Tracking the macro-financial impacts of Brexit uncertainties: Killing the goose that lays the golden eggs?

Tuesday’s IMF warning of the adverse (global) impacts of a Brexit vote, with some effects already apparent, follows concerns in the March MPC minutes (which seem likely to be amplified in Thursday’s April MPC minutes).  Unfortunately, neither provided any specific evidence. This post fills that gap, detailing the macro-financial impacts evident thus far, drawing on business/consumer surveys, Bank of England credit demand/supply data and financial market developments. The main points are:
•  Brexit concerns have raised business uncertainty, reduced firms’ risk appetite and reduced corporate demand for external finance.
•  There’s cross-survey evidence of a hit to corporate investment intentions, falling to three-year lows.
• Corporate hiring intentions show signs of faltering, although not in all surveys.
Consumer confidence has also declined on concerns about future general economic prospects, but with consumers apparently happy to make large purchases despite multi-decade low savings ratios and continued high debt levels.
•  Such macro impacts risk exacerbating the UK’s continued unbalanced growth dynamics (by further weakening capex) or slowing growth (by hitting consumption, the main growth driver). The IMF’s UK GDP forecast cut is consistent with markets likely paying increased attention to UK growth dynamics (here).
•   The most prominent financial market impact has been to generate a sharp fall in sterling, with the TWI down 11% since November, substantially greater than implied by interest rate differentials (especially GBPJPY).  GBP implied volatilities have also risen sharply while  option-implied downside risks to GBP have reached multi-year highs, with no post-referendum GBP bounceback anticipated.
•  Further sterling weakness seems likely in the run-up to the 23 June referendum, unless “remain” decisively pulls ahead in opinion polls, particularly against JPY, SEK and CAD but also probably versus EUR and USD (see here). That will add to inflatioary pressures and support exports, subject to weak foreign demand constraints.
• But Brexit concerns, combined with Fed dovishness, have also caused BoE rate hike expectations to be be pushed out to end-2019 as longer-maturity OIS rates have fallen sharply. Markets also now price a 28% chance of an MPC rate cut in 2016 and will be watching Thursday’s MPC minutes for dovish signals.
•  UK government bond yields have thus far been unaffected by Brexit uncertainties, with the Gilt-Bund spread remaining flat despite EA periphery-bund spreads rising. Gilt auctions have also remained well-covered.
• Foreign investors, who hold 26% of Gilts, made substaintial net sales of gilts in December, January and February.  And UK sovereign CDS premia have risen sharply. But it’s premature to sound alarms.
•  UK inflation breakevens have risen a little in 2016, alongside the oil price bounce, in contrast to continued weakness of EA breakevens.
MPC seem likely to continue their recent dovish theme on Thursday, with the minutes potentally featuring some of these macro-financial impacts. Rate cut votes will be constrained by wanting to avoid exacerbating uncertainties, although this will likely be a close decision for several MPC members. But MPC seem unlikely to try and push back against very dovish rate hike expectations before the referendum (the market probably wouldn’t listen!), not least because there is a positive option value of waiting for further information.  But they will likely welcome the inflationary impulse from lower market rates and sterling’s depreciation.

Bank of England and IMF concerned about Brexit impacts – without being very specific 

The March MPC minutes stated that “there appears to be increased uncertainty surrounding the forthcoming referendum on UK membership of the European Union. That uncertainty is likely to have been a significant driver of the decline in sterling. It may also delay some spending decisions and depress growth of aggregate demand in the near term.” BoE Governor Carney also argued that Brexit respresents the greatest domestic risk to UK financial stability.

The IMF sees Brexit having wider implications as it”could pose major challenges for both the United Kingdom and the rest of Europe…. resulting in an extended period of heightened uncertainty that could weigh heavily on confidence and investment, all the while increasing financial market volatility…also likely disrupt and reduce mutual trade and financial flows“. Upon questioning IMF Chief Economist Obstfeld ackowledged that the IMF didn’t have any detailed material to back up those broad points, stating “It is obvious that there is a lot of uncertainty at the moment about what will happen in June that it is weighing on confidence and investment in the UK.”

So there’s an important gap to fill.  Below I detail the evidence on such macro-financial impacts of Brexit uncertaintes right now generated just by the process of having such an important referendum whose outcome is so uncertain.

