The great Brexit trade-off

Two years ago Boris Johnson’s government had just won a thumping election victory promising to “get Brexit done” and on 31 January 2020 the UK’s formal departure from the EU came into force. A lot of water has since flowed under the bridge and little could they have known that two years later Johnson would be embroiled in a fight for his political survival following the publication of the long-awaited Sue Gray report into “Partygate.” Despite having delivered on his signature policy, Johnson’s premiership has today come into question as never before, with even MPs on his own side prepared to stick the boot in (this intervention from Theresa May was priceless).

It is no surprise, therefore, that a very different government report released today has received virtually no coverage. Benefits of Brexit “sets out some of our achievements so far” and outlines how the government plans to “seize the incredible opportunities that our freedom presents.” It is hard to know where to start. So far, according to the report, Brexit has “ended free movement and [enabled] control of our borders”; “restored democratic control over our lawmaking”; “taken back control of our waters; “reintroduced our iconic blue passports” and “enabl[ed] businesses to use a crown stamp symbol on pint glasses”. To use one of Johnson’s favourite phrases, it really is a pyramid of piffle.

The ending of free movement has been such a great success that last autumn it made a significant contribution to the lorry driver shortage that seemed to impact most heavily on the UK. As for control of the borders, all it has done is make life harder for everyone. Queues have been building up at ports on both sides of the Channel as border controls are reintroduced. Restoring “democratic control over our lawmaking” rings somewhat hollow following the shenanigans in parliament in recent months, with MPs prepared to rig the rules to protect their own and apparently failing to follow the guidelines that all other citizens have to follow. Taking control of waters counts for nothing if fishermen cannot sell their catch and there is mounting anger in fishing communities that Brexit has not delivered the promised benefits. If the restoration of blue passports and the crown stamp symbol on pint glasses really are of such importance to the government, far be it for me to suggest that there was nothing stopping either of these things from being introduced whilst the UK was a member of the EU.

The losses from trade

The most obvious problems are manifest in trade flows due to the form of Brexit implemented by the UK. Merchandise exports in November 2021 were 7% below the average level in Q4 2019 with services exports down 9.4%. Despite a rally from the depths of 2020 exports are struggling to get back to pre-pandemic levels. By contrast German exports in November were 6.9% above Q4 2019 levels. However the statistical office reported that German exports to the UK in November 2021 were down 7.9% compared to the same period a year earlier, suggesting that exporters are finding it more difficult to conduct business with the UK. 

This accords with the results from a paper by Fernandes and Winter (2021) looking at transaction-level export data for Portugal which suggested that exporters reduced export volumes and export prices in the UK market after the referendum shock in a bid to remain competitive. As the trading relationship between the UK and EU continues to evolve, the authors note that such behaviour is likely to make the UK a less attractive market for EU exporters with the decline in prices placing an increased squeeze on margins. Their estimates also point to “a high degree of exchange rate pass-through into consumer prices in the UK after the shock, implying rising inflation and living costs."

Aggregate data suggest that in real terms, UK merchandise trade volumes are currently 12% below Q4 2019 levels. According to the CPB World Trade Monitor global trade volumes have surged, with exports up 17% on late-2019 levels. As a consequence the UK’s share of world trade has fallen well below 2019 levels even if there has been a sharp rebound in the most recent figures (chart above). We only have a year’s worth of data and the Covid shock has obviously exacerbated the problem but it is clear that Brexit has got off to a bad start in terms of its trade impact. There is nothing on the horizon to suggest that the trade agreements currently in the pipeline will generate a big enough boost to offset the damage done to trade relationships with the EU.

Business investment has also clearly stalled (chart below) as the uncertainty effect kicked in. Between 2016 and 2019 there was very little growth in investment volumes and although it has come off its 2020 lows, it is still almost 10% below the 2016-2019 average. As a result, growth in the net capital stock slowed in the wake of the Brexit referendum, from around 2¼% per year prior to 2016 to a rate around 1¾% over the period 2017-19.  To the extent that this is a fundamental driver of the economy’s potential growth rate, the evidence does point to an uncertainty shock adversely affecting the UK’s growth rate and is consistent with the OBR’s prediction that Brexit will cost 4% of GDP in the medium-term.

