What is the stock market for?

The economic textbooks and the websites of the major stock exchanges proclaim that the key role of a stock market is raising equity capital for businesses wishing to invest and expand. They are the location where those seeking to invest in equity securities can interact with those seeking to issue those same securities. A stock exchange provides this primary market role (trading in new equity securities) within the economy and is enabled to do this by its secondary market role (trading in second-hand equity securities) where the pricing of shares evolves minute-by-minute in response to economic, political and corporate news. New companies to the exchange wishing to sell new shares will find the price of their shares determined with reference to the share prices of other similar companies, and existing companies wishing to sell new shares will find the price of such issues determined by the existing secondary market price.

Thus, in theory, stock exchanges play a pivotal role in capitalism, providing the key market mechanism for the delivery of new equity capital.

Broadly this could be argued to be the case until the TMT bust in 2000-01. Many investors who invested in internet-related new issues during the boom saw 90%+ losses on these shares and confidence in the prospects for new equity issues was lost.

Two other trends emerged at the same time. The first was a shift in investor flows from public equity markets to private equity markets. Thus private equity funds had large cash positions to provide the equity capital for firms wishing to expand, obviating the need to issue shares on the stock market. The second was low inflation, leading to low interest rates and bond yields and consequent strong free cash flows for companies.

A combination of strong free cash flows and owners increasingly focussed on optimally-financed balance sheets at a time of low interest rates meant that in fact companies were seeking to reduce their share count rather than increase their share count through new equity issues.

In recent years however, the primary capital-raising role has all but disappeared as many companies have instigated share-buy-back schemes and barely any companies issue new shares. Even the private equity funds seeking to realise their investments rarely use the stock market for their exits as other private equity funds (with very substantial cash holdings) will buy from them directly.

Stock exchanges thus find themselves left only with their secondary market role. To critics this means a stock market is merely a massive casino in which speculators sell second-hand bits of paper to other speculators and no useful economic purpose is served.

In fact though, the function of the stock exchange has evolved. It has now become the key source of expected long term growth investment returns that enable individuals in a society to save for an extended period of retirement following a working lifetime. Thus the function of stock markets has evolved from the provision of capital to the provision of investment returns on long term savings.

Politically this is hugely significant – the level of the stock market has moved from being of minimal interest to politicians to being a vital factor in the public’s estimation of economic and political success.

The implications of this shift in the key purpose of the stock market are:

  1. Economic policymakers are more likely respond to falls in the stock market, whether or not there is an economic justification for the market decline. The famous quote from Paul Samuelson that “the stock market has forecast 9 of the last 5 recessions” highlights the risk of a policy mistake. There is an inbuilt potential policy error of monetary policy being too easy which at some point creates an inflation problem.
  2. The positive feedback loop between a strong stock market, investor (and hence consumer) confidence and a good economy has taken market valuations to historically very high levels. Following a shock to the system, this feedback loop could easily move into reverse with severe economic consequences.
  3. Demographics matter for analysis of stock market trends. The “baby-boom” generation (born between 1947 and 1962) are now aged between 55 and 70, just completing their peak equity-investing years and moving into the period of their lives when they seek to reduce their equity exposure to fund their retirement lifestyle. This has negative connotations for the valuations of financial assets in the future.

