United Kingdom: Brexit is coming
Tail risks rise
In our previous quarterly outlook, we expressed confidence that the EU and the UK would be able to successfully agree upon a draft withdrawal agreement text before the end of November. This has indeed happened. Additionally, the 26-page political declaration — a non-legally binding text which will sit alongside the withdrawal agreement and sets the parameters for the talks ahead on the future relationship — is simultaneously ambitious, ambiguous and complex. Nevertheless, we take heart from the fact that the parties are: A) aiming to develop an “ambitious, broad, deep and flexible partnership” and; B) seeking to “build and improve on the single customs territory provided for in the” Irish backstop. This to us suggests that the most likely form of Brexit will still be a soft one, however, given that the final destination of Brexit is still to be determined over a number of years of further negotiations we recognise that talking about “soft” and “hard” Brexits at this point in the negotiation is becoming increasingly obsolete. Furthermore, the road to get to this point in the negotiations has, as ever with this Brexit psychodrama, been bumpy at best, tumultuous at worst. The height of this tumult came on the 14th of November, the day after the draft text of the withdrawal agreement was agreed to by the UK’s cabinet. This saw six senior and junior ministers, including the Brexit Secretary Dominic Raab, resigning in protest at a deal which will see the UK locked in a stand-still transitional arrangement with the EU for between two to four years.
Looking ahead, we expect tumult to be the modus vivendi of the first quarter of 2019 and perhaps even the first half. This is because, while we fully expect the British executive and the EU to conclude a deal in principal, the UK Parliament seems intent on asserting its authority, and voting it down at the meaningful vote – likely to happen in the week of the 10th of December. Indeed, if only those Conservative Members of Parliament (MPs) who have publicly called for a vote of no confidence in Prime Minister (PM) Theresa May and MPs from the Democratic Unionist Party (the party that currently props up her administration and are avowed Brexiters) voted against ratification of the deal, then she would lose the vote by well over 60. Unfortunately for PM May however, given the broad-based revulsion of the deal by MPs across the political spectrum it’s entirely possible that she loses the vote by over 100.
It is at this point, at this height of maximum uncertainty, that markets are likely to react extremely negatively to what, by automatic operation of international law, would mean the UK crashing out of the EU on the 29th of March. We would caution however, against such a knee jerk reaction. While “no deal” risks have certainly risen (see table below), as PM May has herself emphasised, the options on the table are her Brexit deal, “no deal” or “no Brexit at all”. We at Russell Investments would concur with the PM and have assigned increased subjective probabilities to the tails of the Brexit scenarios in the wake of the British political establishment’s negative reaction to her deal. In particular, we would highlight the upside risk of “no Brexit” happening by the 29th March 2019, either via a new general election or another referendum. This latter scenario is becoming increasingly important as the British public’s opinion on Brexit is progressively souring (see chart below).
|Scenarios||Oct 2018||Nov 2018|
|”No deal” Brexit||10%||25%|
Source: Russell Investments, as of November 30, 2018.
This volatile political roller coaster that is laid out ahead of us makes navigating asset markets particularly difficult at present, both because of the binary nature of many of these scenarios and the possible contradictory signals markets would likely send in their aftermath. For instance, the “no deal” Brexit scenario which would see the UK crash out of the EU without any deal in place. Sterling would take a battering and likely head towards $1.10 against the U.S. dollar (USD) but the FTSE 100 Index would likely move in the other direction as it is dominated by USD and euro earners which would see their earnings appreciated by a falling sterling. In order to cut through this Brexit-induced fog, we will, for the rest of this piece, focus on our baseline or modal expectation for what is likely to happen. Our baseline scenario is that the withdrawal agreement will initially fail to pass through the Commons only to be accepted at a second vote as MPs recoil from the economic abyss that is no deal and the markets’ pummelling of UK-domiciled assets.
For sterling, this baseline scenario implies a significant amount of volatility ahead, with a further bout of negative performance triggered by Parliament’s initial rejection of the deal, followed by recovery, as the deal is approved, and the likely final length of the standstill transition allows the BoE to resume hiking the base rate by at least two times a year. Given markets are currently pricing in only one hike over the whole of 2019, this should provide additional cyclical impetus to sterling against both the U.S. dollar and the euro. For rates markets on the other hand we’re likely to see UK gilt yields fall in the aftermath of a parliamentary rejection of the deal as safe haven flows pour into government bonds. However, if we’re right that a deal is eventually accepted then gilt yields are likely to push up over the course of 2019 as a combination of safe haven outflows and a repricing of the short rate path means that rates will be pulled up towards their fair value yield of 2.2%.
For equities, the story is more complicated. In relative space the performance of locally orientated equites (versus more internationally focussed) is likely to mirror that of sterling. The standstill transition should allow UK economic activity to kick into a higher gear which will likely flow through into higher earnings growth for domestically oriented companies. On an absolute basis, the performance of much more internationally focussed large-cap equities will be driven as much by commodity markets, as by global GDP growth and investor appetite. While commodity markets, particularly, energy and metals are likely to provide a positive tailwind to a subsection of UK companies, a growth slowdown in the U.S. and fading stimulus in China is likely to be the dominant cyclical factor driving UK equities. Additionally, as we highlighted earlier, if we’re right and sterling does eventually rise on the back of a successfully implemented Brexit treaty then this will provide another factor holding back UK equities, as the majority of UK listed companies’ earnings are derived from USD or euros.
- Cycle: For 2019 our expectations for GDP are on the higher end of industry consensus at 1.75% believing that a successfully consummated Brexit withdrawal treaty will allow business confidence to return and investment to pick up. However, on the flip side of this, because of the length of the potential standstill transition the BoE is likely to hike at least twice next year and twice again the year after. As a result, this will intentionally constrain the UK economy which we believe is now at potential.
- Valuation: As UK equities have effectively traded sideways over 2018 they continue to look slightly cheap on our scorecard at Q4 2018. At 1.4%, 10-year gilts are still long-term expensive, and indeed more expensive now than this time last quarter given our higher forecast for UK base rate.
- Sentiment: For equities, price momentum has become more negative, but the market sell-off has triggered a few of our contrarian oversold signals, keeping us slightly positive. For gilts we are getting a mixed signal from the contrarian indicators we track, although momentum has improved significantly of late.
- Conclusion: While the prospect of a negotiated Brexit settlement is still our base-case scenario, the increased tail risks of either “no deal” or “no Brexit” make us increasingly leery at expressing directional views on UK assets such as sterling and gilts. For equities, we still prefer domestically focussed equities versus international focussed large-caps over a longer cyclical horizon. However, if sentiment continues to strengthen for global equities via a higher contrarian buy signal, then we would likely move to an outright positive position in UK equities on an absolute basis as well.
Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.
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