Four and a half years after the vote, Britain is properly out of the European Union and moving into a new era. It will surely be a freer nation, but will it be a richer one? Anatole has argued that the UK faces a long period of sub-par growth that will leave it worse off. My approach in this piece will be to consider the UK’s position by asking three questions: (i) What is the message from financial markets, which are forward-looking? (ii) How is the UK positioned as a trading nation? (iii) Which parts of the world economy will it gravitate towards, now that it can move according to opportunities rather than EU diktat?
Part 1: The message from financial markets
The exchange rate Let’s start with the sterling exchange rate, and deviations in percentage terms between the spot rate (red and yellow lines) and its purchasing power parity level (PPP line at zero). The reversion to PPP is one of the great “return to the mean” trades; it always happens but one never knows when. The “good news” for sterling holders is that the pound has been “undervalued” for more than four years against both the euro and the US dollar.
Now that the UK’s relationship with the EU has been settled, the pound can be expected to return towards PPP against both the euro and the US dollar. In both cases, this implies the pound rallying by 10%. It is also worth noting that the simple carry trade now favors the pound.
I conclude that for non-UK investors to hold British assets on an unhedged basis makes sense. For UK-based investors, owning unhedged foreign assets raises the likelihood of exchange rate losses being incurred. The pound has been undervalued against the US dollar and euro for more than four years The pound is set to return toward the level implied by its purchasing power parity.
The fixed income markets
Another powerful return-to-the-mean trade is the ratio between the total returns of two government bonds with the same duration and the same risks; i.e. the return of 10-year gilts when compared to treasuries and bunds in US dollar terms. On this relative basis, the UK bond market is clearly a buy.
If the cost of capital (see chart above) over the medium term is the same in two countries, the return on capital should converge to the same horizontal line. And since stock markets measure the return on invested capital, the ratio between the same two countries’ equity benchmarks should be flat. The chart below shows this ratio for the eurozone and UK mid-cap indexes. Gilts look decently valued when compared to bunds or treasuries Over time, the ratio between two similar economies’ equity markets should be flat.
The takeaway is that UK equities have hugely underperformed the eurozone market. Moreover, UK mid-cap equities—the best play on the UK economy— are about to get a technical buy signal versus the eurozone mid-cap index as the daily ratio is set to break through its 12-month moving average.
Conclusion on financial assets
UK financial assets look like they are positioned to outrun eurozone assets for the foreseeable future. Both the pound sterling and gilts have outperformed their US or German counterparts for a while now, yet retain the advantage of being undervalued.
I pass no judgment on the ratio between the US equity market and the UK one since the US market’s strong technology bias invalidates the comparison. However, the UK equity market bottomed versus the eurozone’s in March last year and seems likely to start outperforming.
Part 2: UK foreign trade after Brexit
So it seems that British markets are set fair, but is the local economy positioned to deliver the goods? In this section, I will focus on the UK’s external trade situation for goods simply because it is by far the most elastic to prices and revenues of all foreign trade accounts.
It is well known that the UK has run a sizable deficit in goods for many years. Less attention has been paid to it, in effect, having two deficits; one with the eurozone and one with the rest of the world. The chart below shows that over time these two deficits have exhibited very different characteristics.
The structural growth rate of UK imports from the eurozone (seven-year moving average) has long exceeded that of UK exports to the eurozone. This implies that since 2004 (when my data starts), trade with the eurozone has constantly subtracted from UK GDP. In contrast, it is clear that but for UK demand, eurozone growth would have been even more miserable. UK financial assets seem set to outrun comparable eurozone assets There has been a big difference in the UK’s deficit with the eurozone and that with the rest of the world
In the case of trade with the rest of the world, there is no similar relationship. Between 2004 and 2012, trade with non-EU nations subtracted from UK GDP, but since 2012 this contribution has largely been positive. Another way of looking at the relationship is to just compare the growth rate of UK exports to both the eurozone and the rest of the world. What I find is that since 2008, UK exports to the wider world grew by a robust 6% a year, while those to the eurozone expanded by just 1% a year.
The reason is that southern Europe was purposefully driven into a depression after 2010 as the price for “saving” the single currency system. From 2011 to 2020, UK GDP grew by 1.5% and 2.5% more than that of Italy and Spain, respectively. As a result, domestic demand in southern Europe, including imports from the UK, collapsed in these countries. And this led to a sharp deterioration of the UK trade balance and a lower UK growth rate.