Beware the decennial seasonality of Year 7 Summer

Over the last four decades equity market prices have shown a clear and remarkably consistent pattern: from lows established in Year 1 or Year 2 in each of the decades since the 1980s, have risen steady and very profitable bull markets which run into problems that begin in the summer of Year 7.
It was in August 2007 that the first cracks appeared in securities related to the US housing market – BNP Paribas froze dealing in three of their funds which contained packages of sub-prime mortgage loans called CDOs. The next month in the UK, Northern Rock which had been relying for its ongoing liquidity on demand for sales of its securities mortgages saw queues of its savers outside e very branch in a vivid replay of a nineteenth century “bank run”. The next six months saw pressure on any company which had been associated with US mortgage debt – Bear Stearns was bought by J P Morgan, the two major US mortgage providers were put back into government ownership and then Lehmans failed.
It was July 1997 that the Asian financial crisis began when Thailand was unable to ward off speculative attacks on its fixed exchange rate regime had enjoyed rapid domestic demand growth from both companies and consumers who were financed their spending by borrowing in dollars. When the exchange rate link failed, the value of their debts soared leading to a sharp recession and a banking crisis, which spread throughout East Asia. Indonesia, the Philippines, Malaysia and South Korea had similar banking and economic issues. China escaped this crisis and indeed emerged relatively unscathed since the renminbi was a non-convertible currency.
The summer of 1987 saw a major market peak in August 1987, following several years of strong market performance. There was no particular economic or political event that could be said to have been the trigger for the one day fall of 22% in the Dow Jones Index of 22%, other than an increasing realisation that markets were very highly valued. Consequently, many investors had put in place a strategy of “portfolio insurance” which meant that their market exposure was reduced and their positions were sold in response to a market decline. On October 19th this created a wall of continuous selling which pushed the market lower and lower.
The recent very hot weather is a reminder that we are now in the Summer of Year 7 for this decade. There are plenty of candidates for where a new bear market may begin – the consistent upward move from the US stock market in recent years has taken it to valuation levels only seen in 1999, the recent failure of two banks in Italy is a reminder of the weakness of many European banks, in China there has been an extraordinary build-up of domestic debt and the government id desperately trying to maintain its near-fixed link with the US dollar. Or geopolitics may play a part this time – President Trump does not appear afraid to take action against North Korea and tensions in the Middle East between Qatar and the other Gulf nations have recently risen.
History suggests that investors be careful!

 

Passives Produce Premium Performance

Hendrik Bessembinder has recently published here a study of individual, stock returns in the US with some startling new insights into the risks of equity investment. The study encompasses 90 years of monthly return data on every stock in the CRSP database – just about as large a database (25,782 distinct identifiers) as it is possible to compile in US equities, and so any results are likely to have greater statistical significance than most other studies of stock returns which typically use much shorter time periods.

Some of his key insights are:

·       58% of stocks underperform the returns from 1-month T-Bills over their entire lifetime

·       All of the dollar wealth created by the stock market since 1926 (nearly $32 trillion) is attributable to just the best-performing 4% of the stocks and 75% of that wealth to just the best-performing 1% of the stocks.

·       Of all the individual monthly stock returns in the entire database, just 48% beat T-Bill returns, and less than 50% are positive.

·       The median life of a stock on the database is 7 years. The median lifetime return of a stock is -3.67%.

·       Mean returns of stocks are much higher than median returns – stocks display significant positive skew.

·       Smaller capitalisation stocks are more likely to underperform the monthly returns of T-Bills.

 

These insights present significant difficulties for traditional, active investors.

First, there are very few “winners” for stock-pickers” to identify and invest in.

Second, for those investors who focus on the mean and variance of portfolio returns, effective portfolio diversification requires investing in a very large number of stocks to avoid missing out on the few winners – poorly diversified portfolios are all that is required to underperform, even before transaction sots and fees.

Third, even where an investor has performed well, the low number of strongly-performing stocks means that it is more difficult to ascribe the outperformance to skill than to luck.

So investors that want to capture the significant equity asset class risk premium are well-advised not to invest in active portfolios of a subset of the equity market – this is an enormously risky endeavour – and are far better advised to invest in a strongly diversified portfolio of almost all the equity market, such as is found in a wide-ranging index. This is even more true of smaller capitalisation equity securities.

A recent post on Philosophical Economics takes this concept further. If by moving from an active and relatively weakly-diversified portfolio (a traditional active approach) to an indexed and strongly-diversified portfolio (a modern passive approach), an investor reduces the expected volatility of his portfolio, then in theory he would also be willing to accept a lower future expected return.

The most straightforward way to achieve a lower future expected return is to start from a more highly-valued level. Thus it could be that one reason for the historically high valuation of the US equity market is in fact the trend to very significant passive exposures to the US market adopted by many investors in the US market, since the passive approach in fact a less risky way to invest in equities. In this way passive investing is a cause of higher valuations.

The die is cast

Now that Royal Assent has been gained, the European Union (notification of Withdrawal) Act 2016-17 is in force and the only impediment to Britain leaving the EU is for the Prime Minister to write to the EU to trigger Article 50 of the Maastricht Treaty. This is expected in the next two weeks.

The die has been cast and this British action will lead to many repercussions, not all of which are visible today. It is however true that whilst leaving the EU is a very clear demonstration of British sovereignty, it is those repercussions that will determine just how effective and valuable that sovereignty is in today’s world.

