International Equities

Is this the new normal?

Pyrford International provide a snapshot of the UK economy as it inches closer to Brexit.
October 2019

The problem with commentating on current world events is that the word “current” is dynamic – every day seems to bring an accelerating rate of change. When you receive this missive Boris Johnson may or may not be the British Prime Minister. An election may or may not have been called. The hastily re-called British Parliament may or may not have blocked several more “solutions” to the Brexit impasse. Jeremy Corbyn may or may not be polishing his shoes in preparation for a visit to Buckingham Palace. And that doesn’t include allowance for the dramatic political events in the United States. So, we ask for your indulgence – we can only write with the knowledge of the day.

Our view is that the political and public hysteria surrounding the Brexit shambles has left commonsense and reason far in its wake. The anti-Brexit group suggest that if Britain were to leave the European Union the sky would fall and, in the memorable words of Sir Humphrey Appleby in the “Yes Minister” and “Yes, Prime Minister” television series of the 1980s, it would be “the end of civilization as we know it.” The pro-leave camp seems to address the issue in a slightly more sober fashion but nevertheless see nothing but gain with no loss.

Our guess is that many of the most vociferous would struggle if questioned about their detailed knowledge of the EU, its history, purpose, modus operandi and successes and failures. It has simply been accepted as a “given” without interrogation for many years. The Customs Union is key element of the EU operation, yet a former British Prime Minister allegedly commented that had he been questioned about the Customs Union whilst he was in office, he would have been forced to admit that he had no idea what it was.

Let’s attempt a brief (very) potted history.

After WW2 there was an understandable and commendable surge in efforts to ensure that such a disaster would never again befall Europe. In 1949 a Council of Europe was formed with ten members, but it was supplanted in 1952 by the six-nation European Coal and Steel Community. This strangely named body tied the two-key war-making industries together in a broadly-formed political alliance that would render another European war extremely unlikely.

In 1957 the Treaty of Rome was signed which led to the creation of the European Economic Community (1958) and, importantly, established a Customs Union. The then French President, Charles de Gaulle, blocked a British application to join the EEC in 1963 but Georges Pompidou, who succeeded de Gaulle, finally allowed British entry in January 1973 – under Britain’s Conservative Prime Minister, Edward Heath. Interestingly, a referendum was held in June 1975 over Britain’s continuing membership of the EEC and it was passed with a substantial majority (67%) but with strong resistance to many of the super-state goals of the EEC leadership.

Membership of the EEC steadily increased and in 1993 formally became known as the European Union following the signing of the Maastricht Treaty. The Lisbon Treaty of 2009 further amended various legal and administrative aspects of the expanding body. Today, there are 28 member nations of the EU. The eurozone, a sub-plot if you like, is made up of 19 of the 28 members. These 19 all adopt the euro as their national currency and come under the wing of the European Central Bank. The Eurozone sprang into life in 1999 with an original 12 members. Bank notes were not introduced until 2002.

The governance and administration of the EU is far too complex to be addressed in detail in these pages. In other words, we admit that we have great difficulty in coming to grips with what resembles a Jackson Pollock painting gone wrong. There are seven key decision-making bodies: the European Council; the European Commission; the Council of the European Union; the European Parliament; the Court of Justice of the European Union; the European Central Bank and the European Court of Auditors.

To further complicate matters the European Parliament is based in three different cities: Strasbourg (the official ‘seat’), Brussels and Luxembourg city (it hosts the Secretariat of the European Parliament). Most of the staff and institutions are located in Brussels but constant shuttling from city to city is required as Strasbourg holds 12 plenary sessions each year. This travelling circus is recognised as a huge waste of money and time, but France refuses to give up on Strasbourg.

What started out as an entirely admirable effort to eliminate future European conflicts has now morphed over 70 years into a large body controlling a great many aspects of everyday life in its member countries. The Economist has estimated that the European Parliament costs more than the German, French and British parliaments combined. And this excludes the cost of double-handling of many of the issues which inevitably cross-pollinate over the various jurisdictions.

The edifice is financed by its members. Payments are based on the size of a country’s economy, VAT receipts and customs duties on imports from outside the Customs Union. The largest net contributors in 2017 were, in order, Germany, the UK and France. In all, 10 countries were net contributors whilst the remaining 18 received more than they paid. Relative to the size of their economies Bulgaria and Hungary were the biggest beneficiaries.

 

Is it all worth it?

A quick browse of the effusive EU website would suggest that it is the most wonderful political/economic body to have ever graced the world stage. We are informed it is the largest trading bloc in the world, accounting for 15% of world trade in 2017. Half of the EU’s trade was with five main partners: the US, China, Switzerland, Russia and Turkey. There were a combined 700 million items exported and imported and 332 million customs declarations.

And that brings us to the Customs Union – a bone of contention in the great UK Brexit fiasco. The Customs Union is simply an alliance of the 28 EU members which applies standardised rates of customs duties on goods imported from outside the Union – in other words, a common tariff wall (varying by product) is applied to all imports. Once inside the EU the goods are able to move freely around the 28 countries without any further levies or impediments. This, obviously, is a most advantageous feature of any Customs Union. In addition, the Union enforces rules relating to protection of health and safety; weapons trafficking; money laundering; counterfeit goods; prohibited products and the like. All of this saves each member country mounting duplicate defences. No member country is free to negotiate independent trade deals with non-EU countries. All negotiations are handled centrally, and any “deal” applies to all members.

