The UK parliament has voted down the Brexit deal negotiated by Prime Minister May for the second time. Parliament will next vote on whether a NO DEAL is preferable on 29 March, or whether an extension is better. At this stage, we see the most likely scenario as an eventual departure of the UK from the EU without a deal by 30 June this year.
In the event of no deal, the UK economy will suffer first, but do not underestimate the consequences for the Eurozone. We see two types of implications: short-term growth costs for both the UK and the EU; and long-term implications for the Eurozone of facing greater competition from the UK and intensifying political tension. We see Italy as the weakest link in the Eurozone and we stress that bond yields are too low relative to the economic and political challenges ahead.
Our calculations suggest that the sterling is overvalued by 10-20%, while our bias for a mildly stronger USD this year remains unchanged. In the event of no deal, we may see the Federal Reserve cutting rates already this year and a restarting of quantitative easing by the ECB.
We provide an initial assessment on which countries are the most vulnerable going forward. Turkey and Romania stand out as having limited to no fiscal space for countercyclical strategies and meaningful currency depreciation risk. On the other hand, the Czech Republic and Hungary should prove the most defensive, notwithstanding their large export sectors.
For the second time, the UK parliament has voted down the deal struck by Prime Minister Theresa May on the “divorce bill”. Next, parliament is due to vote on whether the UK should opt for a no-deal departure once the current deadline expires on 29 March, or whether an extension should be secured.
We expect parliament to aim for a short extension, which the EU is likely to grant, to 30 June 2019. In our view, the chances of a deal between now and then are very small, so a disorderly departure is the most likely outcome going forward.
In the near term, global GDP growth prospects are likely to worsen, even relative to our conservative projections of 0.7% growth for the Eurozone and 1.2% for the US. Our forecasts for central Europe are also likely to fall, although a recession there remains unlikely.
Central banks have been ultra-dovish during this business cycle and more of this has been visible in recent months. Additional monetary stimulus is likely to materialise soon, with rate cuts by the Fed and potentially renewed quantitative easing by the ECB restarting again eventually. This should soften the downturn related to Brexit, but should stoke bigger debt problems later on.
In the longer run, Brexit poses as many problems for the UK as it does for the Eurozone, in our view, if not more.
Let us simplify what has been a convoluted process. On the basis of the campaign for the referendum and other observations we have gathered in the UK and around Europe, Brexit is about three things ultimately, in our view:
- Fiscal policy for the long run. The electorate was enthusiastically drawn to vote LEAVE on the promise of more funds for the National Healthcare System; while there is a bolder vision for the UK, in our view, that has been put forward steadily by the Conservative party, which would like to see a slimmer social state (the introduction of the Universal Credit system and its implementation is a clear demonstration of this), and more aggressive tax reductions for the highest income quintile and corporations. At the end of the day, there is an evident race to the bottom for corporate taxes taking place in Europe (and in the US), and the UK is not indifferent to this trend.
- The exact direction of the UK’s new immigration strategy is not clear to us. While, officially, there is a desire to limit the free movement of EU citizens in favour of a rebalancing towards higher skills regardless of the country of origin; the ultimate shape of future changes are very much unclear to us. The UK has prospered and gained from attracting talent from across the globe; whether it will continue to do so is a very big unknown to us.
- Excessive European regulations. UK voters, in our view, respond to a malaise that is visible across Europe, which sees a growing number of people disagreeing with increasingly tedious and widespread European regulations, which ultimately accentuate the structural challenges that micro-, small- and medium-sized companies are facing in today’s economic conditions.
If we are correct, then the most obvious response by the UK government would be to cut corporate taxes, and the tax burden on the high and middle class next year. This would accentuate the competitive pressure on the Eurozone, which would suffer from a slower response, a stronger currency and a divided growth strategy.
It is a common view shared by European politicians that a disorderly departure of the UK from the EU will end the debate about Euroscepticism. However, we see this as a misconception. While no party will have an interest in talking about a Euro exit in the near term, the malaise around the EU will not fade until the EU genuinely comes around to a robust growth vision for the next few decades and addresses in full the scepticism of its citizens towards it, in our view.
