Sunday bloody Sunday

( 20 mins)

Sterling underperformed in September, in line with our bearish forecast (UK & Sterling facing potential quadruple whammy, 4^th September 2020). It gradually recovered from 22^nd September, appreciated throughout October and peaked on 27^th November.

Sterling NEER has since weakened about 2.4% to an 11-week low. The sell-off at the turn of December was exacerbated by all four of the United Kingdom’s devolved nations still being subject to tight social distancing restrictions and their negative impact on the UK economy. 

In the past ten days the dwindling odds of the United Kingdom and European Union signing a free trade deal before 31^st December have driven Sterling’s sharp fall – a risk we flagged over three months ago.

About 90% of a draft treaty has been nailed down but many clauses are still subject to a broader agreement and negotiators are still at loggerheads on a number of key issues, including the EU’s fishing rights in UK waters, “level playing fields” and the role of the ECJ.

Senior officials met on 9^th December in a last-ditch attempt to reach agreement but little or no progress was made. Both sides have agreed that a deal needs to be reached by Sunday 13^th December. This is now a “hard” rather than “soft” deadline, in our view. 

Both sides have warned in the past 48 hours that agreement on a new trade deal by Sunday is unlikely and the EU has published contingency measures in the event of a no-deal.

A “hard” Brexit would have a material negative impact on the UK economy in the short-term, according to our analysis, and we would expect Sterling to weaken further, particularly as net short speculative positions are still modest.

We still think a free-trade deal (“soft” Brexit) will be reached but our degree of confidence has sharply eroded in recent weeks. A Sterling rally could still be hostage to “devils in the detail” of such a deal and to the weak near-term outlook for an economy on the back-foot.

Finally, while mass vaccination is a game-changer medium-term it not does not preclude a further tightening of UK social distancing measures in coming weeks, in our view.

Sterling headwinds stronger than tailwinds

Covid-19 related issues have dominated the headlines and driven much of the price action in Sterling in the past nine months, with the currency buffeted by multiple, often self-reinforcing headwinds and tailwinds.

Figure 1: Sterling collapsed in September, recovered in October-November but has dropped in December

Sterling was the second weakest developed market currency in September after the Norwegian Krone and the fifth weakest major currency overall, with the Sterling Nominal Effective Exchange Rate (NEER) weakening 2.4% (see Figure 1), in line with our bearish forecast (see UK & Sterling facing potential quadruple whammy, 4^th September 2020). Sterling gradually recovered from around 22^nd September and appreciated throughout October and most of November, thanks in part to i) the Bank of England’s ongoing commitment to finance the government’s ballooning fiscal deficit via an augmented Quantitative Easing program and ii) the government successfully securing 800,000 initial doses of the 95% efficient, two-dose Pfizer Covid-19 vaccine.

Sterling was the second weakest developed market currency in September after the Norwegian Krone and the fifth weakest major currency overall, with the Sterling Nominal Effective Exchange Rate (NEER) weakening 2.4% (see Figure 1), in line with our bearish forecast (see UK & Sterling facing potential quadruple whammy, 4^th September 2020). Sterling gradually recovered from around 22^nd September and appreciated throughout October and most of November, thanks in part to i) the Bank of England’s ongoing commitment to finance the government’s ballooning fiscal deficit via an augmented Quantitative Easing program and ii) the government successfully securing 800,000 initial doses of the 95% efficient, two-dose Pfizer Covid-19 vaccine.

Tiers for fears

The Sterling NEER peaked around 27^th November and has since weakened about 2.4% to an 11-week low according to our calculations (see Figure 1). The sell-off in late November-early December was exacerbated by all four of the United Kingdom’s devolved nations – England, Wales, Scotland and Northern Ireland – still being subject to tight social distancing restrictions (see Figure 2) and their negative impact on the UK economy (see section below). 

Figure 2: United Kingdom has been in out of lockdowns and tiering systems and near-term future unclear

Sunday 13^th December – Hard deadline for UK and EU to avoid “hard” Brexit

However, in the past ten days or so it is the dwindling odds of the United Kingdom and European Union signing a free trade deal before 31^st December which have arguably driven Sterling’s sharp fall – a risk we flagged over three months ago in UK & Sterling facing potential quadruple whammy (4^th September 2020).