Firstly, with regard to the EU, the deal we gain through the next 24 months of negotiations will primarily be a function of what sort of relationship the EU wishes to have with Britain. It may well make economic sense for both sides to have an essentially free trade regime in goods and services, very similar to that which exists currently. However the EU also has political objectives, prime amongst which is that any deal must look and be worse than remaining within the EU and its single market, in order to deter other countries from following the UK out of the exit door. Anti-EU views are gaining ground in France, Italy and Holland, all founding members of the EEC. Some degree of economic loss will be acceptable to the EU in order to achieve these political objectives, and though this may be higher in absolute terms than the loss to Britain, that economic loss would be much smaller as a share of their total economy than for Britain.

Britain’s economic fortunes are thus dependent on the political calculations of the rest of the EU.

Secondly, with regard to the USA, a “special relationship” may or may not exist, but if it does it has always been on US terms. Pre-Trump, the UK was an invaluable bridge between an inherently individualistic US political philosophy and an inherently social European one. – Britain was able to explain and translate each side’s thinking to the other. By leaving the EU this role is hugely diminished, though may still apply to defence matters.

With Trump as President, the picture is more complex. Trump sees Brexit as part of the same changing political tide that saw him elected and Britain’s need for a series of bilateral trade agreements fits very neatly into his philosophy that the US should only negotiate bilaterally in order to maximise its own influence. He clearly enjoys visiting his properties in Scotland and he may wish to be seen rapidly concluding a trade deal with Britain in order to contrast trading relationships with other developed world economies with those of less developed economies such as Mexico and China which he believes have been detrimental to US jobs.

He is though very unpredictable, and would likely seek some painful concessions from Britain, in order to demonstrate that he had “won” the negotiation. Britain would thus be dependent on his capriciousness, both in any trade deal and more widely in global affairs.

Thirdly, China sees itself as a key world power that is happy to make agreements with other countries, but is not very interested in negotiating them. It prefers to set out its terms and wait for others to agree to them. British sovereignty would extend to deciding whether or not to agree to what the Chinese want.

These 3 giant entities (EU, US, China) account for 57% of the global economy and an even greater percentage of UK goods exports – the fate of the British export sector and thus the wider economy is very much in their hands. Britain can only “take” what they wish to “give”. In relation to the size of these economies, Britain, though the 5th / 6th largest economy in the world, has little negotiating power.

Of the other countries who have expressed an interest in early free trade deals with a Britain outside the UK, both Australia and India have indicated that a key objective in any such negotiations would be greater freedom for their citizens to come and work in the UK. This is directly counter to the British government’s policy to substantially reduce immigration. In addition all the nations seeking trade deals are a very long way from Britain and international trading relationships display very strong correlations to geographic proximity.

British sovereignty has been dramatically exercised – the die has been cast – Britain is about to set out on a new independent path for its economic development – its fortunes, however, certainly in the next few years, now depend very heavily on the actions of others. Re-asserting sovereignty may feel liberating now but be economically painful in the future.

 

Jeux avec frontieres

Before the UK joined the EEC in 1973, most Britons knowledge of Europe was from the BBC game show Jeux sans Frontieres (Games without Borders), which showed that Europeans were as prepared as Brits to dress up in silly costumes and attempt bizarre tasks against teams from other countries. It may even have played a part in Britain’s referendum to support EEC membership.

It is now 12 months since David Cameron permitted his government ministers to break from Cabinet responsibility ahead of the second EU referendum. The campaign and decision to leave, followed a few months later by the election of President Trump has transformed the political debate around the world. Since World War 2, the political debate was between those who thought government should seek to do less within society and those who thought government should seek to do more within society. The events of 2016 however show that the debate is now between those who would like national borders to be more difficult to cross (whether by people or goods) and those who want borders to be easier to cross.

Regarding people crossing borders, Mrs May’s immediate conclusion from the referendum was that the British people voted for regaining control of immigration, and the right to live in Britain, and that this was more important any economic benefits from EU membership. Her policy and approach to Brexit since then has clearly been dictated by that conclusion. It is however, notable, that the parts of the country most concerned by immigration are correlated to those parts of the country with the smallest immigrant populations.

For President Trump, it is the twin threats of illegal immigrants from Mexico and radical Islam from some Muslim nations that underpins his desire to establish more effective control of America’s borders. His geographical distribution of support in the election also correlated with low levels of immigrant population.

