Perspectives 2017: RSM – keynote interview

The UK’s vote in June to leave the European Union has set its economy on an uncertain path. RSM US chief economist Joe Brusuelas explains what it means for the UK and why it is indicative of a deeper structural shift in the forces determining economic policy globally.

How does the Brexit vote affect UK economic growth?
The major impact is sterling declining roughly 20 percent. Looking forward, it is very difficult to estimate where the UK economy is going. It will depend strongly upon policy decisions the government makes and we can only guess what those are. My sense is that the UK economy will muddle along and some time in early-mid 2017 it will enter a period of slower growth, perhaps a technical recession. If Theresa May is serious in negotiations with the EU about not giving preference to the City of London and the banking and financial services sectors, which accounts for 25 percent of GDP, there maybe a larger adjustment.

In these uncertain times, how do you think businesses will behave?
Brexit negotiations are expected to start in March 2017 and probably not conclude until 2019 or 2020. That’s an extraordinary long period of uncertainty. A protracted period of negotiations, the outcome of which no one can accurately predict, leads you to assume that firms and households will likely put off major decisions. You should expect to see dropping capital expenditures in the UK first, followed by firms in the EU. UK firms and households knew following the June referendum that some time in the next three to nine months prices on imports would rise, including food and petrol. And sure enough we are at that point.

If those price increases continue, the standard of living of British households is going to decline. The burden of adjustment will fall on the shoulders of lower and middle income groups. There is not going to be the corresponding growth in employment and wages to compensate for those prices, which will put tremendous strain on the social contract in the UK.

What does that mean for policymakers?
The real concern is that late next year the Bank of England is going to be in a difficult position. The direction of inflation might mean it has to hike rates in an economy that is experiencing no or slow growth, or a very modest contraction. From a policy, economic and financial point of view, that is the worst of all possible outcomes.

In PEI’s LP Perspectives survey, Brexit ranked far below a global economic slowdown, low interest rates and extreme market valuations as a major macro-economic concern. Does that match your assessment?
That’s about right. Global growth and policy conditions remain the two largest concerns because they really are driving financial markets. Brexit has been an interesting, but second order global effect. The major concern is stagflation that has ensnared much of the global economy – that is slow growth, low inflation and low interest rates. The policy implications of those are certainly the major concerns of forward-looking investors, fund managers and the private equity community. Private equity on a global basis is undergoing structural change. Firms are learning how to operate in a low interest rate environment. Traditionally private equity does better if rates are going up, but that is likely not to occur.

So why is Brexit significant?
The important thing about Brexit is that it represented a threshold moment and a trigger moment. The threshold was the taboo that was breached by a country opting to exit the EU, which was not supposed to happen. It triggered renewed concern over the financial condition of Europe in general and European banks in particular. Italy’s Monte dei Paschi di Siena and Unicredit, and, of course, Deutsche Bank are clearly at the forefront of concerns. The major near-term risk is the status of Deutsche Bank and whether its balance sheet will be recapitalised. This is a bank that is clearly too big to fail.

Does the market get use to uncertainty at some point?
Markets generally are good at discounting mechanisms in terms of pricing in short to medium term events. Brexit is different. There is no precedent to frame decisions around. What I suspect will happen is we’ll have intense periods of volatility followed by quiet periods of reassessment.

What’s the impact on asset pricing?
You have to look sector by sector. How sterling depreciation impacts supply chains, what will the price and cost structure be in terms of the provision of services and the production of goods? Second, what’s the impact on the labour situation going to be? Third, are there opportunities for on-shoring or substitution of domestic manufactured goods for foreign manufactured goods and at what cost? Those are the three big questions whether you’re in retail, telecoms, or tech. From there, private equity will make its own decisions as to where the likely winners are relative to the losers. And there could be a period of intense and advanced consolidation, or, pricing overshoots the mean, and then you have opportunity to create value.

Disruption also throws up opportunity. What are you seeing?
American private equity firms are surely eying British tech and telecommunications for any sign of a crack in order to jump into an otherwise incredibly vibrant sector. There is also going to be capital exiting the EU. There will be opportunities in the next 12-24 months to find companies in the US that may offer higher investment returns than they would have done otherwise.

The Brexit decision surprised many. What does it mean for other EU member states?
Political risk in Europe has been rising. Late 2016, 2017, 2018, all bring several challenges in this area, in particular elections in Germany and France next year, which appear to be shaping up as de-facto referendums on the EU and euro. We’ve had a good 25-year run in respect to the relationship between governments and the commercial sector. In all developed economies, governments for the most part have been pro-business and pro-liberalisation. The risk is we’re seeing a pull back from that. Decisions are going to be driven by politics and not by finance and economics going forward, which represents a major structural change.

How should investors respond?
Remain light, flexible and nimble. Be keenly attuned to policy and policy shifts. Hedge your investments carefully. And to the extent you can, reduce your exposure to middle and lower income groups in the UK and EU and increase your exposure to the external sector. A reduction in disposable income will reduce demand, so you need to diversify away from that source of risk. 

This interview was conducted prior to the US election. 

This article is sponsored by RSM. It appeared in the Perspectives 2017 supplement published with Private Equity International in December 2016.