Brexit – 9 (almost) inexorable consequences

Waving United Kingdom and European Union FlagLast Thursday British people decided to take their country away from the EU. No one knows (yet) how the economic relationship between those two areas will be shaped in the future – for those interested a governmental paper outlines the existing precedents in a very clear and interesting way.

In the meantime, looking at the market reaction, the situation has been seemingly well handled so far and stakeholders believe in a smooth transition rather than an abrupt ending. The CBOE Volatility Index, better known as ‘VIX’ or ‘fear index’, has reached levels which can be considered as modest relative to the ones witnessed in 2008 and is already on a downward trend. As I am writing those words the FTSE 100 is only 3.1% down compared with the 23/06 close and the pound has weakened but not collapsed against other major currencies.

Year-high levels reached by the VIX since 2000. Sources: Yahoo Finance, author analysis.
Year-high levels reached by the VIX since 2000. Sources: Yahoo Finance, author analysis.

In the long-term, however, the usual macroeconomic mechanisms will start acting – some of them are already noticeable. I do not have a crystal ball to tell you when and to which extent those trends will manifest themselves – and the ‘2-year window’ the UK benefits from after triggering article 50 adds to that uncertainty. Other future events could also change the course of action. This list of 9 items has therefore been prepared with the information made publicly available and the convictions I have at the time I write those lines. All in all, though, the picture looks relatively grim and one could fear that the UK is now sitting on a potential economic timebomb.

  1. A weakened pound and potentially higher trade barriers will lift inflation. Goods and services from abroad will mechanically become more expensive once their price is translated into pounds – a phenomenon economists call ‘imported inflation’. On top of that, the UK has been enjoying non-existent or low trade barriers, both within and outside the EU,  and it is unlikely that it will be able to negotiate the same terms on its own. Higher trade barriers increase the ‘total cost of purchase’ and therefore inflation.
  2. Lower confidence will weight on growth. The uncertain period we are entering is reinforcing the anxiety-provoking environment in which the developed economies have been living in over the last few months. As a consequence, individuals are likely to save more and consume less and companies are tempted to defer non-essential investments. Thinner money flows ultimately impact GDP.
  3. Interest rates will rise, all other things remaining equal. The UK’s financial strength will decline as it leaves the EU – Standard & Poor’s has already downgraded the country’s credit rating to reflect this point. A weaker credit rating and creditworthiness translates into higher interest rates to reflect a higher probability of default (‘country risk’). I insist on the fact that this is the case all other things remaining equal since we will see later that the Bank of England is likely to have the final word through the benchmark rate.
  4. Rising trade barriers will mitigate the stimulating impact of currency devaluation. Usually, a currency devaluation means that exports are cheaper and therefore more in-demand all other things remaining equal. In our case nonetheless, and as highlighted in point 1, the devaluation comes jointly with an increase in trade barriers that will make exports ‘less more competitive’ than expected. As a result, it is possible that the currency devaluation triggers inflation (as pointed out in 1) without significantly reigniting the economic engine.
  5. There will be a few winners… Companies bearing costs in pounds but selling a large share of their products abroad will benefit from the currency devaluation. The Wall Street Journal mentions Diageo – whose product lines include Scottish whiskey – and pharma behemoths such as AstraZeneca and GSK – whose staff is largely headquartered in the UK while benefiting from a very global sales footprint. Again, this assumes no significant long-term change in the UK’s custom tariffs and policy.
  6. … but there will be many losers: Conversely companies manufacturing goods or providing services with a non-sterling cost base and then selling them in the UK will be negatively affected by the situation. Airlines are a typical example : costs are very often expressed in dollars but tickets are sold in local currencies. Banks got affected since they will not be able to enjoy their ‘passporting‘ right once the UK has exited the EU.
  7. Homeowners may have difficult nights ahead: After several years of continuous (and sometimes impressive) growth, housing prices are likely to flatten or even drop. Several corporations, primarily banks, are thinking about moving part of their operations outside of the UK. This move would impact the demand for housing and thus prices. On top of that, without Central Bank intervention, interest rates are likely to rise, negatively impacting the purchasing power of prospective buyers – and raising the burden on mortgage owners. Homeowners with recent mortgages living in areas where the drop in demand will be the most significant could end up in a ‘negative equity’ situation – a theoretical case where the sale of the house would not be enough to repay the mortgage.
  8. Mark Carney, Governor of the Bank of England
    Mark Carney, Governor of the Bank of England

    The situation will create monetary… We have seen that the Brexit could lead the UK into a period of ‘stagflation’, i.e. inflation with limited economic growth. The Bank of England could use monetary policy to either fight against inflation (by increasing benchmark rates) or stimulate growth (by decreasing the same rates). Whereas in the Eurozone the ECB has a clear mandate to focus solely on inflation (I am not saying that this is an optimal solution), the BoE has both growth and inflation management within its remit and will have to make a trade-off. The Telegraph indicates that growth may prevail as the market is not expecting any interest rate rise before 2020.

