The odds are shifting
In our mid-year outlook, we shifted our base-case scenario to an expectation that for Brexit to occur there would first need to be some form of additional public vote – either another general election or a second referendum – to break the political gridlock. Since then, we have seen markets and events significantly move to pricing in this outcome. However, with Parliament tying the hands of Prime Minister Boris Johnson with the Benn Act, which explicitly precludes a no-deal Brexit on the 31 October, the incentives for him to go for a deal are increasing. Nevertheless, we retain the view that another public vote is required to break the deadlock, either because the deal Johnson brings back is rejected and a new election is called, or a deal is approved, but on the condition that a second referendum is held.
Public opinion is slightly in favour of remain, but the gap is not wide enough to be confident of a remain victory in a new referendum. Polls held before the 2016 referendum gave remain a similar advantage. The division in public opinion mirrors the parliamentary division and is a reason why the issue has been so difficult to resolve. Three years after the referendum, there has not been a decisive shift to either remain or leave.
What does this outlook mean for our Brexit scenario probabilities? Firstly, with Parliament effectively blocking a no-deal Brexit, for now, we lower our no-deal probabilities from 30% to 20%. Secondly, recognising the increased incentives for Johnson to secure a deal, we raise our deal probabilities from 35% to 45%. Finally, with events moving in the direction of a second referendum, we retain our no Brexit probability at 35%.
Probability of Brexit end-state scenarios
| June 2019
Source: Russell Investments
Base-case scenario: A vote is coming
While our base-case of another vote has not changed, market movements over the third quarter have altered our asset class outlook. At mid-year, we expected sterling and domestically focused equity to do poorly as no-deal risks would ratchet up. This quarter, we expect the opposite. Sterling and domestically focused equities will continue to rise as the market moves to our view that no-deal risks have receded. Additionally, UK government bonds will underperform their global peers as the flight to safety that pushed yields so low starts to unwind.
We expect large-cap UK equities will be buffeted by a triplet of threats and opportunities over the quarter: sterling; trade war resolution; and a global recession. Because of the asymmetry of the latter two possibilities, we retain a cautious stance towards global equities. This caution flows through to our UK equity view, with the added wrinkle being our expectation for a stronger sterling which would negatively impact company earnings. As such, we would expect UK large-cap equities to underperform the global benchmark.
- Cycle: Given a stronger than expected second quarter and reducing no-deal risks, we increase our 2019 GDP growth forecast to 1%, still-below industry consensus. The Bank of England will continue to stand pat and hold off on rate hikes until well after Brexit has been resolved, most likely in 2020.
- Valuation: UK equities have moved to moderately cheap levels of valuation according to our Q3 asset class scorecard. At 0.69%, 10-year gilts have remained extremely expensive.
- Sentiment: For UK equities, sentiment has moved neutral on both a momentum and contrarian basis. For gilts, strong price momentum is no longer being countervailed by short-term contrarian indicators, leaving us moderately positive overall.
- Conclusion: The need for an additional public vote remains our base case scenario. For large cap equities, we see some short-term losses as likely due to sterling upside risks. Long term, however, we prefer to be neutral driven by attractive valuations and sentiment that is neither positive nor negative. For UK gilts, we move to a neutral score as sentiment becomes positive.