Join J.P. Morgan Private Bank as we discuss the latest developments in Brexit. As the COVID-19 crisis took hold, the clock did not stop ticking on Brexit and the UK’s negotiations on the future outside of the EU.
J.P. MORGAN
BREXIT: WHAT’S NEXT? 07/17/20
OMAR BUTT:
Good afternoon, from a very sunny London at the cusp of the weekend. Welcome to our clients and guests. We’re delighted you could join us.
My name is Omar Butt. I’m a banker here at J.P. Morgan where I look after clients from the financial services sector focused on private equity firms and their partnerships.
This is one of a series of client webinars that we have hosted in lieu of our usual in-person lunches and discussions, and just a few more left before our clients go off for what we can all agree is a well-deserved summer break.
Over the course of this crisis we’ve had webinars from the likes of the Gates Foundation on sustainable investment; the cutting-edge Oxford vaccination team; and our very own Investment and Private Bank from the various government capital assistance programmes available.
Many are available on replay, so please get in touch with your banker or advisor to access these.
Our thesis for this particular webinar is very straightforward. In the midst of the current Covid crisis the “B” word seems to have fallen as a bi-line in the heart of newspapers and policymakers, but it’s clearly rolling on, and so we wanted to get back to the basics of the situation, what has happened, what may and will happen in terms of the politics, policy and investments.
I’m delighted to be joined today by a friend of the Private Bank - Stephen Adams – who is a Senior Director at Global Counsel, with a gamut of deep experience in Whitehall and the European Commission, across trade industry and policymaking. Somebody who understands the inner workings of the Whitehall machine at a time like this is very important to us.
Also three senior colleagues will be joining the discussion around investments – David Stubbs, our Head of Market Strategy and Advice; Anthony Collard, Head of Investments for the UK Market; and Sam Zief, Head of FX Strategy for the International Private Bank.
So without further ado, Stephen, thanks for joining us. In a very timely way for this webinar the government, led by Michael Gove, this week issued a new website and a host of guidance. January came and went. We left the EU with probably more of a small whimper than a big bang, and then the famous quote of events, dear boy, came very, very true. Since then, Stephen, we’ve had a July deadline, a soft deadline I should say, come and go, and then this week - or late last really - the government launched gov.uk/transition with a classically Johnsonian slogan of “Check, Change and Go”. There’s clearly changes coming for people in companies, everything from summer holiday travel insurance to Customs procedures at Dover to financial passporting, which obviously affects banks like ours.
So talking to clients in the last few days there’s been a certain haze around the dates, deadlines, negotiations. Stephen, can you take it back for us a little bit and give us more clarity on the dates, deadlines and what they’ve actually meant for our discussions and fully leaving the EU over the next 9 months or so. What was the July date? What happened? Take us through the October deadline for the EU ratification and ultimately the steps that will happen up until to September 31st, Stephen.
STEPHEN ADAMS:
Will do. Right, well, thank you very much. Thank you for having me. And, again, let me reiteration very welcome to everyone on the call.
As you say, the first deadline for 2020 we have, of course, already passed through, and that was the deadline of June 31st. And that deadline was important because it was the last point where under the legal framework created by the Withdrawal Agreement it was possible for the two sides to agree to extend the transition period. And in the absence of a request from the UK or the EU to do that we now have a relatively strong assurance that the transition period won’t be extended, and that means that the December 31st deadline, which is the deadline that is baked into the Withdrawal Agreement to agree a new economic framework, a free trade agreement is the next key deadline.
However, as you say, there were a couple of other smaller political deadlines that were embedded alongside that legal deadline, which have to do essentially with individual negotiating files. The French, in particular, were very keen to try and establish June 31st as a deadline for an agreement on fisheries. That deadline, of course, has come and gone, we don’t have an agreement on fisheries. We can talk a little bit about why that might be. But that deadline doesn’t [inaudible] the negotiation in any material way, it was a political one.
And there’s also a political deadline of the 31st June for the agreement, it’s a soft deadline to try and ensure that the two sides have completed their determinations for equivalence for financial services. And, of course, the people on this call that will be something that they understand why it matters. But, again, it’s worth noting that that deadline was not a deadline for the adoption of equivalence decisions, but a deadline for the completion of equivalence determinations, and those two things are quite different. One is essentially the analytical basis for the subsequent legal adoption, and until the adoption is completed the equivalence framework isn’t in place. And the EU very deliberately left that second commitment hanging as a piece of negotiating leverage.
So we’ve pushed through those three June deadlines, and that means essentially that the deadline that really matters is the 31st December, which is the date at which the transition period will end. The slightly illusionary appearance of having left the EU when in fact the UK is, of course, still for most intense and purposes bound by EU law and operates inside the EU regulatory perimeter, which is exceptionally important from the point of view of trade and trade continuity, that period will end.
But there’s a couple of sorts of additional deadlines, if you like which are hidden deadlines, they’re not formally written down anywhere, but they clearly matter, and they come between now and that 31st December deadline. And you alluded to one of them, and that’s essentially the ratification and implementation deadline, because obviously it’s one thing to complete this agreement, it also then needs to be ratified. And ratification, especially on the EU side, is a relatively complex process. It involves the deal passing through multiple parliaments and being signed off by European member states as well. And the EU’s informal assumption has always been you need to complete a negotiation by the end of October in order to be able to ensure that you have enough time to get the deal through a plenary session of the European Parliament, and probably to pass it through most European national legislatures as well, depending on the content, there’s an element of ambiguity there. But the EU has been operating on the assumption that you need to have the deal wrapped up by the 31st October.
The UK has set itself its own soft political deadline for completing the negotiation, which is a month earlier than that, September 31st. And that’s got nothing to do with ratification, passing a deal through the UK Parliament is comparatively easy. That’s got to do with the practicalities of implementation on the ground. That deadline relates above all the government’s assumption that it needs to give business at least three months to prepare for some of the things that will inevitably happen, whether we have a deal or not.
You mentioned, Omar, the implementation of a full customs regime on the Channel ports, that’s probably the single most important. But there’s also, of course, a range of ways in which, well, financial services businesses, for example, need to be ready to be operating under an equivalence regime as opposed to a financial services passporting regime. And you can’t just flip the switch on those changes. Many of them have authorisation deadlines, sometimes three months long. And so we have a series of hidden deadlines, if you like, which are built into the fact that transition ends on the 31st December.
OMAR BUTT:
With that in mind, Stephen, you talked about some of the fisheries agreements, and it’s not necessarily right to talk about sectoral mini deals, it’s all within one larger sort of category of a transition deal, but fisheries is an awfully important thing to the UK. I mean we’ve had a sort of an on-going battle for the last 20, 25, 30 years with the EU, and the same with financial services, the same with many other sub sectors. If we haven’t had a deal on fisheries, that sort of section deal on fisheries or a kind of a really clear deal on financial services, where are we in this process? Because you and I once talked about things like the gateway issues leading to actually agreeing issues with the EU and the Parliament and EU Commission, it doesn’t seem like we’ve gotten very far. Is that true or is it that we’re just making very slow progress and it’s a negotiating tactic? Tell me about that.
STEPHEN ADAMS:
Well, I mean every free trade agreement is a cluster of sectoral agreements in the end. But fisheries stand out in this context and in general. Fisheries is, generally speaking, not treated under WTO law and it’s not usually a part of free trade agreements at the level of the catch allocation. The tariffs on fish will be part of a negotiation. But the reason, of course, this is an unusually sensitive issue is that these are two trading partners who are contiguous and who share a piece of ocean and who have been fishing the same piece of ocean under an arranged framework for the last 40 years. And the question of how that framework is translated into the new structure is exceptionally sensitive. At the end of the day, right or wrong, the UK when it joined the EU allowed a very generous redistribution of access rights to its territorial waters for EU boats or EEC boats as they then were, and that is of course an advantage that the EU is very keen to cherry pick in the new framework. And that’s the reason why the issue has been frontloaded. As you say, we sometimes talk about this when we discuss it as a gateway issue, the EU has set it as a gateway issue in the sense that they want it to be resolved to their satisfaction before they allow the negotiation to move to the panoply of technical issues, such as tariff levels and behavioural disciplines that make up an agreement of this kind, a frontload as a necessary test.
It’s definitely been moving slowly. I think it’s probably actually the one area if we were to sort of review in turn the areas where the EU has essentially established a kind of contingent requirement, a kind of gateway quality to a negotiating bucket. This must be settled before we move onto everything else. Fisheries is actually probably the one area where they’ve made the most progress in the sense that both sides have moved off their initial position. The EU had originally wanted a multi-year fixed quota system modelled on the status quo. The UK wants what, essentially, what Norway has, Norway’s not in the common fisheries policy, even though it’s an EEA member, and essentially it negotiates an annual quota with the EU, and that was the UK’s opening position. And essentially, the EU has recognised, and Michel Barnier when he gave evidence in London last week said as much, that the idea of essentially the EU having the current benefits when the UK is no longer an EU member and is, in fact, a sovereign state with its own sovereign control over its fisheries waters isn’t going to fly. And the UK has moved off that this has to be an annualised quota. So you can see the two sides edging their way, slowly, towards a possible landing ground, which is the midway between the two point somehow.
So I mean I think, yes, definitely, this is an issue that’s slowed things down. It’s designed that way. That’s the way the EU wanted the negotiation to go, but it’s probably an issue where you can see the two sides, as much as anywhere, you can see the two sides working their way towards mutually acceptable outcome.
OMAR BUTT:
And therefore boding well for all of the other small gateway issues or larger gateway issues that need to be.
STEPHEN ADAMS:
Well, there I’m not so sure. I mean I think the challenges – what unites all the gateway issues, sorry, we probably should just say, the three kind of gateway issues that the EU has set are broadly fisheries. The notion of level playing field provisions, so the idea that the UK should in some way essentially commit to continue to follow EU state aid standards, labour standards, environmental protection standards, tax standards, accounting standards, competition standards into the future, and the question of the governance of the agreement itself. So it’s whether the ECJ, the European Court of Justice should have some role in policing the agreement in the future. So those three issues are kind of big ones.
I think we have to add Northern Ireland to. The EU has said that they won’t proceed with an agreement until they are happy, that they are confident that the Northern Ireland arrangements will work and have been implemented properly.
So those four gateway issue are the big ones. And, of course, what runs through all of them is essentially sovereignty, is the notion that the UK should accept an element of continued obligation to follow EU rules into the future.
Now the fisheries issue, in some ways, is the simplest nut to crack because it has a relatively obvious technical solution that probably is okay for both sides. The problem with committing to follow EU rules in the future and by agreeing to do that, allowing the ECJ a role in policing the agreement is in some ways an even more intractable sovereignty problem for a UK government that has decided to prioritise sovereignty in this negotiation. So it doesn’t mean we won’t get there, it doesn’t mean it isn’t a landing zone that you can identify. Both sides have taken fairly rigid positions and they’re a long way apart. But I don’t necessarily think that the fact they’re making progress on fisheries necessarily means that we’re closer on the other issues either.