Source: The Telegraph
George Osborne, (future ex?) Chancellor of the Exchequer
George Osborne, (future ex?) Chancellor of the Exchequer

9. … and fiscal dilemmas. Separately, the government will also have a difficult fiscal decision to make. With tax receipts dropping due to the lower activity, shall it aim for more austerity (and the political consequences attached) or for a fiscal stimulus? In any case, the fiscal and monetary policies will have to be fully aligned to avoid being trapped in the ‘worst of both worlds’ – a situation that some countries are currently facing.

Again, this is based on the assumptions that economic actors keep behaving rationally. Market volatility in the medium-term will indeed be driven less by the outcome of the negotiations than by the way they progress.

The 3 macroeconomic equations underpinning the theory behind this post's thinking.
The 3 macroeconomic equations underpinning the theory behind this post’s thinking. Sorry, couldn’t help myself.

Housing market update: testing the foundations


This post extends the series on the UK housing market which is one of my favourite topics, as you may have guessed by now. In earlier posts I discussed the impact of the stamp duty, clumsy real estate agent advertising and future house price trends in London. Today’s update brings a political flavour to the analysis, with Brexit as an obvious figurehead.

I think that a vast majority of industry experts would agree to state that the apparent uncertainty surrounding Brexit – although this uncertainty is largely a statistical artefact – has cooled down the real estate market. Although transaction volume is not officially monitored, this impression is supported by anecdotal evidence: estate agency Savills reported a 6.7% price drop in London’s prime residential areas compared with 2014, with more than half of homes being sold at a 10%+ discount. The momentum has started percolating to lower price layers, with inflation for homes in Central London costing £500k to £1m now standing at 3.4% over the last year. Commercial real estate is also affected, with investment in central London office buildings dropped 52% quarter-on-quarter. Some readers will recall that the market experienced similar turbulence in the weeks leading to the referendum on Scottish independence in 2014.

Nonetheless, the core of the market remains largely untouched. Prices throughout the UK in general, and in London in particular, still show vigorous growth, which tends to indicate that structural house undersupply largely remains a reality.

Mix-adjusted annual house price change by region as of Feb 2016. Source: ONS.
Mix-adjusted annual house price change by region as of Feb 2016. Source: ONS.

Brexit may come on top an artificial rush generated by the increase in stamp duty on buy-to-let and second homes, which led some investors to bring forward their purchase intent to Q1 2016, as demonstrated in an earlier post.

Zac Goldsmith and Sadiq Khan. Credits:

On the supply side, political uncertainty also takes its toll. Brexit but more importantly London’s mayoral elections have strongly builders to ‘sit and wait’. The Financial Times reported that London boroughs approved 64% fewer homes in Q1 2016 compared with Q1 2015. This does not help.

On the investment side, strategies vary depending on the investor’s mandate. Property funds have been forced to partly withdraw from the market, sometimes crystallising losses, to face increasing outflows and form a sizable ‘war chest’ in case a major bank run happens post-Brexit – public trust in those funds took a hit when some of them had to forbid redemption during the darkest moments of the financial crisis. Conversely, more agile private investors are trying to take advantage from the current feebleness whereas more established institutional buyers’ field of action is restricted by their Boards.

1280px-Barclays_logo.svgFinally, in an environment where investment-grade bonds yield no (or even negative) interest and equity markets have struggled to find momentum, banks rely more than ever on the ‘power of the stone’ to generate satisfactory returns. Yesterday Barclays announced that it relaunched 100% mortgages, a product that got discontinued in the aftermath of the financial crisis, in a hunt for yield – fixed-rate mortgages start at 2.99%, not a bargain by today’s standards. Given that this mortgage can only be activated with a 10% deposit from a guardian, this mortgage is particularly aimed at younger buyers that recent price increases have excluded from the property ladder.

Share of borrowers under 25 within the first-time buyer population. Source: ONS.
Share of borrowers under 25 within the first-time buyer population. Source: ONS.

One cannot forget, however, that London remains one of the most expensive cities in the world, only trailing Hong Kong according to UBS’s well-named ‘Global Real Estate Bubble Index‘, which states in its 2015 edition that “the [London] housing market is in bubble-risk territory“.

Price-to-income benchmark for selected cities. Price-to-income is defined as "the number of years a skilled service worker needs to work to be able to buy a 60 sq. m. flat near the city center". Source: UBS Global Real Estate Bubble Index.
Price-to-income benchmark for selected cities. Price-to-income is defined as “the number of years a skilled service worker needs to work to be able to buy a 60 sq. m. flat near the city center”. Source: UBS Global Real Estate Bubble Index.