Brexit causing higher business uncertainty

An important channel via which the EU referendum vote can adversely affect UK economic prospects is by raising uncertanties about the business environment, thereby adversely affecting business plans.  And the Q1 Deliotte CFO survey provides substantial evidence of such evidence of such impacts.  In particular, 83% of CFOs now rate the level of external economic and financial uncertainty facing their business as above normal or worse, the largest proportion in more than three years (see chart). Associated with this, their risk appetite has fallen to a three-year low: only 25% of CFOs now think that it’s a good time to take risk, down from 72% in Q4 2014.

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That reduced risk appetite accords with 2016’s “risk off” financial market theme (although this appetite has recently recoverd on the dovish Fed, oil price rises and reduced China concerns, see here). But its’s notable that CFOs rated the EU referendum as the most important risk they’re currently facing, with those concerns having risen over the past 3 months (see chart above). The Deloitte report noted that “The dominant concern for CFOs is the forthcoming EU referendum. It tops the corporate worry list, eclipsing longstandingconcerns about emerging markets and growth in the euro area.” But worryingly,  only 26% of CFOs reported that their firms have Brexit contingency or are developing them.

Similarly, the Q1 BCC survey (released 11 April) reported evidence of “a slowdown in Q1 2016. This is the inevitable consequence of mounting global and domestic uncertainties“.  And the March services PMI release reported that: “Global economic uncertainty and the upcoming EU membership referendum were commonly reported to be factors undermining service sector business expectations during the month.” More provocaively, the March CBI/PWC financial argued that “Concerns over China and a volatile start to the year for markets, alongside uncertainty about a possible Brexit, have created a perfect storm to dampen optimism in financial services.”

Corporate external financing demands have fallen

The elevated uncertainty and risk aversion has translated into CFOs thinking that it’s a relatively-poor time to raise external finance, with sharp falls in the attractiveness of both bond and equity issuance (see Chart).  CFOs also think that the attractiveness of bank borrowing has declined, albeit substantially less.  But today’s BoE credit conditions survey also reveals a sharp drop in corporate demand for bank lending in Q1, especially from medium-sized firms. And the survey anticipates a further drop in large corporates’ bank lending demand over the next three months. The concern is that a relatively weak credit demand backdrop equates to downside risks to capex and employment intentions.

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That said, actual PNFC external finance raising has looked reasonably OK in recent months (see Chart below) bank lending flows to PNFCs have remained positive in recent months (see chart below) although the data are only to February and so might not catch Brexit concerns). That’s mainly a story of bond financing, with equity issuance notably absent.  Bank lending flows hae also been ok, although the latest 2.6% y/y growth rate is hardly scorching.  So overall there’s some potentially-worrying signs from UK corporate financing side, which need monitoring for signs of a sharper slowdown.  Certainly, MPC will be very interested in these developments.

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Brexit worries hitting corporate investment intentions (capex)

More worryingly, there’s cross-survey evidence that such elevated uncertainties have caused a reduction in corporate investment intentions.  That’s unsurprising given capex’s “chunky” and irreversable characteristics: higher uncertainty raising the option value of waiting for a resolution of the uncertainty one way or another.  In particular:
•  The Q1 Deloitte CFO survey shows the weakest capex intentions in several years, actually pointing to a capex reduction (see Chart).  The survey also reports a scaling back of CFOs’ M&A plans, to their lowest since end-2012.
•  The BoE Agents survey (data to February) reports weak(er) investment intentions in both manufacturing and services (see Chart).  Manufacturing intentions are the weakest since Q1 2010, while service sector investment intentions are the lowest since November 2010.

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•  The April BCC survey reports lower investment intenions in both manufacturing and services (see chart), again representing around three-year lows. The reports’ authors commented that “From sales and orders to confidence and investment intentions, many of the business indicators we track are at a low ebb.”
•  While the CBI industrial trends survey is a bit of an outlier in reporting a recent improvement in investment intentions I place less weight on that given that it’s the most out of date (released in January). For what it’s worth, the survey reports that demand uncertainty is the main factor limiting capex plans on the next 12 months (see chart below).  Although that constraint doesn’t look especially high, it’s plausible that if anything it will have risen since January (the next CBI report will make interesting reading).
• But the more recent CBI/PwC financial services survey paints are more negative picture, more consistent with the Deloitte CFO survey. In particular, the survey noted that “now that the referendum date has been set some investment decisions have been put on hold by some firms, though this is not widespread.”