For Trump, though not for Mrs May, borders are also important for controlling the movement of goods. He argues that the free trade agreements that the US has made in recent years has meant that cheap goods have poured into the US , displacing US-made goods and thus US jobs, particularly in the areas where he drew the greatest support. He seeks to maximise American negotiating leverage by withdrawing from multilateral trade agreements such as the TPP and NAFTA and replacing them with bilateral agreements where the US will (nearly) always be the more powerful party and be more likely to reach agreements that are closer to American interests.

For the UK, voluntarily withdrawing from a trade bloc even larger than the US and seeking new trade agreements with the rest of the world, the general acceptance of free trade is paramount and much rhetoric about the UK being the beacon of free trade in the world (and goods and services crossing borders easily) can be heard from UK Conservative politicians. One early issue that UK politicians have discovered is that many of the countries (eg India and Australia) that would be keen to enter into free trade agreements with the UK, are also seeking greater freedom for their people to enter and stay in the UK.

Unusually for economists, almost all of them agree that free international trade is a good thing for the global economy (though this is not the same thing as being good for everyone in that global economy), and that the last time, the world economy saw a significant increase in protectionism, in the 1930s – this was associated with dramatic declines in trade levels and a global economic depression – ending in World War.

This desire for reinstatement of borders also flies in the face of the reality of technological progress. For people travel across the world is cheaper, more straightforward to plan and a more realistic aspiration that ever before in history. Making that more difficult implies a key loss in economic terms

For goods, bar codes, the standardisation of shipping container and the prevalence and complexity of international supply chains supported by logistical improvements has created huge efficiencies with both higher volumes of trade and lower prices for all. Re-establishing border controls (not only between the US and Mexico but also between the UK and the EU) will raise prices and reduce the global standard of living, even if tariffs remain at negligible levels.

For services, the digitisation of the world means that borders are increasingly irrelevant. More and more retailing is conducted in the ether, a large part of the world satisfies its desire to watch soccer by watching the English Premier League online, even investment bankers outsource research model-building to staff in India.

The current wave of national populism is selling the idea of greater security through control of borders and plays on traditional human tribal urges to discriminate against outsiders. It appears to be going against where technology is taking the human race and the risk must be that to deliver border control will require increasing levels of force, militarisation and regulation that will act to reduce standards of living. It also flies in the face of another great human urge – to welcome and be hospitable to visitors.

 

 

An era is ending

A year which sees Britain vote to leave the EU and the US vote Donald Trump to be their President is clearly one which could be said to be the beginning of a new era. Perhaps of equal significance is the fact that an old era is ending, which may well have played a part in enabling this new era to begin.

Jim Callaghan’s remark to the BBC in 1976 that “We used to think that you could spend our way out of a recession … I tell you in all candour that that option no longer exists” marked the end of the post-war consensus on Keynesian demand management of the economy and the primacy of fiscal policy over monetary policy in economic policy-making. Since then monetary policy has been dominant, and changes in interest rates have taken the lead in adjusting the course of the economy. Central banks have become independent given the crucial (technocratic) role they are believed to play in the modern economy.

However, recent experience shows that at very low interest rates, further monetary easing has little and arguably, counterproductive, impact on the economy and the central bankers at the Fed, Bank of England, ECB and Bank of Japan have all made it plain that they cannot deliver the faster growth that governments are depending of them. At zero or even negative interest rates and substantial Quantitative Easing, we have reached the limits of effective monetary policy. Even if the next move is “helicopter money”, this is as much a fiscal policy as a monetary policy. The era of monetary policy primacy is ending.

The era of trade policy liberalisation that started in the mid-1980s is also ending (as discussed here) – no major new multilateral  trade deals have been struck for about a decade and the recent TTP and TPP deals look like they will not survive contact with Donald Trump. In addition, NAFTA looks unlikely to survive in its current form and whatever the outcome of the Brexit negotiations, trade between the UK and the EU will be less free than it is today. 2015 marked the first year in decades that the growth in world trade was slower than the growth of world GDP – trade has acted as an accelerator for the world economy, now it is acting as a brake. The message from the successes of both Brexit and Trump is that national borders will be subject to greater controls and it will be less easy for people and goods and services to cross them. The era of greater openness is ending.

The effects of these two major eras has been most clearly seen within financial markets in the 35-year bull market in government bond markets of Western nations. The eye-wateringly high interest rates required by monetarism in the early 1980s to combat inflation have given way to the “rigged” bond markets in which central banks have become some of the largest owners of their own bond markets. It is not yet clear that this bull market is over, but a world of fiscal policy primacy over monetary policy is likely to have higher interest rates and bond yields.