Obviously it is still very early in the post-Brexit period and until the pandemic effect has fully unwound we will not be in a position to make any definitive assessment. But on the evidence so far many of the downsides which we warned about appear to be making their presence felt. In Johnson’s foreword to the Brexit report he noted that it will allow the UK to “seize the incredible opportunities that our freedom presents and use them to build back better than ever before—making our businesses more competitive and our people more prosperous.” The problem with much of the Brexit bluster is that it assumes the UK will have sufficient control over its future to realise these possibilities on its own. It makes no allowance for the fact that other governments may not want to play ball. Those who run businesses take a much more realistic view about what Brexit means for them and government boosterism cuts no ice. And even in the unlikely event there are considerable upsides, it is highly probable that on the basis of recent events Johnson will not be in office long enough to enjoy them.

The cost of living problem

The biggest economic surprise of 2021 was the resurgence of inflation. This was largely unforeseen at the start of last year and even by the spring was still not expected to become a significant problem. Thus the news that global inflation has hit multi-decade highs is an unwelcome development for households who have to deal with the fact that prices are increasing much more rapidly than wages and central banks who have to decide how to respond.

People aged 30 or younger were not even born the last time European inflation rates reached current levels. Data for December showed the German inflation rate at 5.3% – the highest since 1992, which was also the same year CPI inflation in the UK last exceeded the December reading of 5.4%. We have to cast our minds back to the era of Paul Volcker for the last time the US inflation rate exceeded the 7% rate posted in December (1982, for the record). Those who thought high inflation was a thing of the past have had an uncomfortable awakening in recent months. This is attributable to a combination of global supply bottlenecks in the wake of the pandemic and rising energy prices, both of which are likely to prove temporary (although temporary could mean anything up to two years). Both these elements were encapsulated in the UK data for the transport component of the CPI, which accounted for almost one-third of the annual inflation rate last month. The cost of vehicle purchases rose by 13.9% in the year to December with shortages of key components pushing up prices, whilst fuel costs were up 26.6% on the back of higher oil prices.

UK inflation is set to go higher still when the domestic energy price cap is raised in April. This sets a limit on the maximum amount suppliers can charge customers for each unit of energy consumed. The new cap will be announced in February but is expected to rise by anything between 46% and 56% on the basis of recent trends in wholesale energy prices. Other things being equal this may be enough to push CPI inflation close to 7% in Q2 (chart below). For the record, the BoE’s November forecast pointed to an inflation rate of 4.8% in the second quarter: we can expect a significant upward revision when the new forecast is released next week.

A cost of living “crisis”

All this has given rise to lurid headlines about a “cost of living crisis” and the possibility that many UK households will be pushed into fuel poverty, officially defined as above average fuel costs that push their residual income below the poverty line (a rough rule of thumb adopted in Scotland, Wales and Northern Ireland is that a household suffers from fuel poverty when it spends more than 10 per cent of its income on fuel). The poverty campaigner Jack Monroe made the point in a Tweet that subsequently went viral that the index used in calculating the cost of living “grossly underestimates the real cost of inflation” using the case of rising food prices as an example.

This is both right and wrong. It is right because the CPI is calculated on the basis of average spending shares on particular categories of goods and services, but these differ according to income. Thus if prices rise more quickly for those categories where poorer households have a high spending weight, the average CPI inflation rate will understate their “true” inflation rate. But that was not the case in 2021. I am indebted to the calculations by Chris Giles, which I have attempted to replicate, which demonstrate that price inflation has been higher for households at the upper end of the income scale because their spending basket has shown a faster inflation rate than for those lower down the scale. On my calculations, the inflation rate for households in the lowest income decile was 5.3% in December versus 5.8% for those in the highest decile.