OMAR BUTT:
Right. And on that, on the current government which has made sovereignty such a large part of this whole debate, and in that context in the current climate, tell us a little bit more about the institutional capability and capacity within Whitehall at the moment, because I think that’s a very important point when we talk about agreements and free trade agreements and negotiations, clearly there have been massive resources diverted to Covid planning and what’s going on currently. Then we had the resignation of Sir Mark Sedwill, obviously, a key event for the Whitehall machine. So who’s been working through these negotiations. I mean policy papers have continued to be written in February, March, April and now the government’s transition website is out. Are there any lessons, learnings from what’s going on with Covid? Has there been any logistical planning around this, a hindrance, a help? Tell us a bit more about that.
STEPHEN ADAMS:
Well, I mean Whitehall loves this idea of surge resourcing. The idea that essentially you can redirect civil servants around the system to cope with rising and falling demand. And of course, as you say, the last couple of years have been a bit of a rollercoaster in some ways with respect to those kinds of demands. We saw a big redirection of civil service activity in the middle of last year towards planning for a possible no deal, so the Yellowhammer process. We saw the redirection of a lot of that capacity in March to deal with the Covid problem. And to a certain extent some of that staffing is now coming back to no deal planning. As you say, that’s one of the reasons why we’re seeing the new web platform for traders. There’s a lot going on under the surface in terms of planning for the border. If you follow these things closely you’ll know that this week the government published its planned arrangements for the Channel ports after January 1st. So there’s a lot going on under the surface in terms of readiness.
I mean in terms of the ways in which Covid might have helped, I’m not sure that we can lean on that argument too hard. I mean what is certainly true is that the Yellowhammer process did involve quite a lot of thinking about things like stockpiling drugs, and the UK had a very large drug stockpile but, of course, that doesn’t necessarily mean that you’ve got the medicines that you need to deal with a novel coronavirus. But at some level it was a dry run for Whitehall in terms of thinking about how we might be able to manage inventory under conditions of stress, but in many ways I think the strain on the Channel ports is a very sui generis problem that no-one’s obviously had to handle before.
I mean there is, of course, a question around what the fall off of economic activity implies for the scale of potential disruption in January when the Channel port systems have to switch over to a full customs protocol but, in fact, the government has announced this week, in fact, that they don’t intend to use January 1st as the date for switching on a full Channel customs system. That will be delayed by 6 months. So they’re obviously being very cautious in that respect.
OMAR BUTT:
Because on that, some of the areas of risk that Yellowhammer had listed, things like food, medicine, transport, people coming across borders, goods coming borders, as you say, a lot of this has been key issues during coronavirus also. And we read this week that the government’s bought Ashford lorry park. You know, is there some sort of institutional learning going on from what we’ve experienced the last three or four months?
STEPHEN ADAMS:
Yeah. Although I think it’s worth bearing in mind that these are quite different kinds of problems. I mean Covid is both a demand and a supply shock. It has an impact on things like road/rail travel for reasons that aren’t related to customs frictions. The key problem in January, at least for a period, will just be the system’s adaptation to a new series of frictional costs. And the government’s immediate solution to that is to push those frictional costs back into the middle of next year. And while legally importers will be bringing goods into the UK in a way that has to be recorded and accounted for and tariffs paid from January 1st, in fact, they will be able to do something very close to wave those goods through and we will tidy up any of the bureaucratic later via a deferred declaration system and a deferred VAT and tariffs payment. So the government’s obviously taking no chances at all in the extent to which customs protocols could stop traffic in January. I think they’re very, very sensitive to the optics of a customs system creaking under the weight of the new protocols, and they’ve done the obvious thing, which is to give themselves and the business community more time to try and adapt.
But it is worth pointing out, of course, that when you see lorries backing up on the M20 they’re not backing up because of UK customs protocols, they’re backing up because of French customs protocols. So what the other side, the EU side is going to do on January 1st we don’t know for sure, but a big part of the disruption can obviously stem from what happens on the EU side. Customs is a closed system and an interruption in one point in the system very quickly ripples through the whole thing.
OMAR BUTT:
Absolutely. And on this thinking, let’s take it globally given the events that have happened in the last few days and week as well, I’m thinking of China here, and some of the trade deals that we were hoping to strike in the meantime, so I guess partly to do question on, again, government capacity and partly to do with free trade agreements. I spoke to a client yesterday who was quite bullish around trade deals, saying the US trade deal is probably just around the corner, and very, very bullish. But then you have the flip side of that which is the current troubles with Huawei, contracts in China and some of the retribution that they have promised British business as result. What is the likelihood of a concurrent trade deal with the US to happen, not just from a US policy perspective, but from a UK government perspective, and do you think that the current situation with China and Chinese contracts will make it procedurally and politically possible for these trade deals to happen concurrently in the next few months?
STEPHEN ADAMS:
Well, I would be very sceptical of the idea that you can complete an agreement with the US in the remainder of this year. I mean it may be possible that there’s some sort of early harvest agreement or essentially goods only agreement that you can strike, although, to be honest, that would really depend on what the US was willing to forego in a deal, and that’s not the US’s nature, in an agreement of this kind they will generally, in return for the cutting of US tariffs, they’ll want quite a wide monopoly of essentially regulatory amendments from the other side, and I don’t see why they would make an exception for the UK particularly. I don’t think that means that a deal with the US is impossible, and I don’t think it means that we shouldn’t fully expect one to be signed, say, in the course of next year or thereafter, but I think the idea that you can push an agreement like this both through the US system and the US system in the next six months seems pretty unrealistic to me. And I also think it’s worth bearing in mind that while obviously a UK/US deal would be symbolically very potent, it’s one of the reasons why the government wants it, the economic value and, in fact, if you look at the government’s economic analysis it’s not even clear that a deal might not, in fact, have a net negative impact because of essentially the short term disruptive competitive impacts on UK traders. The economic impacts are likely to be relatively marginal, at least at the level of individual businesses.
OMAR BUTT:
Thank you.
So at this point, given the economic context, I’d like to bring in Anthony in our team. So Anthony, you and we have been positioning our clients for what seems like almost forever around these themes, whether it’s in UK equity markets, because of Bank of England actions, sterling fluctuations and now adding the current crisis in. So perhaps you, David and Sam can talk us through some of these themes and areas that you see as areas of opportunity or caution in the next few months.
ANTHONY COLLARD:
Thank you very much. Like Omar said, I’m joined by David and Sam, both David on the investment strategy side, including all asset classes, and Sam, more specifically with the effects. And I think for the purposes of this call we’ll hit some of the key questions and kind of go from there. But if there are questions, we’ll take them at the end.
David, let’s start with you, let’s get to the obvious question with regards to the UK. Do you think there’s any long term damage or consequences for the UK economy, the growth potential of our economy outside of the EU?
DAVID STUBBS:
Hi. I think certainly that’s the key question that everyone has in mind. I think it’s a very difficult one to answer with some of the uncertainties around how we’re going to react and how other countries are going to treat us. I think it’s clear what the downsides are, but the potential up sides are where the uncertainty is. Downsides we know, a lot of access to the EU single market, by some measures the largest single market in the world. We know there’s going to be an increase in paperwork and bureaucracy for traders on both sides. And arguably, the UK will now lose out on some investment from outside of Europe, which would have come to the UK precisely because it was the launch point for the EU single market. So I think that’s all clear. To a certain extent you can see some of that already in the softness of foreign direct investment into the UK and some of the estimates of what the paperwork will cost traders.
The big uncertainty I think is the upsides. What is Brexit really about? As Stephen said this is obviously framed in many ways about sovereignty. Whether we’re to discuss sovereignty is policy space. The UK is going to be able to do thing sit was unable to do as an EU member. It’s going to have control and flexibility and choice in a way that it didn’t have as an EU member. The trouble is what do you do with it? And what is does that mean for your long run growth?
Here you run very quickly into very different narratives about the role that the EU has played in the development of the UK since its membership for decades. Was this the gateway to a great single market which helped us grow or was it an organisation full of red tape that held us back? Now we’re free of it do we get to cut all these terrible rules or do we get to build a kind of public private partnership now that we’re freed of certain EU regulations and what the public sector can do to drive our economy forward into the industries which are going to dominate the next couple of decades. Depending on who you talk to you get completely different answers for this, and therefore it’s very hard to know if we’ll use that policy space correctly. I think we do know the government is going to try to do some of those things. It is obviously on record saying that EU regulations are onerous upon UK EU business. We heard a lot about that in the Brexit campaign. And one of the issues obviously we’ll discussing with the Europeans is the public procurement rules as well and what we’ll be able to do there. And we simply don’t know, furthermore, how we’re going to replace that EU access. What is first going to be the deal with the EU itself, and then the US trade deal and all the other trade deals that we may or may not be able to negotiate and the terms of those create a pretty uncertain way forward. I will say this, that I think most economists and research analysists suggest that the downsides are material and so a lot needs to go right for us in terms of how we rebuild our trade connections and how we run our own economy for this to be a net positive.
I’ll close with one thing though. We do know that wherever you stand on the EU debate a lot of the UK’s success comes from things that are not going to change. That’s about the time zone, the language, the legal system, the history of the business spirit, the historical, economic and political and social connections around the world. And the UK is a powerhouse in some of these regards. The World Bank creates an index about how easy it is to do business in the country. The UK bank’s eighth right now out of almost 200 countries. The World Economic Forum has an index of competitiveness, again more than 100 countries. The UK’s 9th in that index. And then when you look at the kind of industries of the future, there’s a global index on the world’s digital competitiveness rankings, the UK’s currently 6th of all countries in that. So the UK has a lot of strengths that they’re not going to change and therefore should do okay even under a bad scenario.
ANTHONY COLLARD:
Thank you.
Sam, I might bring you in actually, because I just want to get your sense of the currency. Obviously post a deal we still have the same currency but we don’t have the connectivity to the EU in the same way. So you think, just more fundamentally, that there will be more volatility in sterling in the new world as opposed to the old world? Even though it’s still the same currency it doesn’t have that kind of connection to the economic group. Shouldn’t we expect more volatility, and what do you think the drivers of sterling might be before we focus more on specific sterling in other questions.
SAMUEL ZIEF:
Absolutely, yeah. Thanks for having me. I think you’re absolutely right. I mean I think what we’re going to see in the currency is more similar to what we’ve been seeing over the last few months. And what we’ve seen is even though sterling is mostly thought of as one of the major reserve currencies of the world, what we’ve seen is compared to euro, Swiss franc, yen, the dollar, right, really the fundamental reserve currencies, sterling has traded like a high beta currency, right. It’s traded more like the Australian dollar. I’m not going to compare the UK to emerging markets, but the currency has traded, right, with that similar kind of a high beta. And so I do think you’re kind of looking at this global sterling where it’s not going to be anchored by the same necessarily flow driven factors, the central banks, how much they’re allocating into sterling or not. You’re really going to be trading with risk sentiment. And so I do think we’re going to structurally see a higher correlation between global equities and sterling, which is what we’re seeing now. So I think we should get ready for this new normal. Even if a deal is struck and sterling can appreciate I think the volatility with global equities and the connectivity to that is going to be much more substantial.
