State Street: No Deal Brexit is a Natural Disaster

This video first appeared on Morningstar.co.uk.

Emma Wall: Hello, and welcome to the Morningstar series, "Market Reaction." I'm Emma Wall and I'm joined today by State Street's Michael Metcalfe to talk about the prospects for the U.K. economy.

Hi, Michael.

Michael Metcalfe: Hello.

Wall: So, what's caused this unexpected spike in inflation for August to 2.7%?

Metcalfe: Well, firstly, it was a surprise. I think we were expecting this gentle decline in inflation. And I think there are a couple of things influencing that. I think the first, obviously, is activity. We've had a spike in activity. We're not sure whether that will last, but we've certainly had a spike in activity over the summer. And then also, we've had a combination of sterling weakness also. So, I think, there's a conglomeration of factors that have created this. But it's going to be really important now to see whether it's just a one-off or whether actually the downtrend in inflation has paused.

Wall: And if this is not a one-off, if we continue to see this level of inflation, surely that has an impact on interest rate decisions?

Metcalfe: Absolutely. So, so far, the Bank of England has been very relaxed and very gradual in their tightening cycle. It is a tightening cycle. Rates are expected to continue to go up. But they've been allowed to be gradual. And I think the risk is that with the labour market as tight as it is, rising inflation from the current level means they might have to go a little bit faster and that could be problematic for markets.

Wall: Now, inflation is higher than we'd like it to be. And as you mentioned there, the employment market looks good. We've got low unemployment. Those are typically signs of an economy doing well. But there are some concerns about the UK economy, aren't there, because of the spectre in the room, Brexit?

Metcalfe: I thought we'd get to Brexit at some point. Well, it's interesting on growth, isn't it? Because we are growing at capacity, or we have been growing actually even a little bit more than capacity. That's what the labour market is telling us. But growth has been a little disappointing. It wasn't quite as bad – following the Brexit vote, everyone thought there might be an instant recession because of the shock to animal spirits and actually, in the end, animal spirits held up very well, confidence was fine. It's very different now though because actually right now we are trying to make investment decisions, companies are trying to figure out what they do in 2019. And unfortunately, because of Brexit we still don't know. And so, I think, uncertainty, at least on the investment side, has been a big drag and will continue to be so until we figure out the shape of Brexit.

Wall: And how do corporations and indeed, consumers invest in a market where there is such uncertainty?

Metcalfe: Well, I think, from the consumer point of view for the moment, and we have mentioned it couple of times already, the key is the labour market. So, you know, I think until Brexit uncertainty begins to affect employment prospects seriously, then actually the consumer side at least has held up quite well and we know it's distorted by fun things like the World Cup. On the investment side, that's a lot harder from the corporations' side and here we are talking really about business confidence. There's been a lot of open public debate about how difficult it's been to make investment decisions. And so, that's where the hesitation is and that's really where the shape of Brexit is going to matter an awful lot.

Wall: And Brexit is a very emotive issue. There have been some quite negative headlines, journalists, I'm sure, have ourselves played into that, but so have politicians, so have business leaders. How concerned should an investor in UK stocks be about the UK?

Metcalfe: So, it would be very easy to look at how markets reacted around the original referendum result and say, well, actually, we were overly concerned and actually, the economy did fine. I think the reality of an actual Brexit when it comes, particularly if it's a hard Brexit, we'll be very different from that because a hard Brexit would be an immediate real economic shock. And look, as you say, it's very difficult to predict precisely how big an economic disruption it will be. But anything that physically disrupts trade and supply chains, which is what we are talking about, is akin to a natural disaster and the impact on an economy. So, I think that there should be concern. There's certainly a real economic risk of activity being significantly disrupted and that's over and above the impact on investment spending and animal spirits. This is a real economic disruption that we are talking about here and it's difficult to see given how late we are in the game is if we have a no-deal Brexit, it's very difficult to see how you'd escape some physical actual economic disruption. So, I think, to that extent, yes, there is going to be some concern.

What's the probability of a hard Brexit versus a softer Brexit and getting a deal? I think that's the thing right now that the market is weighing up and it's swinging around with all the different commentary. I would say right now the very latest commentary, we should date it at the bottom of the video, seems to be actually that we might get a deal and that's the track that we are on. But this risk that we knocked off maybe by UK politics more than anything else on to a different track. So, yes, it's something that investors really need to consider because it's could be a real economic shock.

Wall: Michael, thank you very much. This is Emma Wall for Morningstar. Thank you for watching.