None of this is to say that we can ignore the distributional aspects of inflation. The rise in the energy price cap will almost certainly hit households at the low end of the income scale disproportionally hard. This raises a question of what, if anything, should be done about it? The financial market response is clear – central banks should raise interest rates, and they probably will, but it is unlikely to have any impact on a supply-driven inflation shock. Indeed central bankers find themselves in an impossible situation. If they don’t raise rates at a time when inflation is overshooting target by a wide margin, the future credibility of inflation targeting regimes will be compromised. Against that, if consumers are facing a cost of living crisis in which real income growth is being eroded by exogenous price shocks, monetary tightening is more likely to exacerbate these concerns.

As MPC member Catherine Mann pointed out in a speech last week, the evidence suggests that the recent inflation surge is not based on a narrow range of goods and services but is increasingly looking more broad-based and “has seeped into those [components] that typically are rather stable.” She also pointed out that “Bank research shows inflation expectations tends to be correlated with wage demands, and that items that consumers buy frequently, such as energy, food, and clothing have particular salience for their short-term perceptions of inflation.” A gradual tightening of monetary policy to offset the threat of a wage-price spiral would thus appear to be a prudent move.

Alternative ways to tackle the energy inflation problem

However, it seems clear that monetary policy is only going to be part of the solution in the near-term. One temporary fix to offset the inflationary impact of higher energy prices might be to zero-rate domestic fuel bills for VAT purposes (in the UK it is currently charged at a rate of 5%). It would come as no surprise if this measure were to be announced in the spring budget in March. Another option might be to remove the green levy on household fuel bills, and instead fund them out of general taxation. At present, the Energy Company Obligation (ECO) requires medium and larger energy suppliers to fund the installation of energy efficiency measures, which is charged back to the consumer via their energy bills (primarily electricity). Permanently scrapping the ECO would obviously reduce energy bills, and thus inflation, but would require an increase in taxation elsewhere to fund the shortfall. This problem could be mitigated if the ECO were scrapped for just a year.

One downside with these solutions is that they would benefit both poor and wealthy households and do little to tackle inequality issues. Amongst the alternatives that have been floated are the extension of existing government-funded support to those on means-tested benefits or simply restoring the uplift to Universal Credit that was put in place during the pandemic but taken away in October. Whilst these measures will do nothing to tackle rapid price inflation in other areas they may help to avoid the worst case outcomes in 2022.

Unpleasant choices ahead

Nonetheless, we are likely to be faced with a series of unpleasant choices in the months and years ahead and tinkering with the tax and benefit system is unlikely to resolve them. On the one hand we will likely have to face up to higher taxes as governments attempt to claw back some of the fiscal costs associated with the pandemic. As it is, UK national insurance rates are set to rise in April, at the same time as the energy cap is due to increase. There is also a wider issue associated with the transition to green energy sources. If we are serious as a society about making this transition, there will be a price to pay and consumers will ultimately have to bear it.

Although the pressures on consumer incomes are particularly great at present, and will undoubtedly diminish with time, we may not return to the nirvana of strong income growth and low price inflation anytime soon (at least, not without a recovery in productivity growth to something like pre-2008 rates). The transition to the post-Covid economy may prove to be more painful than anticipated.

"Life was never better than in 1963"

According to the poet Philip Larkin “So life was never better than/In nineteen sixty-three.” It was a year when Martin Luther King delivered his “I have a dream” speech and the year when the Beatles emerged to light the touch paper of the 1960s social revolution. It was also a highly tumultuous year which saw increased American involvement in Vietnam and the assassination of John F. Kennedy. Here in the UK the Profumo Affair caught the public imagination in which a cabinet minister was revealed to be having an affair with a woman who was also involved with a Soviet naval attaché, thus posing a potential national security risk.

