Brexit: extension of the deadline is likely, but the final outcome remains uncertain

What are the possible Brexit scenarios ahead?

Regarding what happens on 31 October (currently the official Brexit deadline):

• The most likely scenario (probability of 80%) is that the Brexit deadline will be extended, presumably into Q1 2020, following Parliament’s instruction. A snap election would probably follow (although this is not fully certain), as Johnson’s government currently does not have a Parliamentary majority and the sharp political tensions over Brexit calls for a government with a clear people’s mandate. This implies that Johnson finally accepts that he has to request an extension, or that he resigns or is removed (removal or resignation have become more probable following the Supreme Court’s recent ruling).
• A no-deal outcome by 31 October is, in our view, very unlikely (probability of 10%). It would require Johnson to find a constitutional backdoor to avoid obeying Parliament (which can anyway remove him through a no-confidence vote) until the no-deal Brexit happens as it is the default legal outcome. In theory, the EU could also refuse an extension (remember, there is a unanimity rule), but we believe that such a refusal is very unlikely as long as the UK’s request for extension is justified by the need to organise new elections (or a referendum).
• A deal outcome by 31 October is also very unlikely (probability of 10%). The EU will be preoccupied with the issue of moral hazard (ie, granting more concessions to Johnson after the EU said that the deal concluded with previous PM, Theresa May, was not open to renegotiation, all the more so as Johnson is viewed as a populist leader). Moreover, Johnson has no majority to pass a potential deal. Note, however, that things could change very quickly if, against all odds, Johnson accepts the lifting of some of the previous UK “red lines” (for instance, accepting that Northern Ireland could have a different regime than that of the rest of UK in terms of tariffs and/or product and services regulation if no other solution is found to avoid a “hard” border across Ireland). Things could also change if Johnson resigns or is removed, but even then the probability of ratifying a deal before 31 October appears low.

What is your view regarding what happens after the probable extension?

In case of an extension of the Brexit deadline, there would very probably be a snap election (there is a possibility of a new referendum without a snap election, but this is less likely). The election result is very difficult to predict, due to: 1) the UK’s first-past-the-post electoral system; and 2) the rapidly changing political dynamics. Current polls say that the Tories might secure an outright majority. However, they could be weakened by the departure of moderates, all the more so if there is any attempt at alliances with the Brexit Party (considered far-right). The opposition, on the other hand, will have a hard time campaigning on any common platform but a second referendum, and even that is disliked by many pro-Brexit Labour voters. Moreover, due to his hard-left views, Labour leader Jeremy Corbyn is a very difficult figure to rally to for other opposition parties.

• All in, a no-deal Brexit by Q1 2020 is possible (probability 35% after the deadline extension). This would probably require: 1) a Tory victory in the snap election; and 2) the refusal of both the new Tory government and the EU to make significant concessions.
• A deal remains the most likely option (probability 55%). This could happen in case of an opposition electoral victory (the withdrawal agreement could then be similar to the one proposed by previous PM May, but with the intention of negotiating a closer relationship during the transition period, or there could be a full reset of negotiations towards a “softer” deal). A deal is also likely if the Tories win elections, provided the newly elected UK government and the EU give mutual concessions to each other.
• There remains a residual possibility that the UK could remain in the EU (probability 10%). This would probably require a referendum (much more likely in case of opposition victory in a snap election) and that the UK voters choose the “Remain” option (cannot be taken for granted).

What will be the lingering effects of Brexit on the European Union?

Looking beyond the short-term economic pain, slightly reduced potential growth (due to a contraction in trade with the major partner that is the UK), and the need to make up for the UK’s former contribution to the EU budget, the main risk to the EU is probably that Brexit encourages the “leaver” political offer in other EU countries, especially if the UK’s economic performance, after the initial shock, is not that bad. While there seems to be a lower appetite today (than a few years ago) in other member countries for leaving the EU, the situation could change in case of an economic or political crisis. This could happen in southern EU member states, but potentially also in northern countries where “leaver” political parties could try to sell the idea of a closer relationship with the UK. Note that a UK economic outperformance vs the Euro area is not our central scenario (we believe that Brexit will have very detrimental economic consequences for the UK, and for a long time), but this, obviously, also depends on the future economic policy decisions in both the UK and EU.