Monitoring house prices as the political dust settles will solve the conundrum. Only then will we indeed be able to understand if the London housing market has reached an inflection point or if the political milestones paving the first half of the year were mere bumps on the road to continuing inflation.


Brexit: How tight is it, really?

brexit-ballot-boxWith the official referendum expected in less than two months, the latest polls on Brexit show a narrower than ever gap between both camps. The Financial Times’ Brexit poll tracker shows that the June referendum could go either way. However, as mentioned in an earlier post, bookmakers such as Betfair have barely adjusted their odds over the last few weeks and still predict a victory for the ‘Bremain’ side with a 65% probability – and even closer to 75% following Barack Obama’s visit to the UK last week. How can we reconcile those two facts?

Evolution of implied ‘Bremain’ success odds according to Betfair.

First, to reiterate an argument already developed on that blog, bettors and bookmakers believe that, unconsciously or not, individuals positioning themselves in favour of Brexit do not reveal their real vote intention to pollsters. A similar bias can be observed in voters’ behaviour towards the most extreme parties prior to an election. A share of the self-declared ‘extremist’ electorate will actually revise their intentions just before putting the ballot in the box.

Result of the first round of the 2002 French Presidential Elections

That being said, the reverse trend used to be true in some countries such as France – i.e. individuals planning to vote for the Front National were fearful of revealing their real intentions and hid it to pollsters – and partly explained the 2002 French Presidential Election upset where Front National’s Jean-Marie Le Pen unexpectedly ousted Parti Socialiste’s Lionel Jospin from the second round. Being able to identify and quantitatively assess behavioural biases has become part of survey institutes’ core job, especially in tight contests such as the one we are witnessing today.

Unconscious behaviours nonetheless do not fully explain the discrepancy between polls and bookmakers. Statistics also come into play. In the context of the Brexit referendum, the Bremain camp has indeed managed to maintain a small, although very narrow, lead in most of the polls. As a consequence, the odds of the Bremain camp winning are actually greater than the gap could lead us to believe. To illustrate this fact, let us assume that the distribution of vote shares in favour of ‘Bremain’ follows a normal distribution – the infamous ‘bell curve’.

This distribution is centred around an average of 52% – i.e. on average Bremain wins by a 52-48 margin. Let us also assume that we are almost certain (with a 95% certainty to be perfectly exact) that the Bremain camp will score between 44% and 60% on D-day. The resulting bell curve is drawn below, with the shaded area representing the area sitting above the 50% threshold – i.e. the area where the Bremain camp wins. Although we built the bell curve around a 52% average, the shaded area represents 69% of the total area under the curve, which means that the Bremain camp has a 69% chance of winning. The parameters for this example have not been chosen randomly: 69% is indeed very close to Betfair’s latest estimates.

Bell curve with average of 52% and std deviation of 4%. Shaded area corresponds to p>50%.

This exercise would theoretically give us a lot of confidence on the referendum outcome. In practice, the exercise is unfortunately made much more complicated by the high share of ‘undecided’ voters, standing at roughly 30% of the voting population as of today. Given its size, this group will clearly decide on the referendum’s outcome and can overturn any statistical projection. Being able to predict the behaviour of such a heterogeneous group has therefore become the focus – and the nightmare – of all pollsters – notwithstanding the bookies.

Brexit won’t happen – Just ask the bookies


Recent surveys about Brexit depict a very close race between the supporters of ‘Brexit’ and ‘Bremain’. Basing itself on the last 6 polls, The Telegraph asserts that the gap has narrowed to a thin 51-49 majority in favour of remaining in the UK. The Week has drawn similar conclusions: the 2% difference between ‘In’ and ‘Out’ supporters is insignificant if we consider that 4% of voters admitted to be unsure about their vote.


The question now becomes: to which extent can we trust surveys? And are there alternative, more reliable sources of wisdom? In the UK, the answer is ‘definitely yes’ and is in the hands of the likes of Ladbrokes, William Hill and Betfair.

James Surowiecki
James Surowiecki

As explained by James Surowiecki in his book The Wisdom of Crowds, betting markets are great ways to aggregate heterogeneous opinions across a given population. More importantly, by putting their own money at stake (by definition), bettors should not focus on their own views but predict the outcome of the vote instead. Provided that the market is liquid enough, academics such as Justin Wolfers built on Surowiecki’s work to demonstrate that, actually, those markets were the most accurate predictors of future event outcomes – and were given the name of ‘prediction markets’ as a consequence.

