- While a 'no-deal' Brexit scenario is not our main case, it most certainly could happen - and it would have significant economic and financial implications. In this piece, we share some broad reflections related to which path EUR/GBP could follow and the duration of it, should the UK leave the EU without a deal.
- In the event of no deal, the exact outcome of tariffs, economic performance, political uncertainty and policy response (fiscal and monetary) will be the key to the exact pricing of EUR/GBP. In this scenario, we target EUR/GBP close to but below 1.0 (GBP/DKK above 7.50), staying there for 6-12M, followed by a slow shift towards 0.85 (GBP/DKK around 8.76) in the following 1-2 years.
- To assess the FX implications there are four key factors to forecast (our expectation in parenthesis): A) the depth of an ensuing UK recession (shallow) B) the size of spillovers to the euro area (low) C) the inflation shock (mild), and D) quantifying the effect of tariffs and uncertainty into 'overshooting' versus our macro-fundamental model (we use 5%).
In this paper, we discuss the consequences of a no-deal Brexit under a scenario where the UK immediately crashes out of the EU with no transition period. Such a scenario is not our main expectation but it is nonetheless possible. We seek to shed some light on a no-deal event from the point of view of EUR/GBP as input for risk management discussions.
The paper is structured around the four key factors which enter our model to forecast EUR/GBP. We start with a discussion on tariffs, and then move to forecasting EU and UK GDP and inflation forecasts and the cross-country correlation and lastly we put these things together to create a coherent path forecast for EUR/GBP.
Tariffs: take EUR/GBP 5-10% higher, but it is temporary
In our view, the imposition of tariff and non-tariff barriers between the UK and its largest trading partner is truly of minor importance for GDP and CPI but the effect on EUR/GBP is very much measurable.
The point of departure is the institutional (IMF, BoE) ‘disruptive’ no-deal scenarios. These include an immediate reversion to WTO Most Favoured Nation (MFN – yes, the naming seems ironical) trading rules vis-à-vis the EU, entailing a 4% increase in tariffs and a gradual 14% increase in UK non-tariff trade barriers (in tariff equivalent terms) over a three-year period, according to the IMF.
Based on our experience (chart 1) with US-China tariffs and USD/CNH, we anticipate an effect on FX markets (beta) to the tune of 0.5-1.0. Taking into account the uncertainty of quantifying non-tariff barriers and the beta itself, we would suggest that a 5% rise in EUR/GBP can be justified on the basis of tariffs and tariff-equivalent barriers alone, with risk skewed toward the upside – but the impact on broad consumer prices is much more uncertain from the current historical perspective. The UK will also face a new tariff situation and need to respond against non-EU countries, but the effects of this on EUR/GBP are likely to be much smaller.
Over time, the tariffs and non-tariff barriers are broadly expected to fade as deals get done and the effect on the level of EUR/GBP should hence be temporary. This should provide a positive driver for GBP strength, in the years after the deals are enacted.
Spillover and macro scenarios: IMF’s, BoE’s and our view
The big macro effects are in our view directly linked to the possible disruption of crossborder flows of goods, services, capital and people in the immediate Brexit aftermath. The IMF’s and BoE’s worst-case scenarios suggest that the UK economy will enter recession immediately and that inflation will spike significantly.
The Bank of England expects (in the worst case) a peak-to-trough decline in GDP of 5.5 percentage points in absolute terms. The IMF projects a 3.5% reduction in GDP compared to a baseline ‘orderly Brexit’ by 2021. Estimates by the BoE suggest inflation may peak as high as 5.25% in 2020. By extension, the BoE easily makes the case that EUR/GBP will go above 1.0. In our view, a very deep recession is not aligned with a surge in inflation (conversely, a more shallow recession is consistent with a higher level of inflation, as is our base case). In 2008, there was a huge contraction in GDP but a minor effect of falling sterling on CPI. In 2016, after the Brexit vote and at a point where the economy worked fairly well – GDP did fine but consumer price inflation went through the roof on the back of falling sterling. In our view, the inflation impact appears business-cycle dependent.