In any case, Brexit creates a precedent which, by itself, means the trust in the permanent nature of the EU architecture will be eroded. In terms of economic policies, it could be that the departure of the UK weakens the camp that advocates freer competition regarding goods and services markets, and more labour market flexibility. On the positive side, the departure of the UK may facilitate future decision-taking, notably regarding new projects to deepen and strengthen the EU architecture. Note that this may even be the case for projects at the scale of the Euro area only (and not only at the wider scale of the EU) as British resistance had sometimes been felt even in such instances.

FIXED INCOME AND FX

What is the fixed income market pricing in at the moment for UK rates? What could be the reaction regarding rates in the different Brexit outcomes?

Bond markets have recently started to price in the possibility of rate cuts from the Bank of England (BoE). There is about a 50% chance of a 25bps cut by mid-2020. In truth, market rate expectations are a blend of several possible outcomes: a Brexit with a deal, and thus a transition period, likely leading to rates on hold; a no-deal Brexit, leading to immediate World Trade Organization terms and considerable disruption, likely requiring rate cuts to cushion the impact on growth; and the smaller chance of the UK staying in the EU, which would then open the door to rate hikes. A key consideration will be whether the BoE can ‘look through’ the impact of sterling depreciation pushing inflation still higher in one of the downside scenarios. There is also the possibility that sudden supply constraints might squeeze prices higher, complicating the BoE’s decisions. Bear in mind that Mark Carney’s term as Governor comes to an end in January 2020. Along the curve, Gilts are pricing in a very modest growth and inflation outlook, with the benchmark 10-year Gilt yielding just about 50bps.

The GBP has been highly sensitive to Brexit newsflow. What is the GBP pricing in and what are the expectations regarding possible outcomes?

Movement in the GBP is being driven by headlines. Ones that suggest a crash-out Brexit on 31 October or soon thereafter push sterling lower vs the US dollar and lower but less so against the euro. Headlines that suggest a compromise may be reached or, even, that Brexit might be avoided, lead to a rapid appreciation of sterling.

With a GBP/USD rate at around 1.25, the markets seem to signal some hopes that the worst outcomes can be avoided. This reflects the recent passage of a Bill through Parliament that will require the government to request an Article 50 extension if, by 19 October, a withdrawal agreement has not been passed through the UK Parliament. Recent Scottish court decisions and discussion of a ‘Northern Ireland only’ backstop have also led some to hope that disaster can be averted. However, PM Johnson has continued with his strident rhetoric on exiting on 31 October, come what may. Currency volatility will likely remain very high and will depend on news flow.

Inflation-indexed Gilts are harder to call. Already demand from UK pension funds has kept them well bid. There has also been the question of reform of the Retail Prices Index to which they are linked. That reform appears to have been put on the back burner again for now, but it perennially returns because the current system is both illogical and costly for the government. Shorter-dated Gilt linkers are also likely to be affected by movements in the exchange rate as hopes of a deal ebb and flow. Inflation is high already and weak sterling, BoE rate cuts and fiscal stimulus are likely to push it higher. But, passage of a withdrawal agreement and a sterling rally, with BoE cuts priced out, would put downward pressure on inflation.

On currency, although we are cautious on sterling at present, it is necessary to be very nimble in adjusting positions as political winds change. It is also worth remembering that in a portfolio, a short sterling position and a long Gilts position (especially if it is in inflation-indexed bonds) is highly correlated. To improve diversification, as said, focusing on a 2-10Y steepening of the curve can be beneficial, as this position is negatively correlated to these other
two positions (short sterling and long Gilts).

What are your main convictions for UK companies?

UK companies face huge uncertainty which leaves them with very low forward visibility. This has already impacted demand and caused delays to investment and other important corporate decisions.We cannot view the market as a whole, as individual circumstances are very unique depending on each company and sector. From a bottom-up perspective, we think it is key not to attempt to forecast Brexit and therefore take a view on a certain outcome; instead, we prefer to test all investment cases for a range of Brexit outcomes (as well as other external variables). This helps to ensure a more resilient European equity allocation. We are currently cautious on the UK, as we see better opportunities elsewhere in Europe bottom-up. However, in an overall cautious stance, we have recently become more constructive on the market, as selective opportunities in the domestic sector are very attractive from a risk-reward perspective. An example of a compelling investment idea is a UK house builder which specialises in building affordable houses outside of London. This is a company with a strong balance sheet and a solid business model. We are also looking at stocks in the leisure sector, where we think risk-reward is looking increasingly attractive.