OMAR BUTT:
David, maybe on global equity and positioning of clients, pension funds, wealth funds, is there a sense that people are underweighting the UK. It’s not easy to get the data, but what’s your perspective on that?
DAVID STUBBS:
Yes, I think there’s a clear sense that global asset allocators are under way in the UK. There is some data on flows and we see very clearly a multi-year move away in both equity and fixed income from UK assets from investors in general. I think that the starting point of that was not particularly strong, so I think you could absolutely conclude the UK now is a structural underweighting for some investors. Now there’s a lot of different factors that have played into that. Firstly, the UK has been through certainly a decade or more where an awful lot that could go wrong did go wrong. The UK’s obviously very focused on financial services and you had a financial crisis in 2008/9. The equity market is very sensitive to commodities. Mining as emerging market exposure. We’ve seen a very pronounced and continuous move downwards in commodity prices and, indeed, that whole commodity and mining complex in the last couple of years. And then, of course, you had the Brexit referendum which even if it turns out to be a good thing for the UK did inject uncertainty into the UK situation and put off some direct investment and some portfolio investment into stocks and bonds. So absolutely right now that’s the case. Also let’s remember that especially investors in the US they don’t think too much about UK versus France or whatever, they think about European assets as a whole and we’ve seen a move away from European assets, equities and fixed income and the currency as well in the last few years as well. So the UK was also caught up in that. So any way you play it, certainly global investors probably underrate the UK right now. Obviously, the opposite is the case, as we know for UK investors like most people they have a home bias, most people in the UK still have a very significant exposure to the domestic economy and markets.
ANTHONY COLLARD:
Do you think there’s some perception, especially as you say with US investors or global investors that Europe is Europe and UK is part of it? Do you think that there’ll be a dislocation of that? Do you think people will look at the UK separately, that that correlation starts to break down and if that’s case – what is that environment where the UK outperform look like?
DAVID STUBBS:
I think it’s very interesting. In private markets and when looking for like foreign direct investment to base a factory or to take exposure as part of widening your own company, I think there is that granularity. What drives the kind of overall European flows out of America is the fact that simply the major and largest and most liquid funds are overall European funds. So to a certain extent in public liquid markets we’re going to be stuck with the situation where Americans either buy Europe or they sell Europe going forward. And indeed, many of them do wrap Europe into the wider international development market bucket and buy and sell that. However, there’s plenty of investment within Europe and from Europe that absolutely distinguishes at a very granular level between countries, sectors, size of the company as well. And we know that funds will flow towards the UK in an environment that will help our equity markets. So what is that environment?
Firstly, the UK is a sensitive global cyclical economy. It has obviously a lot of large finance firms as well as in the equity market a lot of commodity and mining exposure, things that tend to do well when there’s a robust global demand cycle, a lot of business investment, a lot of fixed investment going around the world. And that’s why traditionally the UK has been seen as a procyclical economy. So if we get a robust recovery around the world the UK will tend to be well suited to pick up that general tail wind, as it were.
And, of course, on top of that we just need the Brexit uncertainty to get out of the way whatever the agreement is and move forward in that regard. To a certain extent, obviously, as I said, a number of things have gone wrong in the last 10 years and it does lead us to look at the UK and say relative valuation seems reasonable, relative to peers. The currency is obviously a lot of lower than it was beforehand. I’ll let Sam comment on potential levels. But if you then layer in what could go right it could potentially open up a better decade ahead than one we’ve just experienced for UK assets.
ANTHONY COLLARD:
Understood. And just maybe a reminder to the listeners, our view currently on the markets and how the UK first into that view. Just a quick 30 seconds maybe from you.
DAVID STUBBS:
Sure. I mean I’ll talk about equities and fixed income and then hand over to Sam for some discussion on the currency. Certainly at the moment within Europe the UK is not one of our most favourite markets. We see the case for taking healthcare exposure in a stable economy like Switzerland. We see the case for taking on some of the industrial exposure that’s linked to China through Germany. We see the case for potentially betting on a strong reopening and some pent-up demand and consumer discretionary in France. But right now the UK is not one of our preferred indices. Obviously, you see the reason why is we do have this overhang around Brexit. You see also projections that the UK economy is going to be one of the worst affected from the Covid recession, that’s partly again because we’re a cyclical economy. It’s also because we’re one of the worst affected by the actual virus itself. And then, of course, you still do have a weak set of dynamics around the world, no immediately catalyst for a very, very sharp recovery that would felt, that’s more a couple of years out. So right now the UK is not one of our more favoured ones. And some uncertainty around the currency as well. Sam.
ANTHONY COLLARD:
Yeah. I mean maybe before I get to you, Sam, just extending on that a little bit David. I mean we’ve seen in the press recently, GDP [inaudible] and this kind of hope for a V-shaped recovery seems to be well and truly on there. As you say, we’ve been disproportionately hit with Covid. Furlough being extended is just costing the government more and more. When you think about the twin deficits have been a problem in the UK for as long as I can remember, it probably just gets worse. Maybe I’ll first come to you and then go to Sam, in terms of does that ultimately suppress potential growth in the UK relative to the rest of, I guess, the G8. And could we be in a situation where we just have sub trend growth as an economy. Not as an investment market, but as an economy for an extended period of time? And then I’ll go to Sam on his views on the currency.
DAVID STUBBS:
That’s obviously a set of very large questions that go into that. I’ll say a couple of things. Firstly, what is the composition of any growth. It’s some mixture of labour inputs, the number of workers, how hard they work, how many hours they work and then the productivity of that work. One of the huge ramifications from the global financial crisis was the almost total collapse of productivity growth in the United Kingdom. We’ve really had very, very little growth in the productivity per hour of per worker in this country.
Why? Well, a couple of our most productive sectors really took a huge battering. One, of course, is financial services. Absolutely a key tenet for the economy. The other was the oil and energy space as well where we saw some declining output. So partly that was sectoral, partly it was because of the overhang of the leverage built up before the global financial crisis. And also it was because we are transitioning towards a more and more service economy. That tends to come with slower trend productivity growth. So I would say that the first thing to understand is that trend productivity growth in the UK and trend GDP growth is going to be very low, it’s going to be lower than it has in the past. We’re not going to have the kind of population growth that we’ve had in the past. This government’s committed to reducing immigration, the key source of population and worker growth. And then it’s just not credible to have a sustained material pick up in productivity any time soon. I hope it would happen and maybe for a certain degree it could, but to really change the dialogue is pretty unlikely. So the UK I think is still going to be in a modestly low growth equilibrium right now.
Just briefly on the twin deficit, obviously when you speak about that one is a budget deficit, one is a currency account deficit. A huge disagreement in economics about the link between those two things and their importance, firstly. On the budget side, absolutely at some point as we’ve seen from both the office of budget responsibility and a number of leading think tanks like the IVS, we’re going to be left with a significantly stretched public sector budget situation, and at some point it’s just not credible that the government will not get round to attempting a fiscal consolidation. I hope they are patient. I hope they allow the recovery to be significantly entrenched before they do so. But I think as soon as next year you’re going to start to see them potentially around the edges trying to find revenue from somewhere. Recent discussion in the press about capital gains tax changes potentially. Hopefully they don’t overdo it and redo the mistake that many countries fell into the early part of the last decade when they rushed to austerity too soon. Certainly there’s not going to be much pressure from the markets to do anything about this. We see right now the markets being very sanguine, especially with the help of central banks, to take huge amounts of debt issue and not really raise the costs in the long term.
The other deficit, of course, the current account or the trade deficit, absolutely the UK’s running a significant one. And the evolution, as Sam said, of this currency away from this kind of bedrock reserve view towards something a little bit more volatile, a little less anchored to the real giant currencies, at the margins should make a deficit like that less sustainable for us. We are reliant on further investment inward. However, I would say most of that investment comes to us because of those structural strengths that I took us through, the competitiveness, the currency, the business environment. Unless we really see a deterioration there I still think that a lot of people will want to engage with the UK regardless of our trade regime. But it could, as Sam said, inject a little bit more volatility into that currency which is unhelpful for planning.
ANTHONY COLLARD:
Brilliant David, thank you so much.
Sam, the perfect time to get you in. I think everything that David’s talking about, the uncertainty, the timing of the deal that we’ve discussed here today, it ultimately seems to boil down to the currency, the currency seems to be the release valve to all intense and purposes. Maybe just the first question, what do you think is priced in in sterling right now?
SAMUEL ZIEF:
Yeah, I say that whenever I talk to clients I get too main questions, the first one is how is Brexit going to play out, and so I’m very happy that I don’t have to answer that on this call, that we have Steve in and David and others that can handle that. The second is where are we going to trade in sterling for all of the barrier scenarios? And so the way that we come at this, or the way that I come at this is we try and do this systematically and analytically. And so basically, we have a fair value model, it’s based on sterling’s or cable’s relationship with global equity prices with some balance of payment measure in terms of trade and with interest rate differential, so the difference in interest rates between the US and the UK. And basically, we decide, right, or it helps us decide where the fair value is for sterling. At the moment, we put that at around 130. So clearly, we’re not trading at 130, we’re trading at 125, and we think of the difference or the discount in what we’re trading relative to this fair value estimate that we have or model based estimate as the Brexit risk premium. The risk premium that investors are assigning to the currency. And so right now that’s at about call it 6 to 8%. I think the question then is where has it been in the past.
ANTHONY COLLARD:
Sorry, Sam, just on that, are you suggesting 125 is pricing in no deal at the end of the year versus 130 fair value?
SAMUEL ZIEF:
No. No. Quite the opposite. So really, the largest this risk premium has ever gotten is about 10 to 15%, and that was right after the referendum in 2016. So we think that that’s really kind of the most pessimistic the markets have ever been really thinking about now deal. And we applied that to where fair value should be at around 130. Then that gives us our estimate for where we think we would trade in a no deal scenario, which is around 110 to 115. We’re not really in the camp that talks about parody. I see that being bandied about. Again, take all of these estimates, they’re model based, with some grain of salt, but we try and do it quantitatively and that gives us this kind of 110 to 115 area. I think the more interesting thing when we think about tactically where we could go in the near term is last October before kind of the Withdrawal Agreement breakthrough, before the General Election, when there was still some uncertainty. That risk premium got up to about 8 to 10%, And so I think if even if though we might expect a deal to get done let’s say in October later this year if the uncertainty rises in the near term, over the next quarter or so, I think that risk premium could build over time and take us down into the low 120 again, which would be us moving from kind of what’s priced in now to pricing a little bit more pessimism closer to what we saw kind of last October before the Withdrawal Agreement breakthrough that we had. So we’re currently thinking about trading sterling in the short term tactically from the short side rather than the long side.
ANTHONY COLLARD:
So in terms of the premium has been significantly larger than it is today, there’s more sense that maybe the market is somewhat complacent of the risks of a deal being done from now to the end of the year.
