UNITED KINGDOM
OUTLOOK

Gridlock

With the UK’s political process gridlocked between No Deal Brexiters and No Brexit Remainers, we shift our base case to an expectation of either a general election or a second Brexit referendum to break the deadlock.

A bifurcating electorate

In our Q2 outlook published in March, we shifted our base-case scenario from an expectation that Brexit would occur via the already-agreed Withdrawal Agreement and accompanying Political Declaration, to a softer form of Brexit induced by the ‘indicative vote’ process. What we didn’t expect, however, was the explosion of the Brexit Party onto the scene and the subsequent bifurcation of the UK electorate into two effectively irreconcilable positions on Brexit.

It is possible to see how this process of bifurcation evolved over the second quarter by tracking the support for the various major parties that contested in the European Parliament election in May. As shown in the chart below, the political parties advocating some sort of compromise Brexit (i.e. a Brexit with a deal attached to it) persistently lost support to the parties at the extremes of the Brexit debate. Indeed, in the election itself, these ‘Compromise Brexit’ parties substantially underperformed what the polls had suggested would be the final result – capturing 22% of the vote versus the 29% predicted by an average of the five final polls conducted before the election.

EU election: opinion polling versus final result

Source: Russell Investments, based on public opinion surveys conducted by BMG,ComRes, Hanbury Strategy, Ipsos MORI, Kantar, Number Cruncher Politics, Opinium, PanelBase, Survation, and YouGov.

This bifurcation of the electorate is likely to infect Westminster politics, and hence the still unfolding Brexit process, in two important ways. Firstly, the lackluster performance of the Conservative Party in both the European elections and national parliamentary polls will almost certainly force the party to swerve towards backing the No-Deal Brexiter Boris Johnson to try to win back voters from the Brexit Party. The second effect will be to further entrench each opposing side’s view, making compromise even harder. We have already seen this latter effect play out in the aftermath of the European Parliamentary elections, with each side claiming victory. As a result, we have shifted our base-case scenario to an expectation that an additional plebiscite of the UK electorate’s opinion on Brexit, either in the form of a general election or a second Brexit referendum, will need to be carried out in order to break the deadlock.

While the immediate impact of either of these plebiscites would push the Brexit deadline back further, either would also shift the probabilities of the three primary Brexit end-state scenarios (see table below). The first and most obvious impact is to substantially reduce the probability of a “Compromise Brexit” occurring from 70% to 35%. Secondly, with No Deal Brexit likely to become the explicit policy of the party in government, the risks of this occurring, either on purpose or by accident, have undoubtedly risen – in our estimation from 15% to 30%. Finally, we are also materially marking up our probability that no Brexit at all occurs, from 15% to 35%. In almost all possible scenarios, this latter effect only comes about through a second Brexit referendum however, we believe this is becoming increasingly likely.

Probability of Brexit end-state scenarios

   Mar 2019
June 2019
"No Brexit" (Remain)
 15%  35%
 "Compromise Brexit"  70%  35%
 "No-Deal Brexit"  15%  30%

Source: Russell Investments

Base-case scenario: another plebiscite

Focusing on our base-case scenario that another plebiscite is required to resolve the Brexit deadlock, we see a number of clear implications for UK asset markets and macro fundamentals.

For sterling, this updated scenario implies further downside potential against both the euro and the U.S. dollar, as both no-deal risks ratchet up and the potential for an avowedly left-wing government in the form of the Labour party becomes a possibility. For UK government bonds (gilts), the picture is almost the exact opposite as either of these political risks would push risk premia, and hence yields, down. Additionally, the threat to gilts of base rate hikes from the Bank of England (BoE) has been taken off the table by the UK economy screeching to a halt. We now expect nearly zero growth over the rest of the year as Brexit-induced uncertainty batters business and consumer confidence.

This damage to the UK economy has already flowed into the performance of locally orientated versus internationally focused equities, and we would expect that trend to continue until some form of political resolution emerges. On an absolute basis, the performance of the much more internationally focused large-cap equity index will be driven by commodity markets, the global cycle and investor risk appetite. Over the second quarter, all three of these have taken a substantial beating, with both commodity markets and investor-risk appetite down as the global cycle turned negative due to global trade war risks. Looking ahead, we are wary of calling the bottom in the global cycle just yet, as the potential remains for higher U.S. tariffs to further damage global supply chains. Bringing all this together, while we expect UK equities to outperform to some extent as sterling weakness provides a tailwind in the short term, in the medium term we expect UK equities to broadly track global equity market movements.

Strategy outlook

Cycle: We significantly mark down our 2019 UK GDP growth forecast to a near industry consensus of 0.5% on the basis of a substantially delayed Brexit deal. We believe this delay will continue to sap UK business confidence and investment. We believe the Bank of England will stand pat and hold and rate hikes until well after Brexit has been resolved, most likely in 2020.

Valuation: UK equities continue to look slightly cheap at mid-year on our asset class scorecard. At 0.85%, 10-year gilts have become even more expensive.

Sentiment: For UK equities, price momentum has neutralized alongside our suite of contrarian indicators. For gilts, strong price momentum is being countervailed by both short- and medium-term contrarian indicators firing, leaving us neutral overall.

Conclusion: A much more drawnout Brexit process on the back of another plebiscite has become our new base case. For large cap equities, we see some short-term gains as likely due to sterling downside risks. Long term however, we prefer to be neutral driven by cycle concerns and sentiment that is neither positive nor negative. For UK gilts, we continue to retain a negative score driven by valuation concerns.

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.

The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested.

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