Betfair_logo.svgWhat are the odds then? Well, all bookmakers concur to assert that the situation is much clearer than the polls suggest. The odds of a ‘Bremain’ on Betfair, the leading betting exchange platform (i.e. a platform where players take bets against each other), have been fluctuating between 1.30 and 1.60 over the last few days, which translates into a probability range of 62% to 77%. This takes into account the recent bombings in Brussels which slightly revived the ‘Eurosceptic’ sentiment – see green arrow in the chart below. According to the same bookmaker, the exact split as of yesterday was 65-35 in favour of ‘Bremain’, with more than £2.7m worth of matched bets.

Historical evolution of ‘Bremain’ odds. Source:

Beyond bookmakers, the world of finance also provides us with a number of prediction markets. The evolution of the GBP/USD exchange rate, for instance, is another way to assess the relative ratio of power between the two sides if we believe that a Brexit would translate into a significant depreciation of the pound. This type of analysis, however, does not allow us to deduct a precise probability of ‘Brexit’ happening but can only track its relative evolution.

Historical evolution of USD/GBP FX rate. Sources: Oanda, author analysis.
Historical evolution of USD/GBP FX rate, with selected time averages.
Sources: Oanda, author analysis.

Given the high stakes, the political establishment will undoubtedly keep a close eye on these indicators over the next few months. Will they prove accurate?

For those unfamiliar with Betfair, here is a short corporate video presenting the basics of the betting platform.

A budget for “the next genera(l elec)tion”?


On Wednesday the Chancellor of the Exchequer George Osborne announced the budget for the fiscal year 2016-2017, a “Budget that puts the next generation first”. The content and the form of this speech have been widely debated in the press already. Without repeating what has already been written, here are a few thoughts:

  1. Brexit has definitely taken its toll. This is the first budget speech since the overwhelming Tories victory in last year’s general elections. With the House of Commons under their control, the context was ideal to outline an ambitious budget instead of delaying the bulk of the government budget rebalancing effort to the end of the parliament – we are talking about a £32bn reduction in Public Sector Net Borrowing (PSNB) between 2018-2019 and 2019-2020. An interesting analysis compiled by Torsten Bell for NewStatesman and reproduced below shows that PSNB is only reduced the year after general elections, and tend to soar the year before. And yet, the next general election is planned for… 2020. Unfortunately, Mr. Osborne as well as the rest of the Tories establishment will bet their political future in 3 months’ time. If the UK gets out of the EU, this future will be rather short-lived. As a consequence, this budget speech was partly design with the intention of rallying the Eurosceptics, especially those living outside London – hence the focus on the importance of devolving power to “our nations” and the lengthy discussions on local issues such as “enhanced capital allowances to the enterprise zone in Coleraine” or the “upgrade [of] the A66 and A69”. The Chancellor made use of the carrot but resorted to the stick as well, warning that the Office for Budget Responsibility (OBR)’s growth forecasts, and ultimately the budget equilibrium, were based on the assumption that the ‘Remain’ vote would win in June.
Credit: NewStatesman

2. Raising a fiscal surplus – Mr. Osborne’s self-imposed mantra – is an unpredictable mission, especially when the goal is positioned in a distant future. According to the OBR, by 2019-2020, all the efforts outlined by the Chancellor will only offset the drop in fiscal receipts generated by the latest OBR’s GDP growth forecast reduction (0.5% p.a.).

Changes to public sector net borrowing in 2019-2020
Changes to public sector net borrowing in 2019-2020

Furthermore, there is a very high chance of seeing the forecast revised again multiple times over the next few years, making the target even harder to hit. Finally, history has demonstrated that a higher than expected growth rate does not always lead to lower borrowing.

3. Similarly, the PSNB will largely depend on the uncertain evolution of the Bank of England’s interest rate. Unemployment at a 40-year low and wages growing by 2.1% over the last 12 months could well translate into sustainably higher inflation in the medium-term – the Chancellor indicated that it was forecast to reach 1.6% next year -, which would ultimately force the Bank of England to raise the cost of money. With a debt to GDP ratio approaching 85%, public finances would obviously be significantly impacted by such a change.

4. For the reasons listed above, some aspects of this budget appear as slightly unexpected and Mr. Osborne could well hide a different political agenda. Two options come to mind immediately. The first is that Mr. Osborne will resort to the same tactics towards Brexit as the one he used last year in the aftermath of the general elections, by issuing a revised budget as soon as the vote outcome is known – although this could come at a possibly unbearable political cost. The second option is that, as hinted by George Eaton, Mr. Osborne is actually preparing the ground for an early election which could free his hands to achieve his massive PSNB reduction ambitions in 2019-2020.

You can watch the replay of the Budget Speech below: