Short and Sharp: a softer Brexit but still a weaker pound

There are many anxieties for investors in global markets. The one keeping me up at night is Brexit. Having defied all the negative economic forecasts following last year’s Brexit referendum, the UK economy is now losing momentum. GDP growth in first quarter was just 0.2%, and 0.3% in second quarter. Business investment was stagnant and consumer spending was the weakest since late-2014. Higher inflation – the result of the weaker pound sterling – has been eating into household incomes, while the uncertainty surrounding Brexit is beginning to weigh heavily on households’ and firms’ spending decisions. I don’t expect the pound to strengthen or the outlook for the UK economy to improve.

Next week, the third round of the UK’s negotiations with the European Union (EU) takes place. Having dragged its feet for the past year, the UK government made some valiant last minute efforts to push discussions along. However, it might be too little, too late. The EU still seems to view the UK as ill-prepared for the talks and therefore, negotiations on the key issue – the UK’s trade relationship with the EU post-Brexit – must be delayed further.

It’s easy to understand why the EU may consider the UK ill-prepared. After all, we’re still in the dark about what the UK government really wants. Take one of Theresa May’s red lines (the supposedly non-negotiable elements): an end to the jurisdiction of the European Court of Justice (ECJ). According to recent position papers, the government is considering replacing the ECJ with the jurisdiction of the European Free Trade Association (EFTA) court. But the EFTA court takes its lead from the ECJ. Isn’t that essentially the same thing? Another red line was to leave the customs union. But the government is now suggesting replacing it with a new customs partnership with the EU, which essentially replicates what it currently has.

It seems Theresa May has belatedly recognized the superior trade position the UK currently enjoys. It looks to me that she is now simply trying to appease the Leave voters while also attempting to create a poor imitation of the current deal. While this is hardly inspirational policy, it does suggest the UK has become more willing to compromise. Indeed, one major concession is that the UK government finally acknowledges the need for a lengthy Brexit transition that defers any economic adjustment for a number of years beyond the formal exit in 2019. A softer Brexit is looking more likely, and this is certainly positive news.

Why isn’t this enough to prevent a further decline in sterling? Because Britain is still ending up with an inferior deal to the one it currently has. Furthermore, the clock is ticking, and without negotiations advancing quickly, we’re likely to head into 2018 with little more Brexit certainty than we have now. This will weigh further on business investment. In fact, the Bank of England now expects investment in the UK economy to be 20% lower in 2020 than it had forecast before last year’s Brexit referendum. Unsurprisingly, market analysts have reduced their expectations for policy rate hikes and with the recent drop in core inflation – a recipe for further weakness in sterling.

A weaker sterling would provide the UK with a much-welcomed defensive policy tool, and would contribute to growth later on. For the time being, sterling is a reflection of Brexit negotiations. A weakened government, disjointed support for Brexit, and a hardened and united EU don’t bode well for the pound.

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