SAMUEL ZIEF:
Exactly. Or at least we think that this uncertainty could rise a bit, causing some uncertainty to rise and sterling to weaken a bit. I think the perhaps the more interesting thing is even though we have this fair value estimate it’s quite low, right, and that’s really where we would expect sterling to trade, even if a deal gets done. We’re really only talking about 130, maybe a bit higher than that. We’re really not talking about a deal getting done and all of a sudden going back to 140 where we were kind of pre-Referendum. And that’s really because of what we’ve been talking about. There are structural changes happening in the UK economy. And one of those that I think is really important is this current account deficit that David brought up. It really means that the UK is reliant on foreign inflows, foreign investment. Now I don’t think there’s going to be a run on the currency or anything like that, but the UK what it used to have, even as it was running this very large current account deficit in recent years was relatively high interest rates, at least when it came to the G10. And certainly now with all interest rates across the G10 complex collapsing to zero, particularly on an inflation adjusted basis, so on a real basis, the UK offers one of the lowest real interest rates in G10 and one of the largest current account deficits. And that just leaves it vulnerable to these fluctuations and risk sentiment. And so that’s really what I was getting at before. We have to be prepared for a little bit more volatility.
ANTHONY COLLARD:
So there’s arguably an asymmetry right now. 130, we’re at 125, the discount you would have expected at that extreme level is closer to 110, 115. If there was more negative news we could test 120. So there’s that asymmetry which makes it a little bit more uncomfortable. Now we’re only talking about sterling, we’re not talking about dollar, but this is obviously a Brexit from Europe. What’s your sense if our clients have euro/dollar/sterling assets, what’s the best way to hedge, how should we think about that?
SAMUEL ZIEF:
So we do think that euro is probably the best - of those three - going to be the best performer over the coming 12 months. We think the euro will strengthen against the dollar and strengthen against the dollar by more than sterling. Again, our base case is that a deal gets done and so sterling eventually does appreciate against the dollar back to 130. But we do have euro sterling moving higher, grinding higher up to 92, 93, because we think global investors while they’re underweight GBP, they’re underweight sterling, as David said. They’re even more underweight euro. And we think that as the global economy kind of continues to improve, that the worst of the Covid recession moves behind us, that there will some rebalancing among these real money investors, and they’ll be more likely to go back into Europe. And so we do think the euro probably appreciates the most. Sterling, provided a deal gets done, will appreciate against the dollar, but again there’s a lot of uncertainty there.
ANTHONY COLLARD:
I think it’s good to just remind the listeners, because the view that you have had of the currency that’s worked really well is broadly weakening dollar, stronger euro. So maybe just remind people of that broad view and it actually reinforces the euro/sterling trade over the sterling/dollar trade, doesn’t it?
SAMUEL ZIEF:
Exactly, right. So it’s really a lot of people question me, they say oh, but when we come out this the US will grow by more than Europe and we agree. This is really a relative story here. And global investors have been so pessimistic on Europe. They’re so underweight euro and European assets that we think as the worst of the Covid recession moves behind us an area of improving global growth tends to benefit euro at the expense of dollar, we tend to see a broadly weaker dollar. At that same time there are, it seems to be, structural improvements happening on the euro side of the equation. Every exchange rate is two sides of a coin. On that side it does seem like there’s a real fiscal thrust, a real push towards some more cohesive fiscal union. The ESB has been incredibly forceful in their response, kind of tamping down any sovereign risks. And we think that as those risks are pushed to the side global investment managers that are so underweight euro will move back. And it’s been proving right and we think this move still has legs. For euro/dollar particularly, just in case anyone’s interested, you know, we’re looking at 115 from the end of this year, that’s looking at little conservative at the moment, but we’re looking for a move towards 120 by the middle of next year.
ANTHONY COLLARD:
And it’s moving extremely fast. It wasn’t all that long ago we were at 1.08.
SAMUEL ZIEF:
Exactly.
ANTHONY COLLARD:
Last question before we open the lines, I don’t know David or Sam, feel free to take this. I know we’ve had a lot of scenarios here, deal/no deal, but do you think there’s any either inflation risk or deflation risk on the horizon for the UK, or do we just kind of get a boring sort of trend lower growth environment?
DAVID STUBBS:
I’ll kick off there, Sam can add any other comments. We’re clearly in the deflationary camp worldwide for the Covid 19 impact and the recession. We know why, recessions tend to be very deflationary, they damage confidence, businesses stop investing, consumers start to save. People do not have the kind of confidence to demand wage increases. Businesses do not have the confidence in their market to push through price increase. This tends to be very deflationary. I would argue that some of the most inflationary impacts of what we’re living through have been delayed by aggressive policy, both fiscal and monetary, but will be present for us over the next couple of years. We will see waves of insolvencies, bankruptcies, defaults. Those are incredibly deflationary. And although there are pockets of inflation, we’ve seen that in food inflation globally. We’ve seen that in the price increase specifically in the shops in the developed world as everyone was shopping from home because they couldn’t eat out. We’ll see volatility, as usual, in other commodities. We saw oil plunge to negative prices only a few months ago, now it’s rising back up, when that moves into the statics we’ll have some mechanical rise in inflation. And it’s not impossible to imagine an environment where you would have some inflationary impact if reopening went very well and the entire population was convinced that Covid was not a threat and decided to use up their recent savings in a burst of spending and enjoyment then sure, you would see pockets of inflation start to build. Unfortunately, evidence is exactly the opposite. Reopening is something that at best is going to go in fits and starts with periodic lockdowns in local areas, and there is also evidence that even though you tell people the shops and the restaurants are open a lot of the people are not going, at least not in vast numbers to make the restaurant full and convinced that they can start to raises prices. So at this point I think we’d definitely be in the inflation camp. Sterling, in particular, again you can come up with a scenario where globally things go really well, commodity prices start to rise around the world as there’s an industrial resurgence and then we get a no deal outcome at the end of this year, the market punishes sterling down to 110, in Sam’s range, and a few months later you start to see that in sterling terms things are a lot more expensive because they’re going up around the world and currency has gone down. That is a one time shop that the Bank of England will look straight through and say this is not something that is going to be maintained.
Remember, for any country at any time to have a genuine inflation issue, inflation needs to be pervasive across a range of sectors, goods and services. It needs to be echoed through the labour market and through other linked prices. We are a million miles away from that kind of environment right now and we will be no matter happens with Brexit.
ANTHONY COLLARD:
David, thanks.
Sam, the very last question, we’re getting a bit short on time. You’ve talked about very clearly the view on sterling, the view on euro, and obviously positive on euro. David’s talking about deflation, a lot of people don’t associate gold as a great investment on inflation, not necessarily true. What’s your thoughts on gold as an alternative currency in a world of low rates and not a lot of alternatives to the dollar.
SAMUELK ZIEF:
Yeah, I mean I’d say next to the euro or even in front of euro gold has been our highest conviction view for some time and certainly in this environment. I think everything on the inflation front, I agree 100% with everything that David said. I think the one wrinkle that I would throw in, which is maybe coming from – I came from a central banking background, I used to work at the Federal Reserve, I can say that this time if inflation does eventually start to move higher, and at some point it should start to normalise from extremely low levels, even if we are certainly not in the camp of any kind of runaway inflation, this time around, central banks globally, whether it’s the BOE or particularly the Federal Reserve, are dead set against moving to normalise policy any time soon. They will allow inflation to rise and exceed probably their mandate, and that’s an environment that tends to push real yields lower, inflation adjusted yields lower. And when we think about gold we really think about two main drivers, one is the US dollar, but even more than the dollar is real yields. And with an environment where the economy starts to come back, inflation normalises, central banks allow inflation expectations to rise, that’s the environment that you get lower and depressed real yields, and when real yields are extremely low the only knock on gold is that it’s a negative yielding asset or a zero yielding asset. When everything else is yielding zero, particularly in inflation adjusted terms there is no knock against gold.
And if you’re really worried about kind of the amount of fiscal spending that’s happening, and about twin deficits, because let’s face it, in the US there’s twin deficits, in the UK. Even though we don’t think really that there’s going to be a huge negative shock stemming from that any time soon, gold is as perfect hedge against that, against inflation because it’s an alternative currency without any of the fiat currency kind of issues. So absolutely, we think gold should be in everyone’s portfolio, if it’s not in there you should be pricing sensitive and it should be adding for the diversification benefits, for the hedging benefits. And if you already have it there are ways that we can try and accumulate more at lower levels or earn premium while we’re waiting.
ANTHONY COLLARD:
Fantastic, Sam. Sam, David, thanks so much for your time. Omar, I’m going to pass it back to you.
OMAR BUTT:
Great. Thank you very much, AC.
We’re running a little bit short on time but we have one question for Stephen, which hopefully we can answer.
Stephen, you were talking a little bit about state aid rules - I’m just making the question a bit more succinct – but do you think given the current situation in the UK with airlines and other sectors, do you think that there will be some sort of coming together for the EU and the UK during this negotiation on state aid rules given what’s happening, or do you think there’ll be a lack of flexibility on both sides, or particularly on the EU side?
STEPHEN ADAMS:
Well, I mean I think the thing is that it’s not necessarily that the two sides fundamentally disagree on what represents an appropriate level of state aid or an appropriate system for policing it. The key thing about the EU’s demand in this area is not so much the actual description of what’s admissible in terms of state aid, but the mechanism that they want to use to govern the relationship between the two sides on state aid. And state aid is the one area where the EUS essentially ask the most because what they want is for the UK to remain inside the EU’s state aid regime. And the reason they want that is because the internal tests inside the single market for determining whether state aid is harmful in a cross border sense are much, much more sensitive than the equivalent tests that are applied, for example, by the WTO rulebook or an international law. And it makes it much easier in potentia for Brussels to be comfortable that they will have a way of grasping UK state in the future that they seem to be injurious to competition. Obviously, that’s a very big ask of a sovereign trading partner. It’s not an ask that the EU has ever made in an agreement other than an agreement with a state that is essentially a regulatory satellite of the EU, Norway, Liechtenstein, the Ukraine. And, of course, it’s something that the UK has just resisted absolutely point blank.
I mean what is, of course, interesting and what you’re hinting at is that it is notable that at the same time of course that the EU is taking a position that implies that its baseline on state aid is rigid and high, what we are in fact seeing in practice, of course, is just how much flexibility there can be in that baseline in extremists. And if I was a UK negotiator I would be pointing that out, of course, every time the question came up. So I mean I think this is an area where the two sides are potentially in fact quite comfortable with the same level of restrictions on state aid. For all of the talk about the UK indulging in a burst of state driven growth in the wake of Brexit, I don’t actually think that’s the way the UK political economy is particularly structured to work or inclined to work. But the challenge is going to be can you get the EU comfortable with the idea that the UK is only subject to some relatively rudimentary external checks, just like all of the other EU’s trading partners in the way these things are governed. And at the moment that’s an area where the EU is still looking for quite a lot from the UK in terms of its willingness to stay bound to EU standards.
OMAR BUTT:
Thank you very much, Stephen. And on that we’re perfectly on time. So I’d just like to thank you, Stephen, for your time, it’s been very insightful. And we’ve had a few other questions in, so we’ll probably email them to you later.