The Profumo scandal severely dented public confidence in the government and rumours swirled that senior members of the Royal Family were also caught up in this messy web (sounds familiar). The establishment attempted to close ranks to protect the status quo but something in Britain profoundly changed. The author Pamela Cooper concluded three decades later that “it wouldn't be too much to say that the Profumo scandal was the necessary prelude to the new Toryism, based on meritocracy, which would eventually emerge under Margaret Thatcher.” The historian Richard Davenport-Hines suggested that “authority, however disinterested, well-qualified and experienced, was increasingly greeted with suspicion rather than trust.”

Something similar is stirring today with a “last days of Rome” feeling to the UK public debate. Just as voters in 1963 were increasingly out of tune with politicians who had come of age during the Edwardian era, many people today are expressing outrage as revelations of the government’s behaviour during the pandemic come to light. We can even stretch the parallels a bit further. In 1963 the Conservative government was about to celebrate 12 years in office; was onto its third prime minister (Churchill, Eden and Macmillan), with a fourth (Douglas-Home) set to take over before the year was out, and had engaged in a disastrous international excursion in the form of the Suez Crisis. Fast forward to 2022 and the Conservatives are into their twelfth year in office; have had three prime ministers (Cameron, May and Johnson) and have engaged in a colossal economic gamble in the form of Brexit. History does not repeat itself; it may not even rhyme all that often, but the lessons of the past suggest that this is not going to end well.

The playwright Arthur Miller penned the line “you can quicker get back a million dollars that was stole than a word that you gave away.” This goes to the heart of the government’s troubles: It has lost the trust of the electorate. The same thing happened to John Major’s government following sterling’s departure from the ERM in 1992. Boris Johnson today epitomises that lack of trust. Ironically, the foreign press has always tended to see through him in a way that the British press has not. This week the European press went for the jugular with the Süddeutsche Zeitung suggesting that “Johnson does not govern: He merely plays at being premier.” Jyllands-Posten in Denmark commented that “The garden party is over for Boris Johnson” and pointed out that “it's like reading Animal Farm all over again - Orwell's satirical fable about the Soviet Union under Stalin: all animals are equal, but some are more equal than others.” Perhaps one of the most damning pieces was that published in the New York Times which accused Johnson of something worse than incompetence: A full scale “assault on civil liberties” and an “authoritarian assault so comprehensive that once settled as law, it will prove very tricky to unpick.”

It is ironic that drinks parties during lockdown should provoke such outrage whereas constitutionally outrageous actions such as proroguing parliament or the unlawful fast-tracking of PPE contracts to those with political connections were shrugged off. Nor has the assault on civil liberties outlined by the NYT had much impact. So why now? After all, it is not like Johnson’s actions come as any surprise to those who know him. He is clearly temperamentally unsuited for the highest office. Moreover, governments routinely break their electoral promises. It is not as if this government is any worse than many others on that score.

To get to the heart of the matter we ought to draw a distinction between political sincerity and political accuracy. In this framework, voters identify with politicians who reflect their beliefs (the sincerity effect) and are prepared to overlook factual inaccuracies – beliefs after all cannot be proven. Conversely, politicians who try to make a rational case find it more difficult to get through to voters if there is no meeting of minds. This is just a formal way of saying that people will believe what they want to believe, but it makes sense. Johnson was able to use the Brexit issue to propel himself to the political forefront by speaking to large parts of the electorate which were able to tune out his obvious failings. As the old saying goes, if you can fake sincerity you’ve got it made.

On the question of lockdown parties, Johnson was way out of  tune with the electorate. Voters sincerely believed they were doing the right thing by adhering to the Covid rules and were prepared to make the necessary sacrifices, including not being able to tend to loved ones that were dying. Perhaps if the government had come clean at the start rather than trying to pretend there was nothing to apologise for, it might – just might – have been able to ride this crisis out. It would at least have had a chance of maintaining its political sincerity.