This bull market has supported and inflated the markets in all other financial assets as the risk-free rate of return has declined, creating large gains both for those invested in financial assets and for those firms that aid and service them. This “financialisation” of the economy, in which the financial sector has been growing faster than the rest of the economy over this period has been a major trend.

The big winners of this trend have been the asset managers – attractive market returns have attracted strong inflows of assets and substantial economies of scale have nearly all accrued to the fund managers rather than their investors. The recent report from the FCA on the asset management industry highlighted that it was one of the industry sectors with the highest profit margins. Asset managers now top the tables of highest-paying industries, having recently overtaken investment bankers, for whom profitability has been of increasing concern since 2008. The attention of the regulators has noticeably shifted in recent years from banks to investment managers. The asset management era, which began in the early 1980s, may also be peaking.

All these trends began between 30-40 years ago, and all have showed distinct signs of ageing in recent years. The dramatic events of 2016 may represent the “coup-de-grace” for them and the conclusion must be that the future will look increasingly different from the past.

Fiscal policy will become more important than monetary policy, international trade will come under increasing pressures, bond yields will not always fall, the financial sector will fall back as a proportion of the economy and the profit margins of the asset management industry will decline.

Brexit with Trump

Just six months ago, the probability of victory for each of Brexit and Trump were 30% – and the odds on the double were thus 10-1 against. The world going into 2017 looks a very different and more uncertain place than it did a year ago.

However, Trump’s victory provides the UK with an opportunity to gain a substantially better agreement with the EU than it would have done with a Clinton victory, even though Mrs. Clinton may well have leaned on the EU countries to give the UK a sensible deal.

Trump’s victory has many European governments feeling considerably less secure. With his outspoken admiration of Vladimir Putin and his tendency to see foreign relations as a zero-sum game rather than mutual gains through international agreements, Trump’s view of NATO and European security is very different from his predecessors. For those in Eastern Europe, Putin is today a bigger threat to their borders and US military support less likely to be forthcoming.

One of the few cards that the UK holds in the Brexit negotiations is it deep and unwavering commitment to the military defence of its European allies, and despite the harsh words used against the rest of the EU from those seeking to leave the EU, their military support for the EU has not changed and they have consistently voiced this before, during and since the referendum. That support has now become much more meaningful and valuable, especially to those countries in the former Eastern Europe. 

The desire to punish the UK for its audacity to leave the EU is now (post Trump) more likely to be to seek a strong agreement with a staunch ally who is also a nuclear power. On the Maslovian hierarchy of needs, the basic security of your country is a far more powerful force than the continued existence of a financial passporting system or some controls on the uninhibited movement of people between countries.

In addition, once again, through their votes, the UK and the US have shown the similarity of their thought processes (a clear parallel being  the ascensions of Thatcher and then Reagan), which often baffle European minds.  Maintaining a close and friendly relationship with the UK is likely to be helpful to Europeans in understanding and interpreting the actions of the US. Trump has spent time in the UK (though mostly in Scotland), has openly identified his success with Brexit and did

promise to put the UK at the front of the queue for a trade agreement post-Brexit, following Obama’s threat that it would be at the back of the queue. Though of course this would be strictly on Trump’s terms, and have almost no cost to US jobs – it would enable him to show that there are some trade deals he will do if they are right for the US. The EU-US trade deal, already stymied by European doubts before Trump’s  success is now dead in the water.

Trump’s victory will change the world in many ways, but one of the more surprising ones is likely to be that the UK obtains a better exit agreement from the EU than would have occurred without Trump.

In the down phase of the trade deals cycle

The UK’s referendum decision to leave the EU, leaves it seeking new trade deals not only with the rest of the EU but also with the 50 or so nations with whom the EU has trade deals in place. The new minister for International Trade (Liam Fox) has also indicated that he would be keen to see trade deals with the US, Canada, Australia, New Zealand, India and China. Without trade deals, countries may impose tariffs on imports of goods and stiff regulations on imports of services.

Not only does the UK have very few experienced trade negotiators, since this has long since outsourced to the EU but the UK’s demand to make trade deals comes at a most inopportune time in the trade deals cycle. Recent events indicate the momentum and desire for agreeing trade deals have reversed.

The trade deals cycle began to turned upwards in 1986 when talks for the Uruguay Round within GATT began – with the free market philosophies of Thatcher and Reagan leading the way for countries to reduce the barriers to international trade that were in place. The talks concluded successfully in 1994 with an agreement that reduced global tariffs on goods substantially, so boosting the volume of trade. Other key free trade agreements have been NAFTA which came into force in 1994, the development of the EU Single Market in the 80s and 90s, where Mrs Thatcher did much to drive progress.

As part of that agreement the World Trade Organisation was set up in 1995 to take over GATT’s responsibilities for matters relating to international trade. In 2001 the WTO initiated the Doha Round, at the same time as China was admitted to membership of the WTO. The accession of China to the WTO saw a further dramatic rise in global trade volumes until 2008.

In hindsight this was peak of the trade deal cycle and agreement between nations to reduce trade barriers. No significant progress has been made since then.

The aim of the Doha Round was to further reduce global trade barriers especially within agriculture and services. It had an original deadline for an agreement by 2005, but was plagued by difficulties – negotiations collapsed in Geneva in 2008 and the Global Financial Crisis has meant that since then national governments have been unwilling to make concessions that might harm their citizens.

In recent years, following the collapse of the Doha Round there have been three attempts at major non-global trade agreements. These are between (i) the US and the EU via the TTIP (Transatlantic Trade and Investment Partnership) talks, launched in 2013, (ii) the US and other American and Pacific nations via the TPP (Transpacific Partnership) and (iii) Canada and the EU via the CETA (Comprehensive Economic and Trade Agreement) talks, negotiated between 2009 and 2014.

Of these TTIP talks have got stuck – the original intention to conclude by 2014 has been extended to 2019 but across Europe there is increasing unhappiness at the secrecy of the proposals and the progress of negotiations. The TTP talks produced an agreement but requires ratification from the US – during the campaign Donald Trump has stated his opposition to this and other trade agreements and would not ratify it, and Hillary Clinton, having been a supporter of it when in government has now said that she would not ratify it. The CETA has recently run aground as EU ratification of the Treaty requires each of the 28 member states to ratify it individually and Belgium cannot do so without the agreement of the Walloon parliament, which is currently firmly opposed to doing so, seeing as a further dangerous step towards globalisation.

Trade deals have lost their political support and the momentum of the trade deal cycle is now firmly down. Though the UK and the rest of the EU ought to be able to agree on a post-Brexit trade deal given the economic benefits to both sides, for the UK to conclude many other significant trade deals is likely to be a very long and arduous process.

The UK’s post-Brexit need for free trade deals will prove to be cyclically poorly-timed and a negotiating weakness at a time when countries are growing increasingly suspicious of the benefits of such deals.

 

A hard Brexit please

This week the government made clear its decision regarding the sort of Brexit it will be seeking. The red lines of control of immigration and withdrawal from the European Court of Justice’s jurisdiction represent the “taking back control” that the Leave campaign promised.

The other 27 countries in the EU have made abundantly clear that the price of Britain denying freedom of movement is that it cannot continue to be inside the single market –  the working definition of a hard Brexit. Thus some sort of agreement on how trade will be conducted between Britain and the EU will be required.

There appear to be two key areas to be negotiated before Britain actually leaves – (i) a transitional trade agreement pending a more permanent agreement which might take many years to conclude and (ii) an agreement on the financial services sector and the current passporting system.

It is interesting to note that the red lines regarding “taking back control” do not include the subject of the UK’s net contributions to the EU budget and it seems that Britain may be prepared to pay (financially) for a transitional trade agreement and agreement over continued financial services passporting. Whether this would be acceptable to the EU countries is not clear – the current payment from the UK of £18bn per year (which would presumably be the maximum that Britain would be prepared to pay), does not go very far when spread around 27 countries.

Whilst now is the time of maximum pessimism about Brexit negotiations -before formal talks have even begun and with each side setting out their red lines – Britain has lost goodwill in Europe over the last week following policy ideas announced at the Conservative Party ‘s regarding foreign-born workers.

Both Merkel and Hollande have made clear that it is important for them that Britain should be not be seen as having won anything by deciding to leave the EU, and though it is quite possible neither will be around to have much influence over the negotiations, their fellow-countrymen are unlikely to have very different ideas.

With important votes and elections in Italy, Spain, France, Netherlands and Germany over the next 12 months, little progress should be expected in the Brexit talks in that time period. This will prove negative to the world’s view of Britain – the pound has continued its post-referendum decline this week, and gilt yields have risen in anticipation of the higher inflation this is likely to create in the British economy.

International investors will at best defer further investment into the country and at worst begin making adjustments to their factory and office locations to reflect a Britain outside the single market. Any good news regarding the benefits of new trade agreements with other non-EU countries will have to await the outcome of talks to agree our relationship with the EU.

By announcing when it expects Article 50 to be triggered and its red lines, Britain has now entered a period of massive vulnerability for its economy. Maintaining the goodwill of the other EU countries should now be a key objective of foreign policy.

How do you like your Brexit – hard or soft?

“Brexit means Brexit” has been Theresa May’s equivocal line since the referendum. It has become clear that this actually means that Britain will leave the EU – the manner of that departure, however, remains unclear.

The difference between a “hard” and a “soft” Brexit centres around the relationship with EU single market which allows goods to move around the EU unhindered. A soft Brexit would allow Britain to remain in the single market, whilst a hard Brexit would see it leave both the EU and the single market.

All UK politicians agree, at the very least, that Britain should aspire to “have access to the single market”. This is, however, a meaningless form of words since all countries in the world (with the exception of North Korea) are able to sell their goods to buyers in the EU if they wish – ie they have access to the single market. What is more important is to have “tariff-free access to the single market” – provided a nation is a member of the WTO (World Trade Organisation) then a maximum tariff (or a tax) of 10% can be applied to trade in goods between them. In general, this tariff will be applied to all goods imports unless there is a separate trade agreement between the importing country and the exporting country. There is also considerable bureaucracy involved in proving that the goods meet any national standards or regulations of the importing country.

Being “a member of the single market” means that there are no tariffs and no bureaucracy – if the product meets EU standards then it can be freely sold anywhere inside the EU, and in practice the slightly larger EEA which includes Norway and a few other small countries. The major disadvantage of not being inside the single market is the bureaucracy involved at border points when goods cross in to the EU, which means higher costs for business. This is a particular problem for the border between Northern Ireland and the Republic of Ireland, which is currently completely open.

Being inside the single market is a real prize for business, is the main reason that Mrs Thatcher wanted Britain to be a member of the EU, and has been the UK’s main focus of political activity while a member.

Given the referendum result, the best outcome for Britain is not to be a member of the EU, and thus able to control its own borders (by ending freedom of movement to EU citizens) and write its own laws, but to retain membership of the single market. In fact, this would probably be the best outcome for every EU member and is why the EU negotiators will not agree to it.

Since Article 50 has not yet been triggered and negotiations have not yet started, both sides are talking tough and making clear that they would not be unhappy if nothing is agreed and Britain leaves the EU with no new agreement about trading relations in place. This is assumed by both sides to be that Britain would leave the EU and become a member of the WTO in its own right, rather than as part of the EU. This would be the hardest Brexit – access to the EU but with 10% tariffs applying to all trade (though Britain could unilaterally set a zero tariff on imports if it so wished). In any negotiation, the side least able to accept the situation if the event of no agreement has the weaker hand, so both sides are saying publicly that this would not be a problem for them.

Many in the UK claim that the €90bn trade deficit in goods that Britain has with the rest of the EU, means that the EU would suffer more, in money terms, from no agreement, whilst those in the EU point out that with 47% of Britain’s goods exports going to the EU, while for the EU’s leading exporter, Germany, the UK represents just 7.5% of their exports, the effective impact of tariffs on the British economy would be much greater than on the rest of the EU.

In practice, the obvious solution for both sides is tariff-free access for goods – it is the closest solution to the current situation and any tariffs would be negative for both parties. Provide the negotiations are conducted on a friendly basis, this should be the outcome, and can be construed as a medium-hard Brexit.

In financial services, where the UK has a large trade surplus, the EU operates a “passport” system, if a firm is regulated by an EU country it can apply to have a passport to provide those services in the rest of the EU. British firms are very keen to keep these rights, but if outside the EU they are dependent on the EU agreeing to this. France and Germany are both keen to have the power and the jobs from these financial services in their own countries, and so the price for maintaining these passports will be high. It is likely that the UK would have to offer concessions on the freedom of movement of people to achieve this – this would be a difficult compromise for the British people and politicians to accept.

Britain does not hold too many cards in the negotiations and a hard Brexit looks the most likely outcome.  Provided there is rationality and goodwill on both sides, tariff-free access for trade in goods should result, but an agreement on services, which is of greater importance for Britain will be much tougher to achieve.