The Silver Bullet | Introducing the Brexit Walrus

Friday, 31 March 2017

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“The time has come,” the Walrus said,
“To talk of many things:
Of shoes — and ships — and sealing-wax —
Of cabbages — and kings —
And why the sea is boiling hot —
And whether pigs have wings.”
The Walrus and the Carpenter, by L. Carroll


We now have a Divided Kingdom outside the European Union. Brexit will be a hard one, which will hit the UK economy and hurt most those who voted for it.


After an eight-year recovery built on rising asset prices and debt but stagnant wages, the poor and the old will see their incomes and savings dwindle. The canary in the coal mine is the Pound, which already dropped from over 1.50 to 1.25 against the Dollar. For an island that imports half its goods and food, this means higher inflation. High street retailers are already feeling the pinch: expect even smaller portions and less fruit and vegetables on the shelves.

But Brexit uncertainty could also scare off investment and push jobs away, as shown by some firms already relocating elsewhere. This means Britain’s ultimate store of wealth, property, could turn into a trap. With a fall in investment and demand from foreigners and interest rates already at the bottom, London’s market has already cooled off.


There is little the government will be able to do this time around: schemes like the Help-to-Buy will have to give in to the reality of a 5% budget deficit and the need for lower spending. Higher taxes may be on the way too. While the last budget from Number 10 ignored Brexit, some local councils are already feeling the pinch and threatening to raise taxes.


Brexit will cost Britain £140bn, 7.5% of GDP or the equivalent of £300m a week over eight years, according to our calculations based on direct costs such as job losses from the finance sector, as well as inflation eroding incomes and savings (The Silver Bullet | The High Cost of a Hard Brexit).


But for a country deeply divided by economic and social rifts, leaving Europe was never about the economy. It was about finding unity. Polarising public opinion against the EU and immigration and away from domestic issues was an easy political win. Yet Brexit will not fix the shortfalls of the Anglo-American growth engine, which ran on credit and rising asset prices over the past decades, disregarding rising inequality, a lack of inclusive access to education and declining social mobility. Britain’s richest and privately-educated seven percent makes up for two thirds of judges, around half of journalists and members of parliament, according to a government report. Meanwhile, the Child Poverty Action Group estimates that 3.9m children live in poverty. The UK ranks second in the developed world for inequality, after the US.


Brexit will not change that, nor will it make Britain more united: the English patient was sick long before his divorce from Europe. With an economy focused on finance and services and highly dependent on foreign investment, the idea of creating a “truly global Britain” isolated from his closest trading partner is economic la-la-land.

The reality instead will be a hard Brexit: Britain’s bargaining position is weak. Europe’s incentive is to give the UK a bad deal to set an example for other countries, yet not too bad to backfire. Britain’s incentive is to take it. Brexit Secretary David Davis recently admitted to not knowing the cost of a no-deal. His thinly-veiled threats to walk away from negotiations bear little credibility: Britain depends on the EU for half of its exports, while the EU exports to Britain only one sixth. For Britain, this means any deal would be better than none at all.


The irony is that running away from a European Union they thought was about to fall apart, Brexiteers have instead made it stronger. Electorates in France and the Netherlands are rejecting populism and politicians in Brussels and Berlin have switched gears towards reforms and pro-EU spending measures.


Theresa May, self-appointed leader in this historic negotiation, has so far revealed little about her strategy. We do not know whether beyond this secrecy lies a feasible plan. But one thing is sure: the Prime Minister has already weakened Britain’s negotiating position.


First, she wrong-footed the start by threatening to walk away and to make the UK a Singapore-style tax haven. Second, she has made unrealisable promises. Keeping substantial access to the single market and having strict immigration controls are mutually exclusive for the EU: achieving both is highly unrealistic. Third, the Prime Minister has not been honest about the true cost of Brexit. Theresa May said repeatedly that Britain could walk away without a deal and be fine. Instead, a painless exit without a cliff-like effect on trade is only possible with a transitional arrangement. To obtain that, the UK will likely have to pay the €60bn it owes from its past years of membership, as well as a membership fee for access to the single market.