Thank you to Anthony Collard, to David Stubbs and to Sam Zief for their time. And thank you all for joining and have a great weekend, and we hope to see you on another webinar soon.
END
J.P. MORGAN
BREXIT: WHAT’S NEXT? 07/17/20
OMAR BUTT:
Good afternoon, from a very sunny London at the cusp of the weekend. Welcome to our clients and guests. We’re delighted you could join us.
My name is Omar Butt. I’m a banker here at J.P. Morgan where I look after clients from the financial services sector focused on private equity firms and their partnerships.
This is one of a series of client webinars that we have hosted in lieu of our usual in-person lunches and discussions, and just a few more left before our clients go off for what we can all agree is a well-deserved summer break.
Over the course of this crisis we’ve had webinars from the likes of the Gates Foundation on sustainable investment; the cutting-edge Oxford vaccination team; and our very own Investment and Private Bank from the various government capital assistance programmes available.
Many are available on replay, so please get in touch with your banker or advisor to access these.
Our thesis for this particular webinar is very straightforward. In the midst of the current Covid crisis the “B” word seems to have fallen as a bi-line in the heart of newspapers and policymakers, but it’s clearly rolling on, and so we wanted to get back to the basics of the situation, what has happened, what may and will happen in terms of the politics, policy and investments.
I’m delighted to be joined today by a friend of the Private Bank - Stephen Adams – who is a Senior Director at Global Counsel, with a gamut of deep experience in Whitehall and the European Commission, across trade industry and policymaking. Somebody who understands the inner workings of the Whitehall machine at a time like this is very important to us.
Also three senior colleagues will be joining the discussion around investments – David Stubbs, our Head of Market Strategy and Advice; Anthony Collard, Head of Investments for the UK Market; and Sam Zief, Head of FX Strategy for the International Private Bank.
So without further ado, Stephen, thanks for joining us. In a very timely way for this webinar the government, led by Michael Gove, this week issued a new website and a host of guidance. January came and went. We left the EU with probably more of a small whimper than a big bang, and then the famous quote of events, dear boy, came very, very true. Since then, Stephen, we’ve had a July deadline, a soft deadline I should say, come and go, and then this week - or late last really - the government launched gov.uk/transition with a classically Johnsonian slogan of “Check, Change and Go”. There’s clearly changes coming for people in companies, everything from summer holiday travel insurance to Customs procedures at Dover to financial passporting, which obviously affects banks like ours.
So talking to clients in the last few days there’s been a certain haze around the dates, deadlines, negotiations. Stephen, can you take it back for us a little bit and give us more clarity on the dates, deadlines and what they’ve actually meant for our discussions and fully leaving the EU over the next 9 months or so. What was the July date? What happened? Take us through the October deadline for the EU ratification and ultimately the steps that will happen up until to September 31st, Stephen.
STEPHEN ADAMS:
Will do. Right, well, thank you very much. Thank you for having me. And, again, let me reiteration very welcome to everyone on the call.
As you say, the first deadline for 2020 we have, of course, already passed through, and that was the deadline of June 31st. And that deadline was important because it was the last point where under the legal framework created by the Withdrawal Agreement it was possible for the two sides to agree to extend the transition period. And in the absence of a request from the UK or the EU to do that we now have a relatively strong assurance that the transition period won’t be extended, and that means that the December 31st deadline, which is the deadline that is baked into the Withdrawal Agreement to agree a new economic framework, a free trade agreement is the next key deadline.
However, as you say, there were a couple of other smaller political deadlines that were embedded alongside that legal deadline, which have to do essentially with individual negotiating files. The French, in particular, were very keen to try and establish June 31st as a deadline for an agreement on fisheries. That deadline, of course, has come and gone, we don’t have an agreement on fisheries. We can talk a little bit about why that might be. But that deadline doesn’t [inaudible] the negotiation in any material way, it was a political one.
And there’s also a political deadline of the 31st June for the agreement, it’s a soft deadline to try and ensure that the two sides have completed their determinations for equivalence for financial services. And, of course, the people on this call that will be something that they understand why it matters. But, again, it’s worth noting that that deadline was not a deadline for the adoption of equivalence decisions, but a deadline for the completion of equivalence determinations, and those two things are quite different. One is essentially the analytical basis for the subsequent legal adoption, and until the adoption is completed the equivalence framework isn’t in place. And the EU very deliberately left that second commitment hanging as a piece of negotiating leverage.
So we’ve pushed through those three June deadlines, and that means essentially that the deadline that really matters is the 31st December, which is the date at which the transition period will end. The slightly illusionary appearance of having left the EU when in fact the UK is, of course, still for most intense and purposes bound by EU law and operates inside the EU regulatory perimeter, which is exceptionally important from the point of view of trade and trade continuity, that period will end.
But there’s a couple of sorts of additional deadlines, if you like which are hidden deadlines, they’re not formally written down anywhere, but they clearly matter, and they come between now and that 31st December deadline. And you alluded to one of them, and that’s essentially the ratification and implementation deadline, because obviously it’s one thing to complete this agreement, it also then needs to be ratified. And ratification, especially on the EU side, is a relatively complex process. It involves the deal passing through multiple parliaments and being signed off by European member states as well. And the EU’s informal assumption has always been you need to complete a negotiation by the end of October in order to be able to ensure that you have enough time to get the deal through a plenary session of the European Parliament, and probably to pass it through most European national legislatures as well, depending on the content, there’s an element of ambiguity there. But the EU has been operating on the assumption that you need to have the deal wrapped up by the 31st October.
The UK has set itself its own soft political deadline for completing the negotiation, which is a month earlier than that, September 31st. And that’s got nothing to do with ratification, passing a deal through the UK Parliament is comparatively easy. That’s got to do with the practicalities of implementation on the ground. That deadline relates above all the government’s assumption that it needs to give business at least three months to prepare for some of the things that will inevitably happen, whether we have a deal or not.
You mentioned, Omar, the implementation of a full customs regime on the Channel ports, that’s probably the single most important. But there’s also, of course, a range of ways in which, well, financial services businesses, for example, need to be ready to be operating under an equivalence regime as opposed to a financial services passporting regime. And you can’t just flip the switch on those changes. Many of them have authorisation deadlines, sometimes three months long. And so we have a series of hidden deadlines, if you like, which are built into the fact that transition ends on the 31st December.
OMAR BUTT:
With that in mind, Stephen, you talked about some of the fisheries agreements, and it’s not necessarily right to talk about sectoral mini deals, it’s all within one larger sort of category of a transition deal, but fisheries is an awfully important thing to the UK. I mean we’ve had a sort of an on-going battle for the last 20, 25, 30 years with the EU, and the same with financial services, the same with many other sub sectors. If we haven’t had a deal on fisheries, that sort of section deal on fisheries or a kind of a really clear deal on financial services, where are we in this process? Because you and I once talked about things like the gateway issues leading to actually agreeing issues with the EU and the Parliament and EU Commission, it doesn’t seem like we’ve gotten very far. Is that true or is it that we’re just making very slow progress and it’s a negotiating tactic? Tell me about that.
STEPHEN ADAMS:
Well, I mean every free trade agreement is a cluster of sectoral agreements in the end. But fisheries stand out in this context and in general. Fisheries is, generally speaking, not treated under WTO law and it’s not usually a part of free trade agreements at the level of the catch allocation. The tariffs on fish will be part of a negotiation. But the reason, of course, this is an unusually sensitive issue is that these are two trading partners who are contiguous and who share a piece of ocean and who have been fishing the same piece of ocean under an arranged framework for the last 40 years. And the question of how that framework is translated into the new structure is exceptionally sensitive. At the end of the day, right or wrong, the UK when it joined the EU allowed a very generous redistribution of access rights to its territorial waters for EU boats or EEC boats as they then were, and that is of course an advantage that the EU is very keen to cherry pick in the new framework. And that’s the reason why the issue has been frontloaded. As you say, we sometimes talk about this when we discuss it as a gateway issue, the EU has set it as a gateway issue in the sense that they want it to be resolved to their satisfaction before they allow the negotiation to move to the panoply of technical issues, such as tariff levels and behavioural disciplines that make up an agreement of this kind, a frontload as a necessary test.
It’s definitely been moving slowly. I think it’s probably actually the one area if we were to sort of review in turn the areas where the EU has essentially established a kind of contingent requirement, a kind of gateway quality to a negotiating bucket. This must be settled before we move onto everything else. Fisheries is actually probably the one area where they’ve made the most progress in the sense that both sides have moved off their initial position. The EU had originally wanted a multi-year fixed quota system modelled on the status quo. The UK wants what, essentially, what Norway has, Norway’s not in the common fisheries policy, even though it’s an EEA member, and essentially it negotiates an annual quota with the EU, and that was the UK’s opening position. And essentially, the EU has recognised, and Michel Barnier when he gave evidence in London last week said as much, that the idea of essentially the EU having the current benefits when the UK is no longer an EU member and is, in fact, a sovereign state with its own sovereign control over its fisheries waters isn’t going to fly. And the UK has moved off that this has to be an annualised quota. So you can see the two sides edging their way, slowly, towards a possible landing ground, which is the midway between the two point somehow.
So I mean I think, yes, definitely, this is an issue that’s slowed things down. It’s designed that way. That’s the way the EU wanted the negotiation to go, but it’s probably an issue where you can see the two sides, as much as anywhere, you can see the two sides working their way towards mutually acceptable outcome.
OMAR BUTT:
And therefore boding well for all of the other small gateway issues or larger gateway issues that need to be.
STEPHEN ADAMS:
Well, there I’m not so sure. I mean I think the challenges – what unites all the gateway issues, sorry, we probably should just say, the three kind of gateway issues that the EU has set are broadly fisheries. The notion of level playing field provisions, so the idea that the UK should in some way essentially commit to continue to follow EU state aid standards, labour standards, environmental protection standards, tax standards, accounting standards, competition standards into the future, and the question of the governance of the agreement itself. So it’s whether the ECJ, the European Court of Justice should have some role in policing the agreement in the future. So those three issues are kind of big ones.
I think we have to add Northern Ireland to. The EU has said that they won’t proceed with an agreement until they are happy, that they are confident that the Northern Ireland arrangements will work and have been implemented properly.
So those four gateway issue are the big ones. And, of course, what runs through all of them is essentially sovereignty, is the notion that the UK should accept an element of continued obligation to follow EU rules into the future.
Now the fisheries issue, in some ways, is the simplest nut to crack because it has a relatively obvious technical solution that probably is okay for both sides. The problem with committing to follow EU rules in the future and by agreeing to do that, allowing the ECJ a role in policing the agreement is in some ways an even more intractable sovereignty problem for a UK government that has decided to prioritise sovereignty in this negotiation. So it doesn’t mean we won’t get there, it doesn’t mean it isn’t a landing zone that you can identify. Both sides have taken fairly rigid positions and they’re a long way apart. But I don’t necessarily think that the fact they’re making progress on fisheries necessarily means that we’re closer on the other issues either.
