London letter, week beginning July 4
“Sailing on unchartered waters, political risks on the rise”
Markets have been considerably volatile following the unexpected outcome of the long waited EU referendum, which opened a new door for uncertainties for the economy and triggered a shuffle at the core of the U.K.’s political parties.
The Brexit could be described as a Piraeus victory for the strongest Brexit supporters. However, the British pound has been volatile and sensitive to market developments and saw its lowest point of the last 31 years. Starting from last Wednesday, stock markets began to recover following the second statement of the Governor of the Bank of England, Mark Carney, who has been unique in bringing stability while navigating in unchartered waters.
Carney said the U.K.’s economy is already showing signs of strain and highlights the broader picture of ‘economic post-traumatic stress disorder.’ He hinted that official borrowing costs could be cut further from their record low of 0.5 percent, possibly as soon as July. Following the speech pound fell by more than 1 percent against the euro and dollar, reflecting an expectation of lower interest rates, softer economic growth and higher inflation.
In late trading the pound was worth €1.19 and $1.32. The FTSE 100 closed at its highest level so far this year, up by 2.3 percent at 6,504.33, as investors hoped that a looser monetary policy would improve business and consumer confidence.
Since 2009, interest rates have been at the lowest level in history at 0.5 percent. In the first quarter this year, the bank was preparing to raise interest rates, despite the long delay. Apparently slower growth followed by the Brexit shock and ongoing uncertainty led the bank to consider a shift and choose a different path in its monetary policy. However, the bank’s space for manoeuvre is rather limited considering the 0.5 percent interest rate.
Rating cuts underlines mounting risks
Last week following Moody’s outlook cut from stable to negative, the country has also been stripped of its last “AAA” rating by Fitch Ratings and S&P. The two-notch downgrade came with a warning that S&P could slash its rating again. The agency added that the vote to remain in Scotland and Northern Ireland “creates wider constitutional issues for the country as a whole.” Intensifying the pressure on the U.K.’s standing on international markets, Fitch cut the U.K.’s rating to ‘AA’ from ‘AA+’.
Fitch had warned more recently that the Brexit could prompt another cut and that it also risked sparking disharmony across the European Union.
Since the referendum results, volatile markets could deep down to a certain point upon recognizing the amount of uncertainties in the short term. But a deeper analysis is needed as the country seem to be heading to a more volatile stage with higher political risks with both the Conservative party and the Labor Party going through leadership challenges. The Piraeus hero of the Brexit, former London mayor Boris Johnson, has already taken a step back from the leadership race of his party after he was betrayed and stabbed in the back by his old ally Michael Gove.
Gove, who had long supported the Johnson campaign, declared that Johnson was not the right person for the role of Prime Minister and announced his bid to be in Number 10. Meanwhile Home Secretary Theresa May launched her Tory leadership bid with a pledge to unite the country. As she seems to be widely supported within the party, the whole process could lead to a new Thatcher like era in the U.K.
Eyes will be on Carney again
The Bank of England governor Mark Carney is set to make his third appearance in 12 days on Tuesday to address the threats facing the financial system. He will outline the macro prudential tools available to support the economy, boost business lending and encourage investment. He could also repeat his previous message of a possible rate cut to ease conditions as well as take a few more instruments out of his toolkit to give more relief to the markets.
Carney’s own series of statements do not seem to alleviate the rising political tension. It will now be down to constructive talks between a stable government and 27 members of the union, resulting in more assurances on the freedom of movement and trade deals between the U.K and the EU, to calm the strain.