10 weeks after the Brexit referendum and speculation about its impact has yet to simmer down. Besides the usual politicking and theorizing, the occasional threat grabs headlines too. However, the latest data show the fear and hype surrounding Britain’s decision to leave the EU hasn’t yet materialized into a certifiable economic downturn—a timely reminder for investors that the media’s “big market negative” often isn’t so.
On Tuesday, Markit reported its August UK services purchasing managers’ index (PMI) rebounded to 52.9 from July’s 47.4—the biggest month-on-month gain in the survey’s 20-year history. This news followed similar bounce-back stories in the UK: Retail sales turned around from -0.9% m/m in June to 1.4% in July, smashing expectations of 0.2%. Markit’s August manufacturing PMI rose to 53.3 from July’s 48.3. Now, we would be remiss if we didn’t include our standard “one month isn’t telling” language. We cautioned investors against equating the UK services’ PMI record drop in July with evidence of economic doomsday. Likewise, this positive report doesn’t mean Brexit lacks economic impact whatsoever and all those prognostications were dead wrong (more on this later). Rather, we recommend looking at this latest report like any economic metric: See what it measures, evaluate the data in context, and assess the popular interpretation of the news.
On that note, the Markit/CIPS UK services PMI is a survey,[i] covering six service sector categories, that tabulates the percentage of respondents reporting improvement/deterioration/no change from the previous month. Readings over 50 purportedly indicate expansion; below 50, contraction. PMIs provide a rough, quick assessment of the breadth—though not magnitude—of business growth. Beyond the record-making reports of the past two months, here is a broader look at the UK’s services PMI.
Exhibit 1: Markit/CIPS UK Services PMI
Source: FactSet, as of 9/6/2016. From September 2013 – August 2016.
Big picture-wise, that contractionary July looks more like an anomaly than a foreboding sign. The drop wasn’t surprising since sentiment influences PMIs. Brexit-related concerns smacked confidence as businesses played the wait-and-see game, delaying new projects and orders just in case. Now it appears they saw that major economic trouble didn’t look imminent and got on with business as usual: New orders jumped in August.
Besides concerns about broader business activity, some feared Brexit would crimp corporate mergers as well as the appetite for British debt. Regarding the latter, there is no evidence demand has fallen off. Recent bid-to-cover ratios—the number of bids relative to the amount of bonds offered—are in line with (and actually somewhat higher than) their pre-Brexit levels, even though yields are far lower. (Exhibit 2)
Exhibit 2: Demand for 10-Year Gilts Is Fine
Source: UK Debt Management Office, as of 9/7/2016. Excludes index-linked gilts.
Generally speaking, ratios in the range of 2.0 or higher suggest robust demand, while closer to 1.0 or lower indicate weak demand. If investors were frightened by the UK’s future prospects, they would demand higher yields to compensate for the higher risk. Or they just wouldn’t buy. Exhibit 2 shows neither are happening.
Similarly, if Brexit spooked foreign businesses from acquisitions, reality doesn’t show it. Now, deals involving UK companies did slow in Q2 as businesses likely hit the brakes on new plans tied to pre-vote uncertainty. However, “slow” doesn’t mean “stop” or “contract”—foreign firms are still interested in doing business with UK firms. It isn’t just smaller companies, either. After the referendum, Japan’s SoftBank put the finishing touches on a £24 billion deal for Britain’s biggest tech company, ARM. AB InBev upped its bid for SABMiller after the vote to compensate shareholders for the weaker pound, rather than try to push it through at a discount—countering the “foreign firms are just bargain-hunting” naysaying. South African retailer Steinhoff had to up its long-running bid to buy British discount retailer Poundland to satisfy major shareholders, who sought higher offers.
Despite plenty of evidence the UK economic environment remains fine post-Brexit vote, mixed opinions are prevalent. On Wednesday, manufacturing output stole headlines because it contracted -0.9% m/m in July—the fastest pace since July last year. However, context matters: The manufacturing PMI similarly slid in July before August’s big bounce back—something similar may happen for manufacturing output. Also, manufacturing isn’t a huge part of the UK economy, so it won’t be a big driver whether it’s negative or positive—services and consumption matter a whole lot more (to the tune of 80% of GDP). Regarding consumption, two outfits recently reported very different estimates of August retail sales: one the weakest in nearly two years, the other a 13-month high. The first group, using survey data provided by participating retailers, said retail sales fell -0.3% y/y in August, due mostly to “non-food categories” and the warmer summer weather—folks were enjoying the sun rather than spending cash. The second group, which analyzes credit and debit card transactions, said consumer spending rose 4.2% y/y in August thanks to the good weather—consumers splurged on clothing and entertainment. For those of you scoring at home, yes, both groups cited the warmer weather as the reason retail sales were up/down. While we won’t have the official numbers until later, the various interpretations indicate how topsy-turvy sentiment is.
That mixed sentiment may be due to confusion over Brexit’s actual consequences, which affect the distant, not immediate, future. Though most economic analysis speculates on Brexit’s potential fallout, the impact will depend mostly on trade terms with the EU and other partners. Britain won’t actually leave the EU until at least two years after it triggers Article 50 of the Lisbon Treaty, which starts formal exit negotiations. Until then, it will be a full-fledged member, with all rights and privileges—including single market access and free trade with the EU’s free-trade partners. Considering UK Prime Minister Theresa May is still laying the groundwork for talks and doesn’t want to rush invoking Article 50, it may be years before Britain actually leaves the union.
Now, it is possible that whatever agreement Britain and the EU reach will lead to bad unintended consequences and dampen growth. Likewise, it could be a great deal with more winners than losers. We just don’t know at this point, and considering negotiating teams are still assembling, it seems a stretch to presume any outcome. Meanwhile, Britain’s primary advantages—its competitive economy, robust private sector, strong property rights, etc.—all remain firmly intact and unlikely to change any time soon. This is the primary reason we believed the immediate handwringing following the surprising Leave vote was a wee bit overwrought. Yes, the vote could have hit Britain’s animal spirits, and it arguably did in July. But a quick sentiment hit isn’t an automatic recession trigger.
We don’t pooh-pooh Brexit news, because it is important and does mean change. However, much of the analysis is heavy on opinion and speculation, not fact. We simply don’t know what the resulting new reality will be, so we aren’t ready to call this a wonderful positive or a huge negative. In the meantime, Britain remains one of the developed world’s strongest economies. Brexit could possibly affect that status years from now, but for the foreseeable future, it won’t—and that matters most for markets today.
[i] Already a limitation.