OMAR BUTT:
Right. And on that, on the current government which has made sovereignty such a large part of this whole debate, and in that context in the current climate, tell us a little bit more about the institutional capability and capacity within Whitehall at the moment, because I think that’s a very important point when we talk about agreements and free trade agreements and negotiations, clearly there have been massive resources diverted to Covid planning and what’s going on currently. Then we had the resignation of Sir Mark Sedwill, obviously, a key event for the Whitehall machine. So who’s been working through these negotiations. I mean policy papers have continued to be written in February, March, April and now the government’s transition website is out. Are there any lessons, learnings from what’s going on with Covid? Has there been any logistical planning around this, a hindrance, a help? Tell us a bit more about that.
STEPHEN ADAMS:
Well, I mean Whitehall loves this idea of surge resourcing. The idea that essentially you can redirect civil servants around the system to cope with rising and falling demand. And of course, as you say, the last couple of years have been a bit of a rollercoaster in some ways with respect to those kinds of demands. We saw a big redirection of civil service activity in the middle of last year towards planning for a possible no deal, so the Yellowhammer process. We saw the redirection of a lot of that capacity in March to deal with the Covid problem. And to a certain extent some of that staffing is now coming back to no deal planning. As you say, that’s one of the reasons why we’re seeing the new web platform for traders. There’s a lot going on under the surface in terms of planning for the border. If you follow these things closely you’ll know that this week the government published its planned arrangements for the Channel ports after January 1st. So there’s a lot going on under the surface in terms of readiness.
I mean in terms of the ways in which Covid might have helped, I’m not sure that we can lean on that argument too hard. I mean what is certainly true is that the Yellowhammer process did involve quite a lot of thinking about things like stockpiling drugs, and the UK had a very large drug stockpile but, of course, that doesn’t necessarily mean that you’ve got the medicines that you need to deal with a novel coronavirus. But at some level it was a dry run for Whitehall in terms of thinking about how we might be able to manage inventory under conditions of stress, but in many ways I think the strain on the Channel ports is a very sui generis problem that no-one’s obviously had to handle before.
I mean there is, of course, a question around what the fall off of economic activity implies for the scale of potential disruption in January when the Channel port systems have to switch over to a full customs protocol but, in fact, the government has announced this week, in fact, that they don’t intend to use January 1st as the date for switching on a full Channel customs system. That will be delayed by 6 months. So they’re obviously being very cautious in that respect.
OMAR BUTT:
Because on that, some of the areas of risk that Yellowhammer had listed, things like food, medicine, transport, people coming across borders, goods coming borders, as you say, a lot of this has been key issues during coronavirus also. And we read this week that the government’s bought Ashford lorry park. You know, is there some sort of institutional learning going on from what we’ve experienced the last three or four months?
STEPHEN ADAMS:
Yeah. Although I think it’s worth bearing in mind that these are quite different kinds of problems. I mean Covid is both a demand and a supply shock. It has an impact on things like road/rail travel for reasons that aren’t related to customs frictions. The key problem in January, at least for a period, will just be the system’s adaptation to a new series of frictional costs. And the government’s immediate solution to that is to push those frictional costs back into the middle of next year. And while legally importers will be bringing goods into the UK in a way that has to be recorded and accounted for and tariffs paid from January 1st, in fact, they will be able to do something very close to wave those goods through and we will tidy up any of the bureaucratic later via a deferred declaration system and a deferred VAT and tariffs payment. So the government’s obviously taking no chances at all in the extent to which customs protocols could stop traffic in January. I think they’re very, very sensitive to the optics of a customs system creaking under the weight of the new protocols, and they’ve done the obvious thing, which is to give themselves and the business community more time to try and adapt.
But it is worth pointing out, of course, that when you see lorries backing up on the M20 they’re not backing up because of UK customs protocols, they’re backing up because of French customs protocols. So what the other side, the EU side is going to do on January 1st we don’t know for sure, but a big part of the disruption can obviously stem from what happens on the EU side. Customs is a closed system and an interruption in one point in the system very quickly ripples through the whole thing.
OMAR BUTT:
Absolutely. And on this thinking, let’s take it globally given the events that have happened in the last few days and week as well, I’m thinking of China here, and some of the trade deals that we were hoping to strike in the meantime, so I guess partly to do question on, again, government capacity and partly to do with free trade agreements. I spoke to a client yesterday who was quite bullish around trade deals, saying the US trade deal is probably just around the corner, and very, very bullish. But then you have the flip side of that which is the current troubles with Huawei, contracts in China and some of the retribution that they have promised British business as result. What is the likelihood of a concurrent trade deal with the US to happen, not just from a US policy perspective, but from a UK government perspective, and do you think that the current situation with China and Chinese contracts will make it procedurally and politically possible for these trade deals to happen concurrently in the next few months?
STEPHEN ADAMS:
Well, I would be very sceptical of the idea that you can complete an agreement with the US in the remainder of this year. I mean it may be possible that there’s some sort of early harvest agreement or essentially goods only agreement that you can strike, although, to be honest, that would really depend on what the US was willing to forego in a deal, and that’s not the US’s nature, in an agreement of this kind they will generally, in return for the cutting of US tariffs, they’ll want quite a wide monopoly of essentially regulatory amendments from the other side, and I don’t see why they would make an exception for the UK particularly. I don’t think that means that a deal with the US is impossible, and I don’t think it means that we shouldn’t fully expect one to be signed, say, in the course of next year or thereafter, but I think the idea that you can push an agreement like this both through the US system and the US system in the next six months seems pretty unrealistic to me. And I also think it’s worth bearing in mind that while obviously a UK/US deal would be symbolically very potent, it’s one of the reasons why the government wants it, the economic value and, in fact, if you look at the government’s economic analysis it’s not even clear that a deal might not, in fact, have a net negative impact because of essentially the short term disruptive competitive impacts on UK traders. The economic impacts are likely to be relatively marginal, at least at the level of individual businesses.
OMAR BUTT:
Thank you.
So at this point, given the economic context, I’d like to bring in Anthony in our team. So Anthony, you and we have been positioning our clients for what seems like almost forever around these themes, whether it’s in UK equity markets, because of Bank of England actions, sterling fluctuations and now adding the current crisis in. So perhaps you, David and Sam can talk us through some of these themes and areas that you see as areas of opportunity or caution in the next few months.
ANTHONY COLLARD:
Thank you very much. Like Omar said, I’m joined by David and Sam, both David on the investment strategy side, including all asset classes, and Sam, more specifically with the effects. And I think for the purposes of this call we’ll hit some of the key questions and kind of go from there. But if there are questions, we’ll take them at the end.
David, let’s start with you, let’s get to the obvious question with regards to the UK. Do you think there’s any long term damage or consequences for the UK economy, the growth potential of our economy outside of the EU?
DAVID STUBBS:
Hi. I think certainly that’s the key question that everyone has in mind. I think it’s a very difficult one to answer with some of the uncertainties around how we’re going to react and how other countries are going to treat us. I think it’s clear what the downsides are, but the potential up sides are where the uncertainty is. Downsides we know, a lot of access to the EU single market, by some measures the largest single market in the world. We know there’s going to be an increase in paperwork and bureaucracy for traders on both sides. And arguably, the UK will now lose out on some investment from outside of Europe, which would have come to the UK precisely because it was the launch point for the EU single market. So I think that’s all clear. To a certain extent you can see some of that already in the softness of foreign direct investment into the UK and some of the estimates of what the paperwork will cost traders.
The big uncertainty I think is the upsides. What is Brexit really about? As Stephen said this is obviously framed in many ways about sovereignty. Whether we’re to discuss sovereignty is policy space. The UK is going to be able to do thing sit was unable to do as an EU member. It’s going to have control and flexibility and choice in a way that it didn’t have as an EU member. The trouble is what do you do with it? And what is does that mean for your long run growth?
Here you run very quickly into very different narratives about the role that the EU has played in the development of the UK since its membership for decades. Was this the gateway to a great single market which helped us grow or was it an organisation full of red tape that held us back? Now we’re free of it do we get to cut all these terrible rules or do we get to build a kind of public private partnership now that we’re freed of certain EU regulations and what the public sector can do to drive our economy forward into the industries which are going to dominate the next couple of decades. Depending on who you talk to you get completely different answers for this, and therefore it’s very hard to know if we’ll use that policy space correctly. I think we do know the government is going to try to do some of those things. It is obviously on record saying that EU regulations are onerous upon UK EU business. We heard a lot about that in the Brexit campaign. And one of the issues obviously we’ll discussing with the Europeans is the public procurement rules as well and what we’ll be able to do there. And we simply don’t know, furthermore, how we’re going to replace that EU access. What is first going to be the deal with the EU itself, and then the US trade deal and all the other trade deals that we may or may not be able to negotiate and the terms of those create a pretty uncertain way forward. I will say this, that I think most economists and research analysists suggest that the downsides are material and so a lot needs to go right for us in terms of how we rebuild our trade connections and how we run our own economy for this to be a net positive.
I’ll close with one thing though. We do know that wherever you stand on the EU debate a lot of the UK’s success comes from things that are not going to change. That’s about the time zone, the language, the legal system, the history of the business spirit, the historical, economic and political and social connections around the world. And the UK is a powerhouse in some of these regards. The World Bank creates an index about how easy it is to do business in the country. The UK bank’s eighth right now out of almost 200 countries. The World Economic Forum has an index of competitiveness, again more than 100 countries. The UK’s 9th in that index. And then when you look at the kind of industries of the future, there’s a global index on the world’s digital competitiveness rankings, the UK’s currently 6th of all countries in that. So the UK has a lot of strengths that they’re not going to change and therefore should do okay even under a bad scenario.
ANTHONY COLLARD:
Thank you.
Sam, I might bring you in actually, because I just want to get your sense of the currency. Obviously post a deal we still have the same currency but we don’t have the connectivity to the EU in the same way. So you think, just more fundamentally, that there will be more volatility in sterling in the new world as opposed to the old world? Even though it’s still the same currency it doesn’t have that kind of connection to the economic group. Shouldn’t we expect more volatility, and what do you think the drivers of sterling might be before we focus more on specific sterling in other questions.
SAMUEL ZIEF:
Absolutely, yeah. Thanks for having me. I think you’re absolutely right. I mean I think what we’re going to see in the currency is more similar to what we’ve been seeing over the last few months. And what we’ve seen is even though sterling is mostly thought of as one of the major reserve currencies of the world, what we’ve seen is compared to euro, Swiss franc, yen, the dollar, right, really the fundamental reserve currencies, sterling has traded like a high beta currency, right. It’s traded more like the Australian dollar. I’m not going to compare the UK to emerging markets, but the currency has traded, right, with that similar kind of a high beta. And so I do think you’re kind of looking at this global sterling where it’s not going to be anchored by the same necessarily flow driven factors, the central banks, how much they’re allocating into sterling or not. You’re really going to be trading with risk sentiment. And so I do think we’re going to structurally see a higher correlation between global equities and sterling, which is what we’re seeing now. So I think we should get ready for this new normal. Even if a deal is struck and sterling can appreciate I think the volatility with global equities and the connectivity to that is going to be much more substantial.