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This hit to capex plans apparent from this combination of surveys is worrying given the recent weakness of fixed investment, which represents an important element of the continued unbalanced nature of UK growth (alongside growth continuing to overly consumption-driven and net exports dragging).  There seems little prospect of more balanced UK growth from this quarter, although sterling’s recent depreciation should support net exports (subject to weak Euro Area demand). Indeed market concerns about UK growth prospects seem likely to growth with cosumption potentially running out of steam, given that the savings rate has fallen to multi-decade lows, plus the fiscal consolidation dragging on growth over the next four years  (see my previous post and below).  Tuesday’s 0.3pp downgrade to the IMF’s 2016 UK growth forecast may not be the last.

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Also hits to hiring intentions, although evidence a bit less compelling

There’s also survey-based evidence for the Brexit uncertainties adversely affected firms’ hiring intention.  This again wouldn’t be surprising given that expanding employment has investment elements to firms i.e. difficulty in reversing at short notice, although flexible UK employment contracts ameliorate that.  The evidence isn’t as universal across the various surveys as was the case for capex, but there’s sufficient to be notable.
•  The hit to employment intentions is most apparent in the Deloitte CFO survey and in the BoE Agents survey (see charts below). In the former employment intentions are around three-year lows.  In the latter manufacturing employment intentions are their most negative since November 2009, while services employment intentions are “only” the weakest since September 2013.

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• There’s also a notable downtick in manufacturing employment intentions in the April BCC survey, continuing a decline apparent for several years.  But services employment intentions actually rose back a little, to remain within the range over the past couple of years.  Moroever, unlike the BoE agents survey, the BCC survey sees recruitment difficulties at the highest for 18 years in the service sector.  But nevertheless the upward pressure for higher pay settlements apparent in the previous BCC survey unwound in the latest release.
• The European Commission monthly survey of UK employment expectations hasn’t demonstrated any major recent falls, and the data goes to March (at a stretch there’s a fall in the expected retail employment balance, but that could reflect the impact of the national living wage).  That said, employment expectations in both industry and services are substantially weaker than two years ago.
• The CBI industrial survey suprisingly reports a recent improvement in expected employment, but I again downplay that due to it being the most out of date.

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Consumer confidence down on general economy concerns but remain happy to make large purchases despite low savings

There’s also been a bit of a fall in UK consumer confidence, with the overall balance falling to zero from +7 in mid-2015, which GfK attributes partly to Brexit concerns despite good economic headlines about low inflation, interest rates and prices in the shops, concerns about Brexit and the ongoing Eurozone crisis appear to be hitting home.” Interestingly, that hasn’t reflected concerns about higher future unemployement (alongside weaker corporate hiring plans) – the future unemployment balance has ticking up only marginally in 2016, although its nevertheless up 16pts from it’s mid-2014 low (but remains  way below the 2009-12 levels).

Rather the main mover has been a reduction in confidence about the UK’s future sutuation, down 18pts over the past year and down 25pts since its mid-2014 highs. By contrast consumers’ expectations of their own financial situation remain at their highest since November 2007. This situation of personal financial expectations being significantlt stronger than general economic expectations mirrors the situation in the run-up to the financial crisis, which didn’t end well!  It’s also notable that households’ major purchasing intenions remain fairly strong – consumers seem willing to keep on spending for now – which also has echoes of the pre-financial crisis period.

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But the concern is that UK growth remains overly-dependent on a continuation of strong consumption growth.  I illustrated above that consumption has been one of the main growth, along recently with stockbuilding. The snag is that the strong consumption trajectory has been accompanied by the household savings ratio falling to a multi-decade low of 3.8% in Q4 (see Chart above).  This suggests, with likely weaker employment growth (see above) and wage growth continuing to disappoint (despite elevated vacancies), that it will likely become tougher for consumption to continue driving growth. Moreover, the continued high household debt-to-income ratio, actually up marginally in Q4, represents a further vulnerabilty/constraint on continued strong consumption.  And the UK may struggle to generate alternate growth drivers given weak capex prospects (see above), an average fiscal consolidation of 1% of GDP per year over the next four years and weak Euro Area growth holding back UK exports. Nearer-term, it’s notable that the  NIESR GDP estimate, which aggregates higher-frequency surveys and official data releases, shows growth falling to 0.3% q/q (see Chart), versus 0.4% implied by the PMI data.