The United Kingdom officially ceased to be a member of the European Union on 31^st January when the Withdrawal Agreement – in essence terms and conditions of the UK’s divorce from the EU – came into effect, 1,317 days after the referendum on 26^th June 2016. Since then the UK has been in an 11-month transitional arrangement during which time it has remained in the EU customs union and single market. In effect its trading relationship with the EU has not changed much although it has been allowed to renegotiate new trade deals with non-EU member states which will come into effect when the UK’s transition period ends on 31^st December. 

However, the brunt of the UK’s focus – officially since its exit from the EU on 31^st January but unofficially for the past couple of years – has been to negotiate a new free trade deal with the EU, by far its largest trading partner. “Soft” deadlines to reach an agreement have come and gone. The British government originally set 15^th October as its target date and when this deadline was missed the EU’s chief negotiator, Michel Barnier, said he was willing to negotiate with his counterpart, Sir David Frost, until early November. But again this deadline was missed and early December was set as the “final” date by which a deal could be agreed on. 

Officials have agreed on about 90% of a draft text for a treaty which will reportedly exceed 600 pages. However, agreement on many clauses is still subject to a broader agreement and negotiators are still at loggerheads on a number of key issues, including:

1. EU’s fishing rights in UK waters;
2. The possible advantage of the UK having tariff-free access to EU markets while setting its own standards on products, employment rights and business subsidies (“level playing fields”), and;
3. Whether the European Court of Justice (ECJ) should be the final arbiter of UK-EU disputes. 

British Prime Minister Johnson, European Commission President Ursula von der Leyen, Barnier and Frost met in Brussels on 9^th December in a last-ditch attempt to reach agreement but little or no progress was made. Both sides have agreed that a deal needs to be reached by Sunday 13^th December. This is arguably a “hard” rather than “soft” deadline as the British Parliament, European Parliament and European Council would need a few weeks to officially ratify the treaty before 31^st December. Put differently, even allowing for an accelerated timeline for these parliamentary and European Council votes, time has all but run out – in line with our prediction that “The past four and a half years suggest that negotiations will go to the wire, with both sides likely to be hammering out the details of a treaty till the very last hour” (see Time is priceless but has a steep cost, 25^th November 2020). 

Both sides have warned in the past 48 hours that agreement on a new trade deal by Sunday is unlikely and the EU has published contingency measures in the event of a “no-deal” which would potentially curtail British trade and travel in the EU.

Implications of a “no deal”: Hit to already weak UK economy and further Sterling downside

The implications of the UK and EU failing to reach an agreement on a new free trade deal before the 31^st December (at midnight) – dubbed a “hard Brexit” – would be widespread for the British economy and to a lesser extent the European Union’s, at least in the short to medium-term, in our view. 

The main implication is that the UK’s trading relationship with the EU would revert to World Trading Organisation (WTO) commercial trading rules. Such a scenario would mean an end to frictionless, duty-free trade. The EU would likely impose tariffs on imports of goods and services from the UK (making UK exports less competitive) and the UK would likely impose tariffs on imports from the EU, with the extra cost likely to be passed on (in part) to British customers according to officials. The UK would also likely face delays (even if temporary) to UK imports/exports at its “borders” with the EU and the government facing possible EU legal action over its Internal Markets bill.

Given that over 40% of the UK’s total exports currently go to the EU, the negative impact on the UK economy would likely be material as we concluded in Final Twist in Brexit Plot (14^th September 2018). Current and former Bank of England governors have recently agreed that a “hard Brexit” would cause material economic damage to the open UK economy. In comparison, only 6% of EU-27 exports of goods and services are destined for the UK (see Figure 7). The shares of exports to and imports from the UK for most individual EU member states, including France, Germany and Italy, are modest (see Figure 8) and we stick to our view that “complex cost-benefit analysis points to UK having more to lose from hard Brexit” (see Appendix for more detailed discussion).

 Figure 3: Net short speculative Sterling positions still modest

Note: * Long positions minus short positions;  **NEER is Nominal Effective Exchange Rate

We also think that Sterling would weaken further should it become clear that the UK and EU will not sign a free trade deal in coming weeks. While Sterling has already weakened materially in the past fortnight, speculative short (net) positions in Sterling remain reasonably modest by historical standards (see Figure 3). History suggests that a material increase in speculative short positions, as was the case in April-August -2019 and in March-May 2020, would lead to a further marked drop in Sterling.

