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
|"No Brexit" (Remain)
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.
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.
The information on this website is only intended for use by professional clients, regulated financial advisers and intermediaries who are knowledgeable and experienced in the financial services market and in investment products of this nature. If you are a retail or individual investor then please leave this website immediately and consult your financial adviser.
You should not use this website unless you understand its nature and the extent of your exposure to risk. You should also be satisfied that the website and investments are suitable for your client in light of their circumstances and financial position.
The information contained on this website is for information purposes only and you should not take it as constituting an offer, solicitation, inducement, commitment or invitation to subscribe for or to purchase, sell or hold any interest in any of the investments mentioned herein.
This website is not intended for distribution or use by anyone in any jurisdiction in which such distribution or use would be prohibited. Nothing on this website or in the materials referred to therein constitutes, or is intended to constitute, financial, tax, legal or other advice.
The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested. Any past performance figures are not necessarily a guide to future performance.
The website may contain forward-looking statements, which are based on a number of assumptions regarding present and future business strategies, which may or may not prove to be correct. By their nature, forward-looking statements involve risks and uncertainties because they relate to events and depend on circumstances that may or may not occur in the future. Forward-looking statements are not guarantees of future performance.
Issued by Russell Investments Limited. Company No. 02086230 and Russell Investments Implementation Services Limited Company No. 3049880. Registered in England and Wales with registered office at: Rex House, 10 Regent Street, London SW1Y 4PE. Telephone +44 (0)20 7024 6000. Authorised and regulated by the Financial Conduct Authority, 12 Endeavour Square, London E20 1JN.
All reasonable care has been taken by us to ensure that the information contained on this website is accurate at the time of publication. However, we accept no responsibility for the accuracy, adequacy or completeness of the information and materials contained on this website and expressly disclaim liability for errors or omissions in such information and materials. We and our respective affiliates do not have any obligation to update the information contained in this website and reserve the right to change these terms and conditions at any time, without notice.
We will not regard you or any person who accesses this website as our client in relation to any of the investment products or services detailed therein, unless expressly agreed.