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Major impacts on sterling: significant depreciation, elevated volatility and downside risks (more to come)

My previous post dissected the significant impacts of Brexit uncertainties on sterling, in both spot and options spaces.  So here I just re-iterate the main points:
• Sterling’s sharp 2016 depreciation (TWI down 11% since November) has substantially exceeded that implied by rate differentials (with short or long, see Chart).
• GBP’s 2016 weakness broadly tracks bookmaker Brexit betting odds, but has recently deviated from that and the recovery in market risk appetite as concerns about the UK’s record 7% of GDP current account, and the greater reliance on more-volatile portfolio flows to fund it, have risen (even if partly reflects Euro Area weakness depressing rates of return on UK FDI assets and the UK international investment position has been improving to only -3.5% of GDP on positive valuation effects generated by the “risk sharing” nature of the UK external balance sheet).
GBP implied volatilities around and following the EU referendum are extremely elevated, both in absolute levels and relative to G10 FX volatility (see Chart).  The Scottish referendum experience indicates that shorter-maturity vols are likely to rise sharply over the coming weeks.

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Market-implied downside risks to GBP (risk reversals) have risen dramatically to multi-year highs. That’s particularly versus JPY, and to a lesser extent versus EUR and USD while being substantially less apparent versus SEK and CAD. Notably, 6-month risk reversals are extremely similar to  3-month ones: the market isn’t pricing a post-referendum GBP bounceback.
Further GBP depreciation and rises in GBP volatilities seem likely in the run-up to the 23 June referendum – the Scottish Referendum experence indicates that the issue really comes into focus as the event approaches – especially versus JPY, SEK and CAD but probably also against the main bilaterals EUR and USD.

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Of course, sterling’s fall represents it’s useful role as a “shock absorber” kicking in.  On 23 February Governor Carney recognised this, arguing that a weaker pound could offset the U.K.’s other economic frailties and help boost inflation. Given worries about persistently-low inflation (the latest inflation uptick was driven by the changed timing of Easter and so shouldn’t affect MPC dovishness) MPC won’t fight too hard against sterling’s depreciation.  Indeed, they’ve previously worried that it’s strength was hurting exports and manufacturing.  That said, foreign demand conditions tend to be more impactful than FX movements, so we shouldn’t expect a rapid improvement in the trade deficit. Rather the biggest impact, unnoticed by many, will be the positive valuation effects on the UK international investment position i.e. preventing the sequence of large current account deficits translate into a worying rise in the external debt position.

BoE rate hike expectations pushed out to end-2019(!) with significant chance of 2016 rate cuts

The second major impact of Brexit uncertainties has been to cause a sharp repricing of BoE rate hike expectations.  The first MPC rate hike is now not priced in until end-2019, as longer-maturity OIS rates have fallen sharply (see chart), also helped by dovish MPC comments (e.g. in the February Inflation Report, see here) and a substantial repricing of Fed rate hike expectations on Dovish Fed comments (see here). That pricing seems excessively pessimistic, it implies BoE raising rates at a similar time to the ECB which seems hard to square with the relative fundamentals (despite greater UK growth prospects concerns).  Moreoever, markets are now pricing a 28% chance of an MPC rate cut in 2016 (21% chance by the time of the August Inflation Report), which accords with today’s Reuters polls showing a majority of economist anticipating a BoE rate cut after a Brexit vote to offset the likely economic damage (see here, I agree). That’s lower than the 60% chance of a further ECB rate cut currently priced, despite the ECB signalling a switch in focus towards credit easing measures (see here), but considerably higher than 2% chance of a Fed rate cut in 2016 (although the chance of a rate rise is only priced at 53%). Of course, such market rates are mean expectations and hence incorporate scenarios such as Brexit (with a higher weight with greater market risk aversion) as well as the modal expectation.

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Gilts looking good, in contrast to EA periphery, but UK sovereign CDS premia up

In contrast to the strong impact of Brexit concerns on sterling and BoE rate hike expectations, the lack of an impact on UK government bonds has been a strong case of the “the dog that didn’t bark”.  Specifically, the chart below illustrates that the 10-year Gilt-Bund spread has not shown any appreciable upward trend on Brexit concerns. You can just about discern a 7bp rise in the spread since the announcement of the EU Referendum date, but Gilt yields have generally tracked Bund yields even after the ECB’s 10 March easing measures.  Moreover, it’s notable that over this “risk off” period EA periphery-Bund spreads have widened reasonably-markedly, especially for Portugal giving it’s ongoing political issues, but also for Spain (politics) and Italy (banking sector issues).

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So from Gilts seems to have been regarded as a safe haven in this “risk-off” period. And that impression is reinforced by the continued relatively-high bid-to-cover ratios on Gilt auctions (see Chart). In particuar, today’s auction of 30-year Gilts had a bid-to-cover ratio of 2.08, around the post-2008 average and similar to recent shorter-maturity auctions.