Conclusion on trade
Being part of a shrinking trade bloc is no benefit at all. Seen in these terms, the UK’s departure from the EU was surely an excellent idea, even if it was done for somewhat different reasons. To put this in cruder terms, when a ship is sinking, being first in the life rafts is pretty smart. As a result of its EU exit, the UK’s economic system will now be able to trade more freely with the rest of the world (it has already signed 60 trade agreements), which should reinforce growth in its non-eurozone trade.
For its part, the eurozone seems likely to remain stagnant, especially as a chunk of UK imports in areas such as agriculture and automobiles may already be shifting away from the EU to the rest of the world. So, it is obvious to me, at least, that the UK’s exit from the EU is very good news for UK exporters and bad news for eurozone ones.
The investment implication is to buy UK companies that export outside of the EU and also UK domestic firms hit hard over the last four years. With the UK free to trade with whoever it likes, one impact should be to improve the margins of UK importers. Conversely, investors should sell big UK companies with a large presence in the eurozone. Since 2008, the UK’s exports to the eurozone have grown at 1% a year compared to 6% for the rest of the world The UK may have made the smart move to get out of a shrinking trade block.
There are some interesting relationships between the level of economic freedom and inequality among developed nations The “common law” cluster of countries favors more economic freedom and so incur more inequality.
Part 3: The new UK international drift
In a recent paper written for my dedicated portfolio construction venture, I explored how countries deal with the contradictory aims of allowing economic freedom while mitigating excessive social inequality. I measured freedom using the Heritage Foundation’s economic freedom index and for inequality, used country-level Gini coefficients published by the World Bank. The quadrant below shows the results with the interesting point being that among developed nations there are three distinct clusters.
1) Northern Europe, which groups the culturally Lutheran countries, or beer drinkers. In this cluster, countries are at the same time reasonably free (satisfactory growth) and very equal.
2) Southern Europe includes mostly Catholic countries, or wine drinkers, which have less economic freedom and quite a lot of inequality.
3) A “common law” group, made up of fellows who will drink anything, including the UK, the old Commonwealth and, surprisingly, Switzerland, the country of direct democracy. Here we have the world’s highest economic freedom rates but more inequality.
The usual stereotypes are pretty accurate. Northern European countries are organized around a social consensus favoring equality, but lose a bit on the freedom side. Common law countries favor economic freedom, as one would expect, and the price is higher inequality. And the Catholic countries favor neither freedom nor equality but the power of their elites and lose both on freedom and equality (but they do, at least, have the best wines).
Finally, there are two outliers; Japan, the country of the consensus, being unsurprisingly right on the average for both equality and freedom; and the US—very free and very unequal—which is perhaps to be expected in a country that has experienced massive and constant immigration. The stars are aligning for the pound to become Europe’s dominant currency… …and the City of London could become the financial capital of the world.
So how does this relationship relate to the UK’s situation? In my view, the UK should never have been in the EU, as it meant accepting rules that would have made it either less free and less equal (joining the Catholic bloc), or more equal but less free (joining the Lutheran bloc). Both movements threatened to change the nature of British society.
It should be noted, however, that despite efforts to do just this by leaders from John Major to Tony Blair to David Cameron, ultimately the project failed miserably. Look at the “sociological” map above and it is clear that the UK has stayed in its “old commonwealth” group, by remaining its educational and financial hub. While not shown on the chart, this function stretches to the likes of India, Singapore, South Africa and Nigeria.
Equally, a similarly unchanged national trait is most Lutheran-group nations’ build-up of “excess savings”. On this score, the City of London remains uniquely positioned to manage such funds, especially as many Lutheran elites were educated in the UK. Also, this Northern European block has historically had strong ties with Russia, which could reappear quickly and benefit the City of London. What I take from this is that the British pound is likely to become Europe’s dominant currency, while the City has a great future.
If the reader accepts my thesis that the world is moving towards there being two main currencies—the US dollar and the renminbi—and that the US and Chinese central banks may not be on the best of terms, then a third “neutral” financial center (in addition to Wall Street and Hong Kong) will be needed.
The only candidate is London, where the Brits will continue to do what they do best, namely, brokering trades between two zones that cannot deal with each other. More than ever, the City will be the “financial capital of the world”, where insurance companies, re-insurers, money managers and legal and accounting firms gather to handle the trades (and disputes) that will have to be settled on a neutral ground between the two dominant powers.
As my father, an officer in the French army, used to say: “Brits are annoying. They lose most of their battles but win all their wars”. Plus ça change, plus c’est la même chose.