Our expectation in a no-deal macro scenario is a mild recession and rising inflation but in scenarios which combined are milder than the worst case of BoE and IMF.
Shock duration: expect a 12M slowdown, 1-2y to normalise
In terms of duration, we expect a 12-month slowdown and a normalisation period of 1-2 years after a no-deal as we look at recent stops in capital flow in emerging markets as a guideline for no-deal Brexit. The inflation dynamics experienced in EM are probably not comparable to UK, but the GDP trajectory should be rather the same as the shocks for capital and trade flows are quite the similar.
In 2018, Turkey’s lira went into free fall on the back of a self-feeding inflation feedback loop, policy failures, and geopolitical standoff versus the US. The economy went from boom to bust in a matter of months, bottoming out in early 2019 - after one year (chart 2). The construction sector was badly hit and the supply shock (imported and domestic inflation) was partially mitigated by significant interest-rate hikes. Today, the economy appears to have been bottoming out and, in line with fading inflation, the central bank has been able to ease monetary policy somewhat and help growth. From the beginning of the slowdown to the bottom of the recession, the duration was one year and it appears it will take an additional 1-2 years for growth to come closer to the previously normal levels.
In 2014, Russia faced two sudden external shocks: a sharp fall in oil price and geopolitical deterioration linked to the events in neighbouring Ukraine. A 60% oil price slide within several months created massive pressure on the Russian economy and a massive fall in the RUB. On the back of which came a severe spike in consumer prices. Overall, the Russian economy contracted 2.5% y/y in 2015, before returning to tepid growth in 2016, and accelerating in 2017-2018 (chart 3). Roughly the same time frame as with Turkey.
In light of the limited historical experiences, we suspect a no-deal implies that the UK should expect a slowdown which will end in a recession which bottoms out 12 months after the country’s formal departure from the EU.
Summary of model input: GDP, CPI, tariffs and spillover
To forecast EUR/GBP, our fundamental model takes our view on expected GDP and core inflation as input and the model output is the exchange rate which historically has been consistent with getting those macro outcomes. To arrive at our expectation, we add an adhoc adjustment for tariffs as EUR/GBP would likely overshoot our model-implied forecast.
We expect normalisation in GDP growth, CPI and tariff levels after some years which is also in line with the IMF’s and BoE’s worst-case forecasts. In the event of a ‘no deal’, the resulting move in EUR/GBP would thus probably be temporary in nature.
There is uncertainty linked to thinking about how deep the ensuing recession would be relative to Europe. We apply a small spillover coefficient, in line with the institutional forecasts (see chart 4 and 5). With regards to expected GDP, we work with a baseline of consensus expectations at -1% growth (i.e. half the downturn that we saw during the 2008 recession). The European GDP thus follows a less extreme UK scenario (chart 4). Turning to inflation, we apply a correction for being in a state of recession and thus expect a similar shock as in 2016 but milder than the official worst-case estimates.
What if: Brexit without a deal? EUR/GBP towards 1.00 and back to 0.85 in 1-3 years
From these projected paths (see chart 6), the supply shock unfolds on a slightly larger scale than what we saw in 2016. As illustrated in chart 7, our macro expectations are aligned with EUR/GBP moving towards but staying below 1.0 and hovering there about 6-12 months. Following this and during, we expect EUR/GBP to start drifting down, targeting 0.85 based on economic differentials over a period of 1-2 additional years.
What will happen in a no-deal scenario is obviously highly uncertain but we nonetheless think the IMF and BoE have very negative worst-case scenarios and we have adjusted our ‘no deal’-view accordingly. The normalisation process in EUR/GBP may arrive faster if fiscal policy becomes extremely expansive or if trade and tariff agreements are reached quickly. Conversely, slower in the opposite situation. Our macro model is consistent with EUR/GBP at 0.95 but we add a buffer for uncertainty about when/if/what will happen and thus expect close to but below 1.0 as the initial reaction to no-deal.