The immediately obvious flaw in a Customs Union set-up is the “one size fits all” tariff arrangements. The UK does not produce bananas so has no need to tariff-protect that industry but is obliged to pay a tariff on non-EU bananas as parts of southern Europe do produce bananas and they ensure that their growers are protected. There are many examples throughout the EU where domestic prices are higher than otherwise would be the case because some part of the 28-country bloc is protecting its domestic industry. Tariffs always mean higher domestic prices and distort the efficient allocation of resources. We have never been fans.

Some of the arguments bouncing back and forth in the UK Parliament advocated staying in the EU Customs Union after leaving the bloc. This makes no sense at all as the UK needs the freedom and flexibility to negotiate trade deals on its own account throughout the world. The UK already conducts a higher percentage of its trade outside the EU than any other EU member so is well placed to expand these relationships.

Ultimately the UK debate about being in or out of the EU comes down to the question of sovereignty. The referendum outcome surprised Parliament, the civil service and the rest of the EU but when distilled it came down to enough people saying that they were tired of being “bossed around” by Brussels. They undoubtedly underestimated the difficulty of untangling a relationship that had been in place for over 40 years but expected, not unreasonably, that more than 3-years later the untangling would have been largely completed and the post-exit arrangements settled. They could not possibly have forecast the strength of the opposition to the “exit” – from the so-called “elites” and the Parliamentarians and officials on both sides of the English Channel. Some of the venom and obstruction issuing from certain members of the EU hierarchy has been ugly. The UK is important to the EU now and will continue to be important post-Brexit. It is senseless to embark on a new relationship despoiled by acrimony.

So now the UK has the idiosyncratic but determined Boris Johnson in charge of the “exit”. He has endeavoured to call a general election but has, so-far, been blocked. His various actions have been lambasted as undemocratic which is more than a little ironic as we tend to believe that letting the voters have their say is about as democratic as it gets. Our view is that the “exit” will happen but the route through the minefield over the next month or two is impossible to forecast. Randomly canvassing views in the UK over the last few months we were struck with the commonality of opinion: “Let’s just get this darn thing over and done with” was roughly the translation that is fit to print.

Many suggest that the UK economy fell off the proverbial cliff after the Brexit referendum – and no doubt some wanted that to happen. Even the Governor of the Bank of England has repeatedly spoken in dire tones. The facts, however, don’t match the rhetoric. Real GDP growth has been pedestrian but at least it has, so-far, stayed in positive territory and is healthier than many of its EU neighbours. Lower growth than the average of the last 40 or 50 years is a common feature of all developed economies. The latest OECD forecast (September) suggests UK growth in 2019 will be 1.0% – lower by 0.2% than the forecast in May. The ‘world’ growth is expected to come in at 2.9% (0.3% lower than the May forecast) whilst the US growth forecast has been lowered by 0.4% to 2.4%.

UK Real GDP growth

UK: Real GDP growth

Source: Refinitiv Datastream

Average real wages have held their ground and are now around 2% higher than at the time of the referendum (mid – 2016). The trend in the last few months has been up. Real wages growth in most developed countries has been anaemic for years. The UK does not suffer in these comparisons.

UK: Index of Real Wages

UK: Index of real wages

Source: Refinitiv Datastream

Retail sales growth has remained in positive territory and, in fact, is none too shabby relative to the past. House price inflation (Halifax index) has moderated substantially but average prices are nevertheless higher than immediately prior to the Brexit referendum.

UK: Retail Sales Volume and House Price Inflation

UK: Retail sales volume and house price inflation

Source: Refinitiv Datastream

And unemployment? The current rate is bobbing very close to a 50-year low.

So rather than tumbling down the cliff the UK economy has held up fairly well. It seems that the mayhem in parliament hasn’t deterred ordinary citizens and the many businesses from going about their daily life in normal fashion.

Obviously, exiting the EU with a deal will be preferable to no-deal but that outcome still remains an unknown. The OECD has attempted to calculate the potential difference between the two in growth terms and suggests that no-deal could shave a sizeable 2% from GDP growth relative to the baseline forecast in 2020 – pushing the UK into recession. However, there are so many variables at play that any forecasting comes with a significant health warning. The OECD admits to such.

Our sense is that whichever way Brexit convolutes in the next few months a clear and final decision one way or another can only be regarded as a relief and a positive. It will be a happy day when the topic disappears from the daily news headlines.

 

Also in this issue:
  • U.S. Yield Curve
  • Demographics
  • Australian House Prices
  • Eurozone
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Pyrford International Ltd is authorised and regulated by the Financial Conduct Authority, entered on the Financial Services Register under number 122137. In the USA Pyrford is registered as an investment adviser with the Securities and Exchange Commission. In Australia Pyrford is exempt from the requirement to hold a financial services license under the Corporations Act in respect of financial services it provides to wholesale investors in Australia. In Canada Pyrford is registered as a Portfolio Manager in Alberta, British Columbia, Manitoba, Ontario and Quebec. Pyrford is a wholly-owned subsidiary of BMO Financial Group, a company listed on the Toronto Stock Exchange (ticker BMO).

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