OMAR BUTT:
David, maybe on global equity and positioning of clients, pension funds, wealth funds, is there a sense that people are underweighting the UK. It’s not easy to get the data, but what’s your perspective on that?
DAVID STUBBS:
Yes, I think there’s a clear sense that global asset allocators are under way in the UK. There is some data on flows and we see very clearly a multi-year move away in both equity and fixed income from UK assets from investors in general. I think that the starting point of that was not particularly strong, so I think you could absolutely conclude the UK now is a structural underweighting for some investors. Now there’s a lot of different factors that have played into that. Firstly, the UK has been through certainly a decade or more where an awful lot that could go wrong did go wrong. The UK’s obviously very focused on financial services and you had a financial crisis in 2008/9. The equity market is very sensitive to commodities. Mining as emerging market exposure. We’ve seen a very pronounced and continuous move downwards in commodity prices and, indeed, that whole commodity and mining complex in the last couple of years. And then, of course, you had the Brexit referendum which even if it turns out to be a good thing for the UK did inject uncertainty into the UK situation and put off some direct investment and some portfolio investment into stocks and bonds. So absolutely right now that’s the case. Also let’s remember that especially investors in the US they don’t think too much about UK versus France or whatever, they think about European assets as a whole and we’ve seen a move away from European assets, equities and fixed income and the currency as well in the last few years as well. So the UK was also caught up in that. So any way you play it, certainly global investors probably underrate the UK right now. Obviously, the opposite is the case, as we know for UK investors like most people they have a home bias, most people in the UK still have a very significant exposure to the domestic economy and markets.
ANTHONY COLLARD:
Do you think there’s some perception, especially as you say with US investors or global investors that Europe is Europe and UK is part of it? Do you think that there’ll be a dislocation of that? Do you think people will look at the UK separately, that that correlation starts to break down and if that’s case – what is that environment where the UK outperform look like?
DAVID STUBBS:
I think it’s very interesting. In private markets and when looking for like foreign direct investment to base a factory or to take exposure as part of widening your own company, I think there is that granularity. What drives the kind of overall European flows out of America is the fact that simply the major and largest and most liquid funds are overall European funds. So to a certain extent in public liquid markets we’re going to be stuck with the situation where Americans either buy Europe or they sell Europe going forward. And indeed, many of them do wrap Europe into the wider international development market bucket and buy and sell that. However, there’s plenty of investment within Europe and from Europe that absolutely distinguishes at a very granular level between countries, sectors, size of the company as well. And we know that funds will flow towards the UK in an environment that will help our equity markets. So what is that environment?
Firstly, the UK is a sensitive global cyclical economy. It has obviously a lot of large finance firms as well as in the equity market a lot of commodity and mining exposure, things that tend to do well when there’s a robust global demand cycle, a lot of business investment, a lot of fixed investment going around the world. And that’s why traditionally the UK has been seen as a procyclical economy. So if we get a robust recovery around the world the UK will tend to be well suited to pick up that general tail wind, as it were.
And, of course, on top of that we just need the Brexit uncertainty to get out of the way whatever the agreement is and move forward in that regard. To a certain extent, obviously, as I said, a number of things have gone wrong in the last 10 years and it does lead us to look at the UK and say relative valuation seems reasonable, relative to peers. The currency is obviously a lot of lower than it was beforehand. I’ll let Sam comment on potential levels. But if you then layer in what could go right it could potentially open up a better decade ahead than one we’ve just experienced for UK assets.
ANTHONY COLLARD:
Understood. And just maybe a reminder to the listeners, our view currently on the markets and how the UK first into that view. Just a quick 30 seconds maybe from you.
DAVID STUBBS:
Sure. I mean I’ll talk about equities and fixed income and then hand over to Sam for some discussion on the currency. Certainly at the moment within Europe the UK is not one of our most favourite markets. We see the case for taking healthcare exposure in a stable economy like Switzerland. We see the case for taking on some of the industrial exposure that’s linked to China through Germany. We see the case for potentially betting on a strong reopening and some pent-up demand and consumer discretionary in France. But right now the UK is not one of our preferred indices. Obviously, you see the reason why is we do have this overhang around Brexit. You see also projections that the UK economy is going to be one of the worst affected from the Covid recession, that’s partly again because we’re a cyclical economy. It’s also because we’re one of the worst affected by the actual virus itself. And then, of course, you still do have a weak set of dynamics around the world, no immediately catalyst for a very, very sharp recovery that would felt, that’s more a couple of years out. So right now the UK is not one of our more favoured ones. And some uncertainty around the currency as well. Sam.
ANTHONY COLLARD:
Yeah. I mean maybe before I get to you, Sam, just extending on that a little bit David. I mean we’ve seen in the press recently, GDP [inaudible] and this kind of hope for a V-shaped recovery seems to be well and truly on there. As you say, we’ve been disproportionately hit with Covid. Furlough being extended is just costing the government more and more. When you think about the twin deficits have been a problem in the UK for as long as I can remember, it probably just gets worse. Maybe I’ll first come to you and then go to Sam, in terms of does that ultimately suppress potential growth in the UK relative to the rest of, I guess, the G8. And could we be in a situation where we just have sub trend growth as an economy. Not as an investment market, but as an economy for an extended period of time? And then I’ll go to Sam on his views on the currency.
DAVID STUBBS:
That’s obviously a set of very large questions that go into that. I’ll say a couple of things. Firstly, what is the composition of any growth. It’s some mixture of labour inputs, the number of workers, how hard they work, how many hours they work and then the productivity of that work. One of the huge ramifications from the global financial crisis was the almost total collapse of productivity growth in the United Kingdom. We’ve really had very, very little growth in the productivity per hour of per worker in this country.
Why? Well, a couple of our most productive sectors really took a huge battering. One, of course, is financial services. Absolutely a key tenet for the economy. The other was the oil and energy space as well where we saw some declining output. So partly that was sectoral, partly it was because of the overhang of the leverage built up before the global financial crisis. And also it was because we are transitioning towards a more and more service economy. That tends to come with slower trend productivity growth. So I would say that the first thing to understand is that trend productivity growth in the UK and trend GDP growth is going to be very low, it’s going to be lower than it has in the past. We’re not going to have the kind of population growth that we’ve had in the past. This government’s committed to reducing immigration, the key source of population and worker growth. And then it’s just not credible to have a sustained material pick up in productivity any time soon. I hope it would happen and maybe for a certain degree it could, but to really change the dialogue is pretty unlikely. So the UK I think is still going to be in a modestly low growth equilibrium right now.
Just briefly on the twin deficit, obviously when you speak about that one is a budget deficit, one is a currency account deficit. A huge disagreement in economics about the link between those two things and their importance, firstly. On the budget side, absolutely at some point as we’ve seen from both the office of budget responsibility and a number of leading think tanks like the IVS, we’re going to be left with a significantly stretched public sector budget situation, and at some point it’s just not credible that the government will not get round to attempting a fiscal consolidation. I hope they are patient. I hope they allow the recovery to be significantly entrenched before they do so. But I think as soon as next year you’re going to start to see them potentially around the edges trying to find revenue from somewhere. Recent discussion in the press about capital gains tax changes potentially. Hopefully they don’t overdo it and redo the mistake that many countries fell into the early part of the last decade when they rushed to austerity too soon. Certainly there’s not going to be much pressure from the markets to do anything about this. We see right now the markets being very sanguine, especially with the help of central banks, to take huge amounts of debt issue and not really raise the costs in the long term.
The other deficit, of course, the current account or the trade deficit, absolutely the UK’s running a significant one. And the evolution, as Sam said, of this currency away from this kind of bedrock reserve view towards something a little bit more volatile, a little less anchored to the real giant currencies, at the margins should make a deficit like that less sustainable for us. We are reliant on further investment inward. However, I would say most of that investment comes to us because of those structural strengths that I took us through, the competitiveness, the currency, the business environment. Unless we really see a deterioration there I still think that a lot of people will want to engage with the UK regardless of our trade regime. But it could, as Sam said, inject a little bit more volatility into that currency which is unhelpful for planning.
ANTHONY COLLARD:
Brilliant David, thank you so much.
Sam, the perfect time to get you in. I think everything that David’s talking about, the uncertainty, the timing of the deal that we’ve discussed here today, it ultimately seems to boil down to the currency, the currency seems to be the release valve to all intense and purposes. Maybe just the first question, what do you think is priced in in sterling right now?
SAMUEL ZIEF:
Yeah, I say that whenever I talk to clients I get too main questions, the first one is how is Brexit going to play out, and so I’m very happy that I don’t have to answer that on this call, that we have Steve in and David and others that can handle that. The second is where are we going to trade in sterling for all of the barrier scenarios? And so the way that we come at this, or the way that I come at this is we try and do this systematically and analytically. And so basically, we have a fair value model, it’s based on sterling’s or cable’s relationship with global equity prices with some balance of payment measure in terms of trade and with interest rate differential, so the difference in interest rates between the US and the UK. And basically, we decide, right, or it helps us decide where the fair value is for sterling. At the moment, we put that at around 130. So clearly, we’re not trading at 130, we’re trading at 125, and we think of the difference or the discount in what we’re trading relative to this fair value estimate that we have or model based estimate as the Brexit risk premium. The risk premium that investors are assigning to the currency. And so right now that’s at about call it 6 to 8%. I think the question then is where has it been in the past.
ANTHONY COLLARD:
Sorry, Sam, just on that, are you suggesting 125 is pricing in no deal at the end of the year versus 130 fair value?
SAMUEL ZIEF:
No. No. Quite the opposite. So really, the largest this risk premium has ever gotten is about 10 to 15%, and that was right after the referendum in 2016. So we think that that’s really kind of the most pessimistic the markets have ever been really thinking about now deal. And we applied that to where fair value should be at around 130. Then that gives us our estimate for where we think we would trade in a no deal scenario, which is around 110 to 115. We’re not really in the camp that talks about parody. I see that being bandied about. Again, take all of these estimates, they’re model based, with some grain of salt, but we try and do it quantitatively and that gives us this kind of 110 to 115 area. I think the more interesting thing when we think about tactically where we could go in the near term is last October before kind of the Withdrawal Agreement breakthrough, before the General Election, when there was still some uncertainty. That risk premium got up to about 8 to 10%, And so I think if even if though we might expect a deal to get done let’s say in October later this year if the uncertainty rises in the near term, over the next quarter or so, I think that risk premium could build over time and take us down into the low 120 again, which would be us moving from kind of what’s priced in now to pricing a little bit more pessimism closer to what we saw kind of last October before the Withdrawal Agreement breakthrough that we had. So we’re currently thinking about trading sterling in the short term tactically from the short side rather than the long side.
ANTHONY COLLARD:
So in terms of the premium has been significantly larger than it is today, there’s more sense that maybe the market is somewhat complacent of the risks of a deal being done from now to the end of the year.
