United Kingdom: Brexit risk is rising
An agreement is coming…
Our expectations regarding the final Brexit deal have consistently been on the softer side of the spectrum. In our previous quarterly outlook report we highlighted the risk that a collision was coming between the Hard Brexiters' vision of "Global Britain" – a sovereignty-wielding, free-trading nation – and the constraints faced by the British government. Namely, a "no deal" outcome is economically unaffordable; a full exit from the single market and EU customs unions wreaks havoc on the Good Friday accord; and parliamentary arithmetic that favours a negotiated Brexit.
However, rather than a battle over remaining in the EU’s customs union being the lightning rod of a collision – as we expected – it turned out the Chequers deal agreed unanimously by the British cabinet on July 7, 2018 proved too much for the Hard Brexiters to stomach. In quick succession, we saw senior Brexiters and cabinet ministers such as the Foreign Secretary Boris Johnson and Brexit Secretary David Davis resign in protest at what they perceived to be one concession too many to the European Union (EU). However, from a dispassionate economic view, the deal agreed at Chequers, is a welcome shift of the needle towards an economically sane Soft Brexit. In particular, we would highlight the reference to "an Association Agreement", potentially along the lines of the recently completed Ukraine-EU Association Agreement, as an important development.
This isn't to suggest that the outlook for the UK economy is now sunlit uplands. First of all, the damaging effects of the preceding talk of no-deal Brexit can clearly be seen in our two favoured measures of UK risk premia – the Pound/Euro exchange rate and the performance differential between the FTSE UK Local and FTSE 100 indices – which, in the chart below, we see getting progressively worse through the first half of 2018 until the end of August. Secondly, the EU rightly has significant misgivings surrounding both the "common rulebook & facilitated customs arrangement" proposed in the Chequers white paper and the risk that these may all but unravel the Single Market, the EU's crown jewel.
Nevertheless, the white paper has acted as a significant catalyst to further progression of the Brexit negotiations in both form and substance. A clear indication to this can be seen in the fact that in his first 34 days as the new Brexit Secretary, assuming the role on July 9, Dominic Raab met with his EU counterpart, Michel Barnier, as many times as his predecessor did in the whole of his 2018 tenure. As a result of all this, we agree with Barnier’s statement on the 11th of September that the EU and the UK will be able to "reach an agreement [...] on the Brexit treaty, within six or eight weeks."
Isolating the Brexit-Induced UK Risk Premia
Source: Thomson Reuters Datastream, 9/10/2018.
- Business cycle: Looking ahead to 2019 our expectation for GDP growth is in line with industry consensus at 1.3%-1.6%. We believe that a successfully completed Brexit withdrawal agreement will allow some confidence to return to the British economy. However, the BoE is likely to stand pat on further rate hikes until after Brexit has been fully consummated, at which point we expect them to hike another two or three times before having to step off the brake pedal because of U.S. recession risks. On the corporate side, we expect earnings growth between 5%-10% over the next year – slightly below expectations due to our constructive sterling view.
- Valuation: UK equities continue to look slightly cheap on our scorecard at Q3 2018. At 1.5%, 10-year gilts are still long term expensive. However, given the near 20bps rally in yields we’ve seen over the third quarter, we no longer classify government bonds as very expensive, just expensive.
- Sentiment: Both UK equities and gilts have neutral overall sentiment scores as of mid-year, and in both cases underneath the surface both price momentum and the contrarian indicators are neutral.
- Conclusion: With the prospects of a negotiated Brexit settlement looking increasingly likely, we feel a marginally more positive outlook for UK assets is warranted. Given the tight negative correlation between the FTSE 100 and sterling, we prefer to express this increased positivity through domestically focused UK equities.
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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