Investment Clock insights

Brexit: Halloween and beyond – adding to sterling…but treating it ‘scarefully’


Melanie Baker and Hiroki Hashimoto

11 April 2019

The EU have agreed a six-month extension to the Article 50 Brexit deadline (with headline writers everywhere delighted this morning with the 31 October Halloween deadline). If the UK parliament can ratify the deal before then, they can leave before then. Given events, if the UK requested a further extension before 31 October, our central case would be that one is granted since the EU clearly wishes to avoid no deal. ‘Brexit Day’ has become even more uncertain. 
Melanie Baker comments…
Six month extension offers limited comfort for businesses and the economic outlook: 
1) Fundamentally, no-one knows when the UK will actually leave the EU or under what conditions
2) Six months is time enough for plenty more political uncertainty – not least a general election (although it would be tight for a referendum) 
3) The blend of economic and political uncertainty is likely to continue to supress business investment which has already contracted for four consecutive quarters 
4) Brexit will remain a major distraction to the normal business of government and parliament. 
Risks to our 1.1% 2019 UK GDP forecast, however, have moved to the upside after strong February GDP growth. Mechanically, the outcome of Q1 GDP has an outsized impact on calendar year growth and Q1 looks set to come in close to 0.5%Q. However, the latest Purchasing Managers’ Index (PMI) business survey indicators point to stagnation and in our previous forecasts we had assumed more Brexit clarity in H2 than now looks likely (with the deal passing by then and boosting the economy). Now, with prospects of more prolonged uncertainty, albeit lower risks of a near-term ‘no deal’ outcome, the probability of the Bank of England raising rates before the end of the year has also fallen (we have been pencilling in a November rise).
 A 2019 general election moving closer to central case:
o  The government does not currently have a reliable majority in parliament. The Conservative party remains split over Brexit and party discipline had been severely compromised. The DUP have voted against the government on several occasions. 
o  Meanwhile, there are no signs that Labour and Conservative talks have actually made progress. The probability has fallen that parliament yet can find a way through all this via that channel.
o  PM May has angered a large chunk of her MPs and party membership by reaching out across party. 
o  Fixed-term parliament legislation is unlikely to prove much of a barrier if a general election were proposed by the government given Labour would presumably support one.
o  PM May cannot be forced to step down as leader of her party until December under Conservative Party rules, but may step down nevertheless. PM May had already said she would step down if the deal is passed and will likely come under even more pressure to step down by the Summer if a deal is not passed, the UK takes part in EU elections and/or the Conservative Party do very badly in local/EU elections. Although a risk, a new Conservative Party leader might welcome an election as a chance to bolster their position.
PM May’s deal is not dead yet…: It is still expected to return to parliament again and it is still not out of the question that May and Corbyn find some formulation they can both support, and the EU willing to accept, around the political declaration that would then lead Corbyn to instruct his MPs to vote for the deal. Furthermore, the UK taking part in EU elections at the end of May is presumably not a welcome prospect for many MPs (let alone the government or political parties already facing the expense of local election campaigning and prospects of a general election) and should increase pressure to pass a deal before then. That the UK leaves with the current deal – or something close to it is still central case (just). ‘No deal’ and not leaving the EU at all are still not the most likely outcomes. However, the process and timing have become much less clear. That the UK fails to leave the EU this year is almost as likely now as leaving with the deal.
…or even a second referendum: Extension to the end of October even allows sufficient time for a second referendum (the clearest route to ‘Remain’), although the timing looks tight given that the case for a referendum still needs more parliamentary support and agreement on the wording would likely take some time. 
 Hiroki Hashimoto continues… 
Case for further sterling strength: Fundamentals and reduced near-term uncertainty suggests that sterling could continue to strengthen from here against the euro. This extension shows the EU’s willingness to avoid ‘no deal’ and does reduce short-term uncertainty. Sterling volatility has now dropped sharply from levels just a week or so ago when volatility was similar to equity markets (chart 1). Despite heightened volatility, sterling was stuck in a range against the euro for most of 2018 (chart 2). Since early 2019, it has been strengthening, partly reflecting a lower perceived chance of ‘no deal’ exit and partly due to economic fundamentals including weaker European economic data and easier policies from the European Central Bank (ECB). 
 Adding to sterling…but treating it ‘scarefully’: However, political uncertainty remains, especially since we still cannot rule out a ‘no deal’ exit or a ‘remain’ scenario. We are tentatively adding to sterling exposure, but are currently reluctant to move too far from neutral. We continue to think that investors should try to hedge Brexit risks by being careful about overseas currency exposure and investing across assets that will perform well in a range of different scenarios (see latest Investment Clock [add hyperlink] for more).
 Chart 1: Sterling and Euro Volatility and Global Average

The EU have agreed a six-month extension to the Article 50 Brexit deadline (with headline writers everywhere delighted this morning with the 31 October Halloween deadline). If the UK parliament can ratify the deal before then, they can leave before then. Given events, if the UK requested a further extension before 31 October, our central case would be that one is granted since the EU clearly wishes to avoid no deal. ‘Brexit Day’ has become even more uncertain. 