Short of a miraculous turn of events, it is hard to see Johnson coming back from this (which calls into question my forecast that Johnson would still be in office at the end of 2022). As to what happens next, your guess is as good as mine. The so-called independent inquiry into gatherings at Downing Street (terms of reference here) represents an investigation by a civil servant into the actions of people she ultimately reports to. It is compromised before it has begun. Whatever the outcome, there has been a certain amount of jockeying for position in the event that Johnson is forced out. But Chancellor Rishi Sunak, who has long been tipped as a possible successor, is not exactly pulling up trees with his approval ratings. Nor is any other candidate for that matter.

One of the things I wish for 2022 is less focus on politics and more on economics. After all, when the UK is struggling to come to terms with the joint economic impact of the pandemic and Brexit, it is important that the government is focused on its job rather than this side show. Yet for all that domestic politics is increasingly viewed as a soap opera (the media’s obsession with tittle-tattle over the years has not helped), we can take comfort from the fact that things do eventually heal. Events do not come much bigger that the assassination of JFK yet the US did (eventually) move on. Perhaps we should view recent events – both in the UK and elsewhere – as the turbulence that results from the swinging of the political pendulum. But the ride could get wilder still before the turbulence abates.

Outlook 2022: Covid and all that

As we head into the third year of the pandemic, Covid will dominate the headlines again in 2022. There are three possible outcomes: things get worse, they get better or they stay the same (how’s that for insight?). Whilst this may be a statement of the obvious, whichever path we are on will have profound consequences for the economy and outlook for financial markets through the course of 2022 and beyond. Since it is impossible to predict how the disease will evolve, it is worthwhile setting out a few scenarios to assess the range of possibilities.

Case 1: The Covid situation gets worse

In the case where a much more virulent strain emerges, we could quickly find ourselves back in the same situation as 2020 with stringent lockdowns and a big hit to the economy. Unlike 2020, however, we will not be facing a totally new threat; we have experienced Covid waves before and the initial reaction from governments will be to impose fewer restrictions than in March 2020. Accordingly, the initial hit to the economy may be less dramatic. But if the emergent strain proves to be more deadly, there will be a significant hit to confidence and the economy may not rebound quickly as people realise that the pandemic is far from over. In such a case, governments and central banks will be forced to open the taps once again, despite the recent surge in inflation, which will continue to put a floor under markets with equities pushing on to new highs.

Case 2: More of the same

A repeat of the 2021 pattern would see a huge rise in cases at the start of the year as the Omicron variant works its way through, followed by a dip during the spring and summer before another less virulent strain emerges in the autumn. Such an outcome would likely mean an uneven recovery with decent but not stellar growth in the spring and summer and a slowdown over the winter months. Covid restrictions would likely be eased in the first half of the year but, as case numbers mount, continued pressure on health services suggest restrictions will be tightened later in the year which would particularly affect sectors such as hospitality as a quasi-lockdown is implemented. In this environment central banks can be expected to ease back on the monetary throttle to curb inflation in the first half of the year but stand pat in the second half, taking some steam out of markets which push ahead relatively slowly.

Case 3: Omicron proves to be the last hurrah for Covid

In the best case scenario, Omicron is the precursor to the emergence of a much milder form of Covid which becomes an endemic problem rather like flu. Economic growth settles towards trend rates and central banks can afford to be more aggressive in tightening policy. However, high inflation in general and rising energy prices in particular will act as a drag on household incomes, with the result that even in this environment GDP growth remains relatively slow. Against that households may run down some of the excess savings accumulated during the pandemic which will act as a growth support. Inflation is likely to slow as supply issues are largely eliminated by end-year and markets lose momentum in the face of higher interest rates and less dynamic growth. We may even start to hear talk of excess supply and disinflation before the year is out.

Politics and geopolitics are back on the agenda

After two years in which the world has been preoccupied with managing domestic pandemic issues, global geopolitical issues are a matter of urgency for western leaders who are increasingly concerned about a more assertive Russia and China. Russian troops have recently been building up along the Ukrainian border and the US has expressed concerns that this could be a prelude to invasion. We have been here before, of course. Last April, Russia built up troop numbers close to the border only to pull back, so latest moves might simply be another chapter in Vladimir Putin’s power play. But they may not, and in the event of invasion there is very little militarily that the west can do in response. The US has talked of unprecedented sanctions, which the Russians would counter by weaponising gas exports. At a time when European gas supplies are in a parlous state, this could have significant consequences for global energy markets.