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There are, however, two less sanguine recent developments:
Foreign investors, who hold 26% of the stock of gilts, made reasonably-substantial net sales of Gilts in December, January and February.  This ammounted to the second-worst 3-month Gilt sales by foreign investors on record, substantially-larger than the sales around the Scottish referendum. At present it’s too early to sound alarm bells about this, given that the sales are not yet large relative to the outstanding holdings and other investors have patently been keen to purchase gilts (given yield moves and high auction coverage).  But this again bears watching, especially should concerns about funding the UK’s record 7% of GDP current account deficit become more pressing (although I illustrate here that the deficit partly reflects Euro Area weakness and that the UK international investment position has actually been improving).
UK sovereign CDS premia have risen quite sharply in 2016 (see Chart above). In particular, 5-year UK sovereign CDS premia have risen to their highest since July 2013, with the spread over their German equivalents hitting its highest since July 2011. This impact is probably linked to Moody’s 22 March warning that a Brexit vote may put the UK’s Aa1 credit rating at risk. After all, UK government finances remain in a fragile/exposed state and market sentiment could turn if Brexit put a large black hole in the finances (weaker tax receipts on slower growth and issues for UK financial services in a post-Brexit scenario). Such credit risks likely haven’t shown up in Gilt yields because they reflect Bank Rate expectations, inflation expectations (and risk premia) plus term premia as well as credit risks.  So sovereign CDS seem like the more natural instrument to trade and hence draw inferences about credit risks.  That said, despite their recent uptick UK sovereign CDS premia remain far below their 2008-10 levels and their rise may also have been driven by more elevated market risk aversion (albeit with recent improvements) as well as underlying credit risks.  So it’s too early to sound alarms. But this situation should be monitored over the coming weeks.

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Some good news on inflation expectations

One potential worry is that Brexit concerns could cause UK inflation expectations to de-anchor – if market participants were to start thinking that the recessionary impacts of a Brexit scenario would be so large that the MPC would have difficulty counteracting them (in an environment where market participants are increasingly sceptical about the efficacy of monetray policy).  But this particular dog hasn’t barked.  Rather UK inflation breakevens have risen a little in 2016, alongside the oil price bounce (see Chart).  And that contrasts with the continued weakness of EA breakevens, despite further EB easing last month (see here). This could, of course, reflect the significant repricing of MPC rate expectations (see here) or the likelihood that Brexit would be associated with a sharp sterling deprecition, pushing up on inflation at least near-term.

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MPC to remain dovish and cautious

I expect that Thursday’s MPC minutes will discuss this growing evidence of Brexit concerns hitting confidence, capex and hiring intentions and UK financial markets.  As such the MPC’s recent dovish and cautious approach will likely be amplified.  While several MPC members (Haldane, Vleghe) may be getting more tempted to vote for rate cuts, I expect them to conclude that such a surprising move would likely be counterproductive at present (leading to “what do they know that we don’t?” questions from financial market participants and firms/households).  In other words, they won’t want to risk “scaring the horses”.  Equally, MPC seem unlikely to try and push back against very dovish rate hike expectations  before the referendum (which would normally significantly raise their inflation projection, it will be interesting to see how they handle this in the May Inflation Report ).  On the one hand they may realise that the market probably wouldn’t listen.  But more importantly, the considerable uncertainty about macro prospects in the “remain” versus “leave” scenarios leads to a positive option value of the MPC waiting for further information (in analogous fashion to the impact on capex and hiring).  Such elevated MPC caution can also be motivated by the information they’re going to receive in the run-up to the referendum  likely being noisy because of Brexit uncertainty distortions i.e. MPC may well find it difficult to discern the underlying signal in official and survey releases.

That said, MPC may well welcome the inflationary impulse from lower market rates profile and sterling’s depreciation. This may, however, be relatively-low on their priorities over the next few weeks.  But it could come more into focus is a “remain” scenario, leading to repricing of UK rate expectations if there is no permanent damage to economic prospects from (temporarily) weaker capex and hiring.  That said, I also noted above that the continued unbalanced UK growth model may be reaching its limits. Moreover, continued fragile global economic prospects argue for continued MPC dovishness.  And MPC rate expectations will likely be importantly affected by Fed policy, which may well also continue to be cautious  given international uncertainties including the EU referendum (their June meeting is only 8 days before the referendum). So my modal expectation is that an early-mid 2017 MPC rate hike looks possible if Brexit is avoided and the associated macro impacts on capex and employment prove to be temporary. But the risks are definitely skewwed to later moves: I’ll be watching the data and MPC comments carefully.

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