Caught between rock and a hard place Prime Minister Johnson likely to choose hard place

Our take is that Prime Minister Johnson is currently in somewhat of a bind. If the UK crashes out of the customs union and single market without a new trade deal, the already very fragile UK economy will take another hit (see below). Moreover, such a scenario would arguably garner little popular support from the 48% of British voters who opted for the UK to remain in the EU (in the 26^th June 2016 referendum) and those who voted for the UK’s exit from the EU but favour a “soft” Brexit. 

If the British government caves in to the EU’s demands in order to get a deal over the finishing line and the deal is perceived as being a “bad” deal for the UK (albeit less damaging than a “no deal”) it will likely come under criticism from many quarters. Of course there is a third possible scenario whereby the UK extracts a similar or greater number of concessions from the EU but we think this is rather unlikely as the EU holds the strongest negotiating hand, as we argue above.

On balance of probability we still think that a free-trade deal will be reached (“soft” Brexit). Prime Minister Johnson has simply too much to lose. For starters he has invested a huge amount of political capital in promising to secure a trade deal for the UK. Moreover, criticism of his handling of the Covid-19 pandemic has left him under pressure to secure a policy “victory”. However, our degree of confidence in this scenario has been sharply eroded in recent weeks. 

The British government will have taken confidence in recent months from its ability to sign free-trade deals with a number of non-EU trading partners (including Canada, Japan and Singapore) under the same terms as the EU’s current deal with these countries, even if these countries account for a very small percentage of the UK’s total trade in goods and services. Moreover, the UK was the first country in the world to formally approve the Pfizer vaccine and to start administering it to non-trial patients (on 8^th December), with the government reportedly on course to inoculate 400,000 people in coming weeks. British officials have argued (rightly or wrongly) that this was possible because the UK is no longer part of the EU and Prime Minister Johnson may feel emboldened about the UK’s prospects even in the event of a “no-deal” Brexit.

Sterling rally in event of “soft” Brexit could still be hostage to “devils in the detail”

Should the UK and EU indeed reach agreement on a comprehensive “Canada-style” free-trade agreement, we would expect Sterling to recover in the remainder of the year, particularly as the market is currently slightly short Sterling based on net speculative positions data (see Figure 3). However, the devil will be in the details – details which corporates on both sides of the Channel and financial markets may take some time to digest. The ability of British companies and the UK’s trade-infrastructure to cope with what could be a complex transition will also be under close scrutiny. Ultimately, the likelihood of UK corporates still facing higher import/exports tariffs on some goods, the end of frictionless trade with the EU and significant administrative costs could still weigh on the UK economy and Sterling in early 2021, in our view. 

There is a third possible scenario in our view, whereby the UK and EU and UK reach agreement on a “narrower” trade deal. In this scenario the EU and UK would reach partial or sectoral free trade agreements, with some transitional arrangements remaining in place for the foreseeable future. We would expect Sterling to appreciate modestly in the short-run but to eventually lose steam and potentially weaken into early 2021. Sterling downside could be acute if the UK private sector is having to deal with both less advantageous EU trading terms and conditions and the economic strictures associated with another national lockdown, with the crucial service sector already under immense pressure. 

 Figure 4: UK GDP growth slowed to just 0.4% mom in October and likely turned negative in November…

Near-term outlook for UK economy on back-foot is weak regardless of “Brexit” outcome

In the face of a resurgence of Covid-19 cases and deaths in the UK social distancing measures were tightened in October and again in November, with England in a four-week lockdown from 5^th November to 2^nd December (see Figure 2). This contributed to UK GDP growth slowing to just 0.4% mom in October, with GDP still 8% below its December 2019 level, and UK Composite PMI data for November point to GDP having contracted sharply in the month (see Figures 4 and 5). 

Figure 5: …based on UK Composite PMI data 

Covid-19 vaccine and start of inoculation – Game changer, not game over

Moreover, the British government has made clear that while mass inoculation and immunisation against Covid-19 is a game changer in the medium-term, its benefits in the very near-term are limited. Indeed, concerns have risen recently that the government could further tighten the three-tier system in operation in England after the festive period. Its first fortnightly review is due on 16^th December and we expect only marginal changes to the three-tier ranking of counties and cities. However, should the number of new Covid-19 cases and deaths rebound during the temporary easing of measures over 23-27 December, we would expect the government to tighten the tiering system, with London potentially being moved to tier-three (see Figure 2). 

