Expert Commentary

No deflation risk in U.K. points to no-deal crash

Britain is the odd man out in the trend towards lower price inflation expectations. That may be because of Brexit.

The United Kingdom of Great Britain and Northern Ireland got a new prime minister last week. Boris Johnson was voted in as the new leader of the Conservative and Unionist Party, thereby assuming the role of head of government and he immediately set about installing a team with one aim in mind -- leave the European Union by 31 October "do or die." Johnson has asserted that the controversial Irish backstop (the insurance plan for the E.U. to maintain a seamless border between Northern Ireland and the Republic of Ireland, thereby requiring the U.K. to retain some sort of trading union with the E.U.) be abolished. This is completely at odds with the E.U.'s position that the backstop is non-negotiable. If these positions remain, it is becoming increasingly likely that the U.K. will leave the European Union with no deal on future arrangements. Indeed, the bond market is probably pricing that in already.

In the rest of Europe and in the U.S., price inflation expectations have been collapsing in recent months as sentiment sours on the state of the global economy. However, as the chart below shows, price inflation expectations in the U.K. remain elevated. Why should this be? Well, ever since Britain suffered from rampant consumer price inflation in the 1970s (reaching 26% per annum in 1975), there's always been some sort of inflation premium priced into U.K. assets. One reason for that could be the openness of the economy and the effect that the exchange rate has on feeding through to prices. The Sterling trade-weighted exchange rate plunged by 20% between 2015 and 2016, a move that encompassed the U.K. referendum vote to leave the E.U. (note that it had already declined by 10% before the vote.) After that, consumer price rises in the U.K. accelerated as the weaker exchange rate made imports more expensive.

With the U.K. not joining the trend towards lower price inflation expectations, this could be a sign that the market is nervous about another plummet in the value of the pound on a no-deal crash-out from the E.U.

Back in 2016, after the referendum vote, the pound continued to crash and the U.K. stock market advanced. People, being people, linked the two together and it was thought that the stock market advanced because the decline in the pound would increase overseas earnings for U.K. companies. We don't agree with that causality. The pound declined and the stock market advanced because of their respective Elliott wave cycles.

Now, in 2019, our Elliott wave analysis suggests that the pound is at risk of another plunge, but that the U.K. stock market is at the beginning of a precipitous decline. This forward-looking analysis might be giving us a clue about a future scenario whereby a no-deal crash-out is so devastating for the U.K. and European economy that no amount of pound devaluation will help corporate earnings. In that situation, asset price and debt deflation will dominate.

190731 Deflation