Like the oysters fooled by the Walrus and Carpenter, Brexiters have bought into the illusion of shaping a fairer and more independent country. Soon they will realise that the Carpenter’s promises are just empty words. They will have no one to blame but themselves.


Brexit Game Theory: A Bad Deal Is Better Than No Deal

PM May officially triggered the Article 50 exit clause on March 29th and set out the UK’s negotiating principles in a letter to the EU. In our view, the four major points in negotiations will be:

1. The “divorce bill”: how much the UK still needs to pay the EU after leaving it
2. Free Trade Agreement (FTA) with the EU
3. Immigration policy
4. Transitional Agreement


From a game theory perspective, we think the Brexit negotiations are likely to lead to a bad deal for the UK, which it eventually has to accept.
On the one hand, the EU is incentivised to offer a bad deal to the UK to set a tough precedence for other countries: the political costs of appearing too lenient will outweigh the benefits from maintaining benign trade relations with the UK.

On the other hand, the UK is economically more dependent on the EU, where 44% of its exports go to and 48% of foreign investment comes from. This is not to mention the potential damage from a loss of passporting rights to the services sector, which makes up for around 79% of the UK GDP. Hence we think the UK may try to act tough at the start of negotiations, but eventually will have to compromise to avoid bigger economic fallouts.


As we illustrate below, the equilibrium scenario based on both sides’ incentive structures will be the EU offering a bad deal which the UK accepts.



Negotiating the Divorce, While Seeing the Kids

The first negotiation point will be to settle the divorce bill which the UK owes for its past years of membership. Past that, the key will be for Britain to secure a transitional agreement and avoid a cliff effect on trade. However, to reach a deal and to have access to the single market, the UK may have to compromise on immigration and potentially pay a fee. Both would require PM May to take a softer stance, something which currently is politically difficult given the split within the Conservative party.

The “divorce bill”: European Commission president Juncker and the EU’s Chief Negotiator for Brexit Michel Barnier have said that the UK has to pay an exit bill of around €60bn, and the bill would need to be agreed before beginning negotiations on an FTA or transitional agreement. The UK’s Brexit secretary David Davis so far ruled out paying for a hefty bill, as it would be politically challenging given that Brexiteers campaigned on a promise of “saving £350mn per week from Brussels”. In her letter to European Council President Tusk, PM May implicitly suggested that a Brexit bill would not be paid before a trade agreement, although she agreed to “determine a fair settlement of the UK’s rights and obligations as a departing member state”. Ultimately, we think the UK and EU would agree to a bill but which would only be paid after a trade deal is finalised: this would permit negotiations to continue, while not appearing as a defeat for PM May.

In our view, the complexity behind the Brexit bill calculation means there is room for the UK to negotiate vs the EU’s current estimate of €60bn. The exit bill itself mainly comes from the UK’s budget commitments for 2019-2023 which it still needs to pay post Brexit, unfunded pension liabilities for UK staff who worked in the EU’s institutions and other contingent liabilities. According to estimates by the Centre for European Reform, the bill could range between €24.5bn and €73bn, depending on the calculation methods and what will be covered.


Free Trade Agreement (FTA): PM May aims to achieve a “bold and ambitious Free Trade Agreement” with the EU and start negotiations early, as expressed in her letter to President Tusk. PM May has down played the challenge of achieving an agreement by stressing that sectors like the auto industry and financial services may adopt existing Single Market agreements as it “makes no sense to start again from scratch when Britain and the remaining Member States have adhered to the same rules for so many years”. However the reality will likely be an extended period of uncertainty as both sides may agree the broad terms of a trade-deal before 2019, but leave the details and ratification for a later date. Additionally, as part of the broad terms agreed to, the EU and UK will need to agree on an institution to settle FTA disputes so as to give the EU assurances that following a trade agreement the UK does not undermine the single market through “regulatory dumping” (FT).


Immigration: The Brexit-campaign focused on the costs of net migration and promised voters fewer migrants if Britain left the EU. PM May will now need to deliver on this promise, as she highlighted in her January speech in Lancaster House. While PM May has effectively ruled out the possibility of implementing a point-based migration system for EU nationals, the final deal may include a limit on net migration from the EU under a work permit scheme.

