17 August 2016
The FTSE is riding high, a weak Sterling has increased UK tourism by nearly 5%, low mortgage payments are about to get even lower and the Game of Thrones like internecine political infighting is being replaced with new cabinets and a new political will.
It is easy to think that the shock election result which was initially labelled “Regrexit” is actually turning out to be ok.
Think again. George Soros’s assertion that the vote could be reversed in the light of a “newfound enthusiasm for EU membership” was probably written while sitting in his study in the US, and is inconsistent with the mood and sentiment that I am picking up on the ground in the UK.
Naturally, the recent interest rate cut and ‘lower for longer’ interest rate expectations have driven gilt yields down even lower and this has, once again, hurt most UK pension schemes. My real concern though is that they could still fall by significantly more and be much lower, for much longer than the market currently expects, and this concern is based on how I expect the Brexit process to play out over time.
So, how might Brexit unfold?
I think there are three scenarios for how the Brexit process can happen in practice.
- Scenario 1 is a ‘Good Exit’ where the UK ends up with a Switzerland type of relationship with the EU and we keep our free trade with some element of border control. Unfortunately, I fear this is a rather unlikely scenario. And even if Scenario 1 does come to pass, I suspect we may end up with Swiss like negative yields which will be very painful for UK pension schemes.
- I believe the most likely path for Brexit is Scenario 2 which I would call a ‘Hard Exit’. Under this scenario it will take 5 to 10 years to negotiate and actually achieve Brexit. Scotland will almost certainly hold another referendum during that period and could split away – particularly if oil prices recover. Under this scenario Sterling would be weak for many years and there would be a number of knock-on effects such as UK property prices falling, particularly in London, and the risk of importing some inflation into the UK. Our economy would slow down, which would result in strong stimulus from the Bank of England, probably driving gilt yields even lower than they are now.
- However, Scenario 3 is my real fear and is what I would call a ‘Bad Exit’ where the EU negotiates very hard and ultimately the negotiations stall or fail. In this scenario I believe we would exit the EU and end up starting from scratch in terms of trading with each European country. Under this scenario Scotland is likely to break away from the UK, house prices in the UK could crash and the impact of the UK leaving the EU could spread to other nations in the EU causing economic instability throughout the EU. This would have a very dramatic impact on growth in the UK economy and leave us with very strong stimulus measures and near zero interest rates for more than a decade.
All three scenarios could result in significantly lower interest rates for UK pension schemes. Whichever way Brexit unfolds, trustees should be reviewing their levels of interest rate and inflation protection and consider whether those levels could and should be increased.
I would expect this drama to unfold over the next two years so I am suggesting that Trustees consider these issues sooner rather than later. Winter is coming.
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