Finally, while Chancellor of the Exchequer Rishi Sunak postponed the Autumn budget and any tough fiscal retrenchment measures till 2021 he has made repeatedly clear in recent months that UK taxes would very likely rise next year to cut a fiscal deficit which the Office of Budget Responsibility forecasts will hit £394bn or 19% of GDP in the fiscal year to March 2021 (see Figure 6). This again is in line with our view that “the spectre of higher taxes and spending cuts looms large” (see UK & Sterling facing potential quadruple whammy, 4^th September 2020).

APPENDIX (originally published in Final Twist in Brexit Plot, 14^th September 2018)

Complex cost-benefit analysis points to UK having more to lose from hard Brexit

Weighing for both sides the relative economic, political and social costs and benefits, both in the short and long-run, under different scenarios, including the UK leaving the EU without a deal, is admittedly immensely complex, partly because it is difficult to objectively measure sometimes intangible costs and benefits.

At first glance, in absolute terms the EU would in aggregate have slightly more to lose than the UK from a trade perspective should the UK leave the EU without a deal. UK exports of goods and services to the EU were £274bn in 2017 while EU exports to the UK were £341bn according to official statistics. If the UK reverted back to World Trading Organisation (WTO) rules higher tariffs would be applied to goods and services traded between the UK and EU and the cost of these goods and services would therefore rise (all other things being equal). Assuming that this loss of price-competitiveness resulted in a first-round effect of a uniform 10% fall in UK exports to all 27 EU member states and a 10% fall in EU exports to the UK, EU exports to the UK would fall £34bn while UK exports to the EU would fall by “only” £27bn.

However, when measured relative to total trade, the picture is vastly different because the EU is by far the UK’s largest trading partner while the UK is only a modest trading partner for the EU as a whole and for most individual member states. Only 6% of the EU-27 exports of goods and services are destined for the UK but about 44% of the UK’s total exports go to the EU (see Figure 7). Put differently, 94% of the EU’s exports go to other countries whereas only 56% of the UK’s exports are destined for outside the EU. 

Figure 7: 

Economies with strong UK trading links, such as Cyprus which sends 13% of its exports to the UK would be hit harder than say Slovenia, which sends only 2% of its total exports to the UK (see Figure 8). But the absolute cost from a trade perspective would be far greater for the UK than for the EU as a whole or for any of the other individual 27 EU member states. 

Figure 8: 

Relatively closed economies, where trade is a modest share of GDP, would in relative terms suffer less than relatively open economies but the picture remains broadly the same, namely that the hit to UK trade would be far greater than to individual EU countries. Figure 9 estimates by how much a country’s total exports would fall if its exports to the UK fell 10%, measured as a percent of GDP. 

For example, if Croatian exports to the UK fell 10%, this would only reduce Croatia’s total exports by a negligible 0.15% of GDP. So all other things being equal we would not expect countries like Croatia or Slovenia to be overly concerned about whether the UK remains in the EU, at least from a trade perspective. At the other end of the scale, total exports from Malta would fall by the equivalent of about 1.15% of GDP. However, in this scenario UK exports to the EU would shrink by the equivalent of 1.2% of GDP, the highest ratio of all 28 EU member states. By comparison the ratio for Germany is about 0.3% of GDP. So if exports between the UK and Germany shrank 10%, the UK’s total exports would fall by four times more than Germany’s (as measured as a share of GDP).

Figure 9: 

The conclusion would be broadly the same if we analyse the impact of higher tariffs and thus import costs. UK imports of goods and services from the EU account for a sizeable 53% of the UK’s total imports whereas EU imports from the UK account for less than 6% of the EU’s total imports (see Figure 12). Of course this basic analysis does not differentiate between trade in goods and services or take into account export elasticity or substitutability. However, it does suggest that from a pure trade perspective the UK has more to lose than the EU and any other EU member state.

1. We argued that the British economy and Sterling were likely to face four potential headwinds in subsequent months: fiscal stimulus measures being unwound, a no-deal Brexit, higher taxes and a re-tightening of national lockdown measures in the event of the number covid-19 cases rising sharply during the winter months. The gradual unwinding of the government’s fiscal stimulus measures (including its generous furlough scheme) and ongoing social distancing measures in September weighed on a British economy heavily reliant on the service sector. GDP growth slowed from 6.3% month-on-month in July to 2.2% mom and just 1.1% mom in September (see Figure 4), in line with our forecast that “GDP growth halved in August and may have slowed to a trickle in September” (see Global growth: Collapse, Recovery, Slowdown…repeat?, 24^th  September 2020). Moreover, the stop-start nature of UK-EU negotiations over a new free trade deal ignited market concerns that the two sides may fail to reach agreement.