Transitional agreement: UK-EU trade will need to be governed by a Transitional Agreement, between the date that the broad terms of an FTA is agreed and when the FTA comes into effect. Rather than negotiating separate terms for this Transitional Agreement, we think during this period UK-EU trade will remain governed under EU law and the European Court of Justice.


Could the UK make a U-turn? A turnaround on the Brexit decision is very unlikely and would result in a split in the government and the Conservative party. However, the rational strategy to avoid a bad deal or no deal would be a more friendly negotiation aimed at agreeing on a transitional agreement and avoiding a cliff-like effect on trade. Doing this, however, requires political capital. The Prime Minister’s approach so far has been a tough one, partly to appease the hard-liners in the party. Negotiating a soft Brexit while appearing to be hard on the EU is a difficult strategy – and in our view it would take time and more signs of economic weakness before the UK is able to soften its approach.


More Downside for UK Financial Markets and the Economy

A weaker Sterling, with higher inflation: We think Sterling will likely weaken further as the illusion of a good deal fades. The Bank of England is unlikely to offer much help, both because it does not have the foreign-reserve fire power to defend its currency, and as the Bank will likely maintain an accommodative monetary stance to support growth in the face of rising inflation. A potential loss of reserve currency status would further hurt Sterling, which currently makes up 4.5% of global FX reserves. With the UK importing nearly 46% of its energy and 50% of its food, a weaker Sterling will lead to higher import-led inflation.


A growing public deficit: Mr Hammond’s Spring Budget effectively ignored the consequences of Brexit, predicting a decline both in borrowing and debt to GDP by 2021. The budget is predicated on unrealistic expectations of declining unemployment, falling inflation and steady growth. The reality is that the government may need to increase fiscal spending to support the economy, leading to a further widening of the fiscal deficit, currently at -3.8% of GDP.

Lower consumer spending hurting retailers: The OBR forecasts that UK household debt to disposable income will rise from 143% in 2016 to 153% in 2022. This will likely result in households having lower disposable income, at a time of higher inflation. UK retailers are likely to be squeezed by lower revenues and higher costs due to import-led inflation.


Negative real returns for savers: With the BoE likely to maintain low rates despite rising inflation, Britons will suffer from negative real returns on their savings which are already precariously low. According to a study by Money Advise Service, over 16m Britons have less than a £100 in savings. Properties are unlikely to provide sufficient protection, with markets already showing cooling signs given lower demand from foreign investors.
Conclusions: Brexit is a symptom of Britain’s deeply rooted economic imbalances: a growth model too concentrated on finance and services and dependent on foreign goods, human and financial capital, record-high social and wealth inequality, lack of investment in infrastructure and education and a monetary and fiscal policy which have favoured a property bubble and excess household debt. In their attempt to create a fairer and more equal country, Britons sought to sever ties from what they saw as a weakened partner. The reality is that Brexit will likely make Britain weaker and, ironically, is making the EU stronger.


Absent a coherent economic and negotiating strategy by the government, we believe the UK economy will deteriorate further. The most vulnerable assets remain Sterling, Gilts and consumer firms such as mid-market retailers. On the other hand, countercyclical like debt collectors are poised to benefit. In the Eurozone, we believe investors are overpricing political risks and underestimating the upside surprises in growth and inflation (The Silver Bullet | Don’t Fret about Frexit). We are positioned to gain from this upside in credit risk, rates and equity sectors linked to reflation and public spending: financials, infrastructure and defence.



“I weep for you,” the Walrus said:
“I deeply sympathize.”
With sobs and tears he sorted out
Those of the largest size,
Holding his pocket-handkerchief
Before his streaming eyes.
“O Oysters,” said the Carpenter,
“You’ve had a pleasant run!
Shall we be trotting home again?’
But answer came there none–
And this was scarcely odd, because
They’d eaten every one.”
The Walrus and the Carpenter, by L. Carroll


Alberto Gallo is Head of Macro Strategies at Algebris (UK) Limited, and is Portfolio Manager for the Algebris Macro Credit Fund (UCITS), joined by macro analysts Tao Pan and Aditya Aney.

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