SAMUEL ZIEF:
Exactly. Or at least we think that this uncertainty could rise a bit, causing some uncertainty to rise and sterling to weaken a bit. I think the perhaps the more interesting thing is even though we have this fair value estimate it’s quite low, right, and that’s really where we would expect sterling to trade, even if a deal gets done. We’re really only talking about 130, maybe a bit higher than that. We’re really not talking about a deal getting done and all of a sudden going back to 140 where we were kind of pre-Referendum. And that’s really because of what we’ve been talking about. There are structural changes happening in the UK economy. And one of those that I think is really important is this current account deficit that David brought up. It really means that the UK is reliant on foreign inflows, foreign investment. Now I don’t think there’s going to be a run on the currency or anything like that, but the UK what it used to have, even as it was running this very large current account deficit in recent years was relatively high interest rates, at least when it came to the G10. And certainly now with all interest rates across the G10 complex collapsing to zero, particularly on an inflation adjusted basis, so on a real basis, the UK offers one of the lowest real interest rates in G10 and one of the largest current account deficits. And that just leaves it vulnerable to these fluctuations and risk sentiment. And so that’s really what I was getting at before. We have to be prepared for a little bit more volatility.
ANTHONY COLLARD:
So there’s arguably an asymmetry right now. 130, we’re at 125, the discount you would have expected at that extreme level is closer to 110, 115. If there was more negative news we could test 120. So there’s that asymmetry which makes it a little bit more uncomfortable. Now we’re only talking about sterling, we’re not talking about dollar, but this is obviously a Brexit from Europe. What’s your sense if our clients have euro/dollar/sterling assets, what’s the best way to hedge, how should we think about that?
SAMUEL ZIEF:
So we do think that euro is probably the best - of those three - going to be the best performer over the coming 12 months. We think the euro will strengthen against the dollar and strengthen against the dollar by more than sterling. Again, our base case is that a deal gets done and so sterling eventually does appreciate against the dollar back to 130. But we do have euro sterling moving higher, grinding higher up to 92, 93, because we think global investors while they’re underweight GBP, they’re underweight sterling, as David said. They’re even more underweight euro. And we think that as the global economy kind of continues to improve, that the worst of the Covid recession moves behind us, that there will some rebalancing among these real money investors, and they’ll be more likely to go back into Europe. And so we do think the euro probably appreciates the most. Sterling, provided a deal gets done, will appreciate against the dollar, but again there’s a lot of uncertainty there.
ANTHONY COLLARD:
I think it’s good to just remind the listeners, because the view that you have had of the currency that’s worked really well is broadly weakening dollar, stronger euro. So maybe just remind people of that broad view and it actually reinforces the euro/sterling trade over the sterling/dollar trade, doesn’t it?
SAMUEL ZIEF:
Exactly, right. So it’s really a lot of people question me, they say oh, but when we come out this the US will grow by more than Europe and we agree. This is really a relative story here. And global investors have been so pessimistic on Europe. They’re so underweight euro and European assets that we think as the worst of the Covid recession moves behind us an area of improving global growth tends to benefit euro at the expense of dollar, we tend to see a broadly weaker dollar. At that same time there are, it seems to be, structural improvements happening on the euro side of the equation. Every exchange rate is two sides of a coin. On that side it does seem like there’s a real fiscal thrust, a real push towards some more cohesive fiscal union. The ESB has been incredibly forceful in their response, kind of tamping down any sovereign risks. And we think that as those risks are pushed to the side global investment managers that are so underweight euro will move back. And it’s been proving right and we think this move still has legs. For euro/dollar particularly, just in case anyone’s interested, you know, we’re looking at 115 from the end of this year, that’s looking at little conservative at the moment, but we’re looking for a move towards 120 by the middle of next year.
ANTHONY COLLARD:
And it’s moving extremely fast. It wasn’t all that long ago we were at 1.08.
SAMUEL ZIEF:
Exactly.
ANTHONY COLLARD:
Last question before we open the lines, I don’t know David or Sam, feel free to take this. I know we’ve had a lot of scenarios here, deal/no deal, but do you think there’s any either inflation risk or deflation risk on the horizon for the UK, or do we just kind of get a boring sort of trend lower growth environment?
DAVID STUBBS:
I’ll kick off there, Sam can add any other comments. We’re clearly in the deflationary camp worldwide for the Covid 19 impact and the recession. We know why, recessions tend to be very deflationary, they damage confidence, businesses stop investing, consumers start to save. People do not have the kind of confidence to demand wage increases. Businesses do not have the confidence in their market to push through price increase. This tends to be very deflationary. I would argue that some of the most inflationary impacts of what we’re living through have been delayed by aggressive policy, both fiscal and monetary, but will be present for us over the next couple of years. We will see waves of insolvencies, bankruptcies, defaults. Those are incredibly deflationary. And although there are pockets of inflation, we’ve seen that in food inflation globally. We’ve seen that in the price increase specifically in the shops in the developed world as everyone was shopping from home because they couldn’t eat out. We’ll see volatility, as usual, in other commodities. We saw oil plunge to negative prices only a few months ago, now it’s rising back up, when that moves into the statics we’ll have some mechanical rise in inflation. And it’s not impossible to imagine an environment where you would have some inflationary impact if reopening went very well and the entire population was convinced that Covid was not a threat and decided to use up their recent savings in a burst of spending and enjoyment then sure, you would see pockets of inflation start to build. Unfortunately, evidence is exactly the opposite. Reopening is something that at best is going to go in fits and starts with periodic lockdowns in local areas, and there is also evidence that even though you tell people the shops and the restaurants are open a lot of the people are not going, at least not in vast numbers to make the restaurant full and convinced that they can start to raises prices. So at this point I think we’d definitely be in the inflation camp. Sterling, in particular, again you can come up with a scenario where globally things go really well, commodity prices start to rise around the world as there’s an industrial resurgence and then we get a no deal outcome at the end of this year, the market punishes sterling down to 110, in Sam’s range, and a few months later you start to see that in sterling terms things are a lot more expensive because they’re going up around the world and currency has gone down. That is a one time shop that the Bank of England will look straight through and say this is not something that is going to be maintained.
Remember, for any country at any time to have a genuine inflation issue, inflation needs to be pervasive across a range of sectors, goods and services. It needs to be echoed through the labour market and through other linked prices. We are a million miles away from that kind of environment right now and we will be no matter happens with Brexit.
ANTHONY COLLARD:
David, thanks.
Sam, the very last question, we’re getting a bit short on time. You’ve talked about very clearly the view on sterling, the view on euro, and obviously positive on euro. David’s talking about deflation, a lot of people don’t associate gold as a great investment on inflation, not necessarily true. What’s your thoughts on gold as an alternative currency in a world of low rates and not a lot of alternatives to the dollar.
SAMUELK ZIEF:
Yeah, I mean I’d say next to the euro or even in front of euro gold has been our highest conviction view for some time and certainly in this environment. I think everything on the inflation front, I agree 100% with everything that David said. I think the one wrinkle that I would throw in, which is maybe coming from – I came from a central banking background, I used to work at the Federal Reserve, I can say that this time if inflation does eventually start to move higher, and at some point it should start to normalise from extremely low levels, even if we are certainly not in the camp of any kind of runaway inflation, this time around, central banks globally, whether it’s the BOE or particularly the Federal Reserve, are dead set against moving to normalise policy any time soon. They will allow inflation to rise and exceed probably their mandate, and that’s an environment that tends to push real yields lower, inflation adjusted yields lower. And when we think about gold we really think about two main drivers, one is the US dollar, but even more than the dollar is real yields. And with an environment where the economy starts to come back, inflation normalises, central banks allow inflation expectations to rise, that’s the environment that you get lower and depressed real yields, and when real yields are extremely low the only knock on gold is that it’s a negative yielding asset or a zero yielding asset. When everything else is yielding zero, particularly in inflation adjusted terms there is no knock against gold.
And if you’re really worried about kind of the amount of fiscal spending that’s happening, and about twin deficits, because let’s face it, in the US there’s twin deficits, in the UK. Even though we don’t think really that there’s going to be a huge negative shock stemming from that any time soon, gold is as perfect hedge against that, against inflation because it’s an alternative currency without any of the fiat currency kind of issues. So absolutely, we think gold should be in everyone’s portfolio, if it’s not in there you should be pricing sensitive and it should be adding for the diversification benefits, for the hedging benefits. And if you already have it there are ways that we can try and accumulate more at lower levels or earn premium while we’re waiting.
ANTHONY COLLARD:
Fantastic, Sam. Sam, David, thanks so much for your time. Omar, I’m going to pass it back to you.
OMAR BUTT:
Great. Thank you very much, AC.
We’re running a little bit short on time but we have one question for Stephen, which hopefully we can answer.
Stephen, you were talking a little bit about state aid rules - I’m just making the question a bit more succinct – but do you think given the current situation in the UK with airlines and other sectors, do you think that there will be some sort of coming together for the EU and the UK during this negotiation on state aid rules given what’s happening, or do you think there’ll be a lack of flexibility on both sides, or particularly on the EU side?
STEPHEN ADAMS:
Well, I mean I think the thing is that it’s not necessarily that the two sides fundamentally disagree on what represents an appropriate level of state aid or an appropriate system for policing it. The key thing about the EU’s demand in this area is not so much the actual description of what’s admissible in terms of state aid, but the mechanism that they want to use to govern the relationship between the two sides on state aid. And state aid is the one area where the EUS essentially ask the most because what they want is for the UK to remain inside the EU’s state aid regime. And the reason they want that is because the internal tests inside the single market for determining whether state aid is harmful in a cross border sense are much, much more sensitive than the equivalent tests that are applied, for example, by the WTO rulebook or an international law. And it makes it much easier in potentia for Brussels to be comfortable that they will have a way of grasping UK state in the future that they seem to be injurious to competition. Obviously, that’s a very big ask of a sovereign trading partner. It’s not an ask that the EU has ever made in an agreement other than an agreement with a state that is essentially a regulatory satellite of the EU, Norway, Liechtenstein, the Ukraine. And, of course, it’s something that the UK has just resisted absolutely point blank.
I mean what is, of course, interesting and what you’re hinting at is that it is notable that at the same time of course that the EU is taking a position that implies that its baseline on state aid is rigid and high, what we are in fact seeing in practice, of course, is just how much flexibility there can be in that baseline in extremists. And if I was a UK negotiator I would be pointing that out, of course, every time the question came up. So I mean I think this is an area where the two sides are potentially in fact quite comfortable with the same level of restrictions on state aid. For all of the talk about the UK indulging in a burst of state driven growth in the wake of Brexit, I don’t actually think that’s the way the UK political economy is particularly structured to work or inclined to work. But the challenge is going to be can you get the EU comfortable with the idea that the UK is only subject to some relatively rudimentary external checks, just like all of the other EU’s trading partners in the way these things are governed. And at the moment that’s an area where the EU is still looking for quite a lot from the UK in terms of its willingness to stay bound to EU standards.
OMAR BUTT:
Thank you very much, Stephen. And on that we’re perfectly on time. So I’d just like to thank you, Stephen, for your time, it’s been very insightful. And we’ve had a few other questions in, so we’ll probably email them to you later.
Thank you to Anthony Collard, to David Stubbs and to Sam Zief for their time. And thank you all for joining and have a great weekend, and we hope to see you on another webinar soon.
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