The ongoing divorce settlement with the EU has moved into a crucial period. Negotiations will continue over the next few months and in our view this will lead to an outcome by year end, despite the embarrassment to the Prime Minister in Salzburg, because common sense will prevail and ultimately both parties are reliant on the strength of each other.
However, recent developments have also increased the possibility of a ‘no deal’ scenario and if that event was to unfold then expect to see sterling weakening again, in a similar fashion to immediately after the referendum vote, albeit from a lower level and to a smaller extent.
Looking ahead, expect the Brexit momentum to remain over the next few months as the parties look to work to an agreement on key issues. As has been the case since the referendum, the price of sterling provides a good indicator of how things are developing, more recently it’s been on the back-foot as we hover around $1.30.
Despite this backdrop, the Bank of England decided to increase interest rates in August, the second time in ten years – and to their highest level since the financial crisis.
What is surprising is the timing of this interest rate decision given its proximity to Brexit negotiations. There are two possible conclusions one can draw from this:
1. Either the Bank of England feels increasingly confident that we will achieve a positive outcome from ongoing Brexit negotiations and growth will remain strong as a result.
2. Or, the Bank is looking to inject some ‘firepower’ into the economy if we do face a bad outcome and is giving itself the flexibility to stimulate the economy in the not so distant future.
Interest rate normalisation is long overdue, with the overall strength of the economy and its growth over the last five years suggesting that we could withstand higher interest rates despite inflationary pressure.
In hindsight, the UK has actually been quite fortunate with the timing of Brexit, in the sense that it has coincided with the strongest period of global growth since the financial crisis and a world that has been the most synchronised it has ever been from a globalisation perspective.
Going into 2016, the UK was one of the fastest growing economies in the developed world but is now a laggard amongst these nations. Nonetheless, it is widely believed that the level of growth we are currently experiencing is strong enough to withstand higher interest rates, and this appears to also be the view of the Bank of England.
While it is unlikely that the current economic cycle will see interest rates peak anywhere near the last highs we saw back in 2007 (5.75%), perhaps half that figure would be a more realistic expectation for markets.
Famously, the Bank of England cut interest rates immediately after the referendum in August 2016 and restarted its quantitative easing programme in order to reduce the impact of the result on the economy. Perhaps this move will put the Bank in a ‘win-win’ position. If the Brexit result is positive they will have done the right thing, but equally, if growth stalls from a ‘no deal’ result then they will still retain the ability to manoeuvre going forward.
Global Trade Tensions
Away from the UK, trade tensions continue to dominate the headlines, as the ongoing US and China trade war ramps up. The White House has slapped Chinese goods with a number of rounds of tariffs during the year and China has retaliated in kind.
This hasn’t been positive for equity markets as it adds a level of uncertainty and threatens to slow global growth. It’s not just China that the US is standing toe-to-toe with at present, there are also ongoing political tensions with a number of other nations including Iran and Turkey.
The former is important because it’s been supportive of a higher oil price more recently and the latter has led to heightened risk aversion within Emerging Market currencies and equities. Set against this headwind was a strong earnings season, particularly in the US, which helped the market extend its lead as the best performer year to date, helped by further strength in the dollar.
In conclusion, we are moving into an interesting time in markets, US ‘negotiations’ with global nations are causing some isolated areas that we need to be aware of and respond to. Closer to home, we are still battling to understand what Brexit actually means. As always, we remain focused on navigating our clients through this period and taking advantage of opportunities as they arise.