14 October 2016

Will Brexit protect or destroy wealth?


“The British people didn’t vote to make Britain poorer,” said Phillip Hammond of Brexit recently. Sounds fair. People won’t drink the potion unless they have reason to think it will do them good.

But here’s the trouble. When will we know if Brexit is good or bad for us? Is it even possible to know?

There is still very little economic data on which to base a position, for or against. That’s why politicians have to fall back on platitudes like: “Brexit means Brexit”. They do so precisely because they have no conclusive knowledge.

As we pick our way through this arena of unknowns, the reminder that the plan is not to get poorer does sound very comforting. But, hidden in that message of comfort is something else, something more akin to a note of existential alarm.

Philip Hammond is, lest we forget, a Conservative Chancellor of the Exchequer, and the clue is in the name. Being Conservative can mean many things, some of them contradictory. But being conservative must include responsible stewardship of wealth in every sense.

Hence the alarm. If Brexit turns out to be a project that destroys wealth, it is not a project you can pursue and stay conservative. So why wouldn’t a Conservative be alarmed?

So what do we know about Brexit? What about the collapse of sterling, which has fallen about 17 per cent against all other important currencies since the referendum vote? Doesn’t that look like the hardest of hard data?

The problem is that, in the ideologically supercharged post-referendum world, each side of the argument has found something encouraging in the currency re-alignment. Either it is a global vote against the prospects of the entire UK economy and a harbinger of inflation – or it is a welcome adjustment of an overvalued currency that will cut the trade deficit and make our exporters rich.

In fact, neither of these positions captures the truth: the currency effect is just another reminder of the unknowable quality of Brexit.

In any advanced economy, the impacts of currency fluctuations are always complex – they seldom push decisively one way or another. If your trade is in commodities, like Boris’s bananas, then a currency fall will make your exports cheaper. But Britain’s commodity trade is negligible. Complex products, of the kind we specialise in, are little affected by currency changes, because price is only one small component of their competitiveness.

Customers, especially corporate customers, are much more interested in what they call the “total cost of ownership” than they are the ticket price – which is one reason why currency-driven “trade boosts” seldom actually materialise.

In any case, the ticket price is very unlikely to change by as much as the currency valuation. Indeed, it may not change at all, because a weaker currency also means more costly components and raw materials. So while Brexit has certainly caused the currency collapse, neither side of the argument can pray it in aid for their case.

Indeed, while most of the propaganda flow in this furious debate is about trade, it may be wiser to look instead at things that are more fundamental to the wealth-creating economy.

Here I turn to my day job, which is about tracking the flows of merger and acquisition deal-making into and out of the UK. This is important, because there is a consensus that rates of M&A are a good proxy for the rate at which new wealth-creating businesses are being formed.

Very big cross-border acquisitions worth in the tens of billions or more – of which there are a few every year – make it into the headlines. But there are hundreds more deals going on all the time. The most active channel for this deal-making is between the US and the UK: every quarter there are usually somewhere close to 130 of these deals, worth anything from a few million pounds up to a billion.

These are deals that you never hear of but which add up to a lot – with more coming into the UK than the other way around. They include every sector of the economy, but most of them are in technology, where the UK is a very prolific producer of new businesses. They represent new investments into companies that will create future jobs, pay taxes, and support demand in the economy. They are a predictor of whether we will be richer or poorer.

It has always been assumed that one of the reasons such acquisition investment comes into the UK is because it is a springboard into Europe. A linked assumption was that the prospect of Brexit would knock a big hole in the investment flow.

In fact, that didn’t happen. Although global M&A into the UK has fallen this year, the figures on total M&A volumes in this transatlantic investment channel – which is far and away the most important – have barely registered a blip. (Total value fell, but for technical reasons the figures on that are a bit unreliable.)

It is tempting to conclude from this that the implacable world of global capital does not give a stuff about Brexit; everything’s fine, carry on as normal.

Unfortunately, that’s not the right conclusion. We are in another realm – one where we just cannot know the outcome, not yet, and maybe not for a long time.

If you talk to US investors about why they want to buy UK assets, it is perfectly true that having an open door to the Single Market is rarely the first thing they say. They are much more likely to cite their comfort level with the UK business environment.

But it is often the second thing they say – and it is very difficult to make a case that loss of this attraction will have no impact on our inward investment.

Another factor is the deal cycle: most M&A deals of size take a minimum of six months from conception to delivery, and some of them have even longer lead times, perhaps years. It is simply too early for Brexit effects to be visible in the figures. There are no useful data.

So let’s pretend we are investment managers, but we lack data. A locus of uncertainty is a risk, and investment is about quantifying risks. What the investment manager does when there are no data is identify uncertainties,  calculate possible outcomes, and price them.

It’s not just investment flows, or trade. We don’t know what will happen to asset prices, long-term borrowing rates, inflation, infrastructure investment. These are a lot of unknowns, and they will stay unknowns long after the Brexit Kool-Aid is brewed and served.

There are multiple outcomes, but it is striking that in most cases they are either flat-line (meaning we keep what we’ve got) or downside (we pay). The upside possibilities are fewer.

And that means – with so many of these equations to be solved – that the likelihood is a net downside. That’s not opinion, it’s the maths of probability.

I’m well aware that many Leavers believe there is a deeper story, something to do with the dividends of sovereignty, something that somehow can’t be captured in the data. To which I would only point out that any decent asset manager is immediately on guard when an investment comes with a “story” attached. Stories are for salespeople, not for responsible custodians of wealth.

That is why the Chancellor is taking his line on not getting poorer. The outcome of Brexit may be unknowable, but the risk to present and future wealth is not. It is not a stretch to see this has the potential to do to the Conservatives what Corbynism has done to Labour, to fracture the vessel top to bottom. It’s Conservative policy, but is it conservative? We won’t know until it’s too late.

Richard Walker is a journalist and communications adviser to financial companies.