euro as the divorce talks reveal how weak the U.K.'s negotiating position is.

Arguably, it's a question of perspective. Look at this graph and you might think things are improving. In recent weeks, the pound has been nowhere near the 30-year lows it hit in October.

But on a longer-term perspective (the one below goes back two years), this still looks like a line that is heading downwards, even if it has enjoyed a bit of a breather recently.

Source: Investing.com 

Martin Beck, chief U.K. economist with Oxford Economics in London, argues that while Brexit does justify a slightly cheaper pound, it doesn't justify the discount of 15%-20% to "fundamental anchor" such as purchasing power parity—suggesting that a dollar rate of $1.45-$1.50 is more appropriate than today's $1.25. Others, like Barclays and Morgan Stanley, also say the market is already discounting a "Hard" Brexit, meaning it will rebound on a more benign outcome.

Which brings us back to the big problem with Brexit. The air is thick with known unknowns. You can read a reasonably exhaustive list here, but they boil down to this: which will prove stronger – the spirit of enterprise, or the spirit of bureaucracy? How much will the British desire to cut immigration, and the European desire to 'defend the cohesion of the EU' get in the way of the millions of people and businesses just doing what makes sense for them? Nothing is certain and everything depends on the quality of the discussion over the next two years. Right now, the biggest danger appears to be that the European Union's bureaucrats will use up a large amount of that time defending their precious budgets and pensions. That would make it impossible for Prime Minister Theresa May to get what she formally requested Wednesday—a comprehensive deal on trade at the same time as a separation settlement (read her letter in full here).

May would like a quick response, but she'll be disappointed. The EU's heads of government won't discuss drafting a common line for another month. And one isn't likely until France and Germany, which have elections running through September, have new governments. After that, things should get clearer. But given that May has needed nine months just to get her own single-party government to line up behind her, don't get your hopes up. It might get loud, it will get messy.

YouGov director Anthony Wells reckons that May can head into the negotiations still enjoying a lot of goodwill from her voters. Even the bulk of those who voted to Remain "would just like the government to get on with it." But, he warns, "if negotiations do go badly people may be less firm in their opinions than they care to admit to either pollsters or to themselves."

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