Melanie Baker comments…

Six month extension offers limited comfort for businesses and the economic outlook: 

1) Fundamentally, no-one knows when the UK will actually leave the EU or under what conditions

2) Six months is time enough for plenty more political uncertainty – not least a general election (although it would be tight for a referendum) 

3) The blend of economic and political uncertainty is likely to continue to supress business investment which has already contracted for four consecutive quarters 

4) Brexit will remain a major distraction to the normal business of government and parliament. 

Risks to our 1.1% 2019 UK GDP forecast, however, have moved to the upside after strong February GDP growth. Mechanically, the outcome of Q1 GDP has an outsized impact on calendar year growth and Q1 looks set to come in close to 0.5%Q. However, the latest Purchasing Managers’ Index (PMI) business survey indicators point to stagnation and in our previous forecasts we had assumed more Brexit clarity in H2 than now looks likely (with the deal passing by then and boosting the economy). Now, with prospects of more prolonged uncertainty, albeit lower risks of a near-term ‘no deal’ outcome, the probability of the Bank of England raising rates before the end of the year has also fallen (we have been pencilling in a November rise). 

A 2019 general election moving closer to central case:

o  The government does not currently have a reliable majority in parliament. The Conservative party remains split over Brexit and party discipline had been severely compromised. The DUP have voted against the government on several occasions. 

o  Meanwhile, there are no signs that Labour and Conservative talks have actually made progress. The probability has fallen that parliament yet can find a way through all this via that channel.

o  PM May has angered a large chunk of her MPs and party membership by reaching out across party. 

o  Fixed-term parliament legislation is unlikely to prove much of a barrier if a general election were proposed by the government given Labour would presumably support one.

o  PM May cannot be forced to step down as leader of her party until December under Conservative Party rules, but may step down nevertheless. PM May had already said she would step down if the deal is passed and will likely come under even more pressure to step down by the Summer if a deal is not passed, the UK takes part in EU elections and/or the Conservative Party do very badly in local/EU elections. Although a risk, a new Conservative Party leader might welcome an election as a chance to bolster their position.

PM May’s deal is not dead yet…: It is still expected to return to parliament again and it is still not out of the question that May and Corbyn find some formulation they can both support, and the EU willing to accept, around the political declaration that would then lead Corbyn to instruct his MPs to vote for the deal. Furthermore, the UK taking part in EU elections at the end of May is presumably not a welcome prospect for many MPs (let alone the government or political parties already facing the expense of local election campaigning and prospects of a general election) and should increase pressure to pass a deal before then. That the UK leaves with the current deal – or something close to it is still central case (just). ‘No deal’ and not leaving the EU at all are still not the most likely outcomes. However, the process and timing have become much less clear. That the UK fails to leave the EU this year is almost as likely now as leaving with the deal.

…or even a second referendum: Extension to the end of October even allows sufficient time for a second referendum (the clearest route to ‘Remain’), although the timing looks tight given that the case for a referendum still needs more parliamentary support and agreement on the wording would likely take some time.  

Hiroki Hashimoto continues… 

Case for further sterling strength: Fundamentals and reduced near-term uncertainty suggests that sterling could continue to strengthen from here against the euro. This extension shows the EU’s willingness to avoid ‘no deal’ and does reduce short-term uncertainty. Sterling volatility has now dropped sharply from levels just a week or so ago when volatility was similar to equity markets (chart 1). Despite heightened volatility, sterling was stuck in a range against the euro for most of 2018 (chart 2). Since early 2019, it has been strengthening, partly reflecting a lower perceived chance of ‘no deal’ exit and partly due to economic fundamentals including weaker European economic data and easier policies from the European Central Bank (ECB).  

Adding to sterling…but treating it ‘scarefully’: However, political uncertainty remains, especially since we still cannot rule out a ‘no deal’ exit or a ‘remain’ scenario. We are tentatively adding to sterling exposure, but are currently reluctant to move too far from neutral. We continue to think that investors should try to hedge Brexit risks by being careful about overseas currency exposure and investing across assets that will perform well in a range of different scenarios (see latest Investment Clock for more). 

Chart 1: Sterling and Euro Volatility and Global Average

Source: Bloomberg as at 11/04/2019

Chart 2: Sterling since the EU referendum

Source: Thomson Reuters Datastream as at 10/04/2019

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