President Xi Jinping is the most powerful Chinese leader since Mao and sits at the head of a country determined to regain what it sees as its rightful position at the top table. Unlike in Mao’s era it now has the financial and military clout to back up its ambitions. Recent years have demonstrated that China has no interest in living within the strictures of the western-dominated economic architecture, as its behaviour at COP26 demonstrated, and it continues to make threatening noises regarding Taiwan. Unlike Russia, China has no need to throw its weight around to demonstrate its power. But like Russia, it is increasingly seen as a competitor to western interests and the failed policy in Afghanistan, culminating in the shambolic withdrawal in 2021, will only encourage China to press at the west’s weak spots in 2022 and beyond, leading to even more fraught relations.

Here in Europe, Emmanuel Macron will face his biggest test as he gears up for the French presidential election. Despite poor approval ratings, the polls suggest he will easily make it into the second round where he will face a runoff against either Marine Le Pen or Valérie Pécresse, the centre-right candidate of Les Républicains. The polls suggest he can beat either of them in the second round but the pollsters have been wrong before, notably in the German federal election last year which saw the SPD come from behind to beat the CDU into second place. Still, it would be a surprise if Macron were not re-elected to the Elysée Palace in April.

Another leader under pressure is Boris Johnson who faces mounting discontent amongst his backbench MPs. There has been speculation that a leadership challenge could emerge in 2022 which might happen if a combination of failed pandemic response policies and Brexit pain add to existing woes over political scandals. My own view is that Johnson will end the year in Downing Street. Ditching a third Tory leader in six years, before their term is up, will not play well with an electorate that appears increasingly restive, particularly when there is no obvious candidate to replace Johnson.

Markets: More upside but how much is already priced in?

There are good reasons to expect more upside for equities in 2022, albeit not at anything like the 2021 pace. Economic growth conditions remain favourable and earnings are projected to increase at a decent pace. A high inflation environment in the first half of the year may see a rotation towards inflation trades with gold appearing to be a natural beneficiary along with energy stocks. Up to three Fed interest rate hikes are expected in 2022 which may take the edge off equities, but an absence of Covid-related uncertainty would limit any downside.

Crypto will be one of the fascinating areas to watch this year. Bitcoin hit an all-time high above $67,566 in November and although it has since slipped below $43,500 it is too soon to write off the possibility that it can rally back above previous highs. Although concerns about the energy cost of mining persist, and China has recently cracked down on Bitcoin mining, there has been more widespread retail interest of late. Any wobbles in the equity market could certainly see renewed interest in crypto assets as investors hunt for yield. I maintain that the future of cryptocurrencies will depend on the extent to which central banks enter the field, and with the likes of the Bank of England and ECB looking seriously at the prospect of introducing a central bank digital currency, this may well place a floor under any downside for crypto assets in 2022.

What else?

There are a host of other themes that will move the needle in 2022. Environmental issues are one of them and the debate over how to manage climate change can be expected to make its presence felt. This has traditionally not featured much in near-term economic thinking but maybe 2022 will be the year that we pay more attention to the risks. 2022 is also World Cup year. Assuming it goes ahead, the tournament will start in Qatar in November rather than coinciding with the European summer, which will make things interesting. I am not going to pick a winner but with qualification yet to be completed I can confidently state that Portugal and Italy cannot both qualify.

As 2020 showed, unexpected events are the true enemy of forecasting and whatever happens this year, there will be some unexpected events that come out of left field. As Martin Luther King once remarked, “you don't have to see the whole staircase, just take the first step” which is a good way of saying that so long as our forecasts are not outdated before end-January, we can be reasonably satisfied.