The Outlook: October 2018 economic commentary

Commentary
 


In this month’s commentary we explore how the outcome of ongoing Brexit negotiations could impact sterling, gilts and UK equities during the coming months.

Deal or no-deal: Brexit and UK financial markets

In last month’s commentary we discussed the possible impact of a no-deal Brexit on the UK economy. This month, we turn our attention to the possible financial market reaction.

There are numerous scenarios for how Brexit developments could pan out during the coming months. At one extreme, there might be a second referendum – an option that Prime Minister Theresa May has so far ruled out - which results in the electorate voting to remain in the EU. At the other extreme, a no-deal Brexit would see the UK crash out of the EU in March 2019 without a transition arrangement in place.

How the UK economy and financial markets perform over the long term will be highly dependent on the future UK-EU relationship that is ultimately agreed. However, it is likely to be years before the details of any future trade deal emerges. From a short-term perspective, the major binary consideration for financial markets is whether or not there is a deal on the withdrawal agreement that avoids a ‘cliff-edge’ Brexit next March.

At the time of writing, negotiations remain deadlocked, with the Irish border issue a key sticking point. Even if Theresa May can secure a withdrawal agreement with the EU, there is a significant risk that it will be rejected by parliament.

Against this backdrop, it is pertinent to explore how sterling, UK government bonds (known as gilts) and UK equities might react under deal or no-deal scenarios. We obviously do not know the ultimate outcome of the Brexit negotiations, and it is important to remember that Brexit is only one factor amongst many that will influence UK financial markets during the coming months. As such, we are not seeking to forecast market performance, but rather identify the channels through which different Brexit outcomes could impact UK assets, all else remaining equal.

Sterling

Ever since the June 2016 referendum, the pound has served as a key barometer of the state Brexit negotiations, rising when progress has been made and falling back at times when concerns over a no-deal Brexit have come to the fore.  During the two weeks after the June referendum, the sterling effective exchange rate (which measures the pound against a basket of currencies) fell just over 11%, as markets downgraded the outlook for the UK economy.

Brexit, of course, is not the only driver of sterling. There are many factors that can influence the exchange rate, including the relative strength of the economy, the outlook for monetary policy and a country’s external accounts position.

However, there is widespread agreement that the political and economic instability that is likely to result from a no-deal Brexit would usher in renewed weakness in the pound. It would not be surprising to see the sterling index dip below post-referendum lows in the event of a no-deal Brexit, possibly falling 10% or so.

Conversely, in the event of a deal being secured with the EU and it being approved by parliament, sterling can be expected to appreciate.

Gilts

In the wake of the June 2016 referendum, the yield on UK gilts fell sharply, causing their price (which moves inversely to the yield) to rise. The yield on the 10-year gilt fell from close to 1.4% prior to the referendum to just above 0.5% by mid-August 2016.

Yields fell as uncertainty prompted a flight to the relative safety of government bonds and investors downgraded expectations for growth in the UK economy. In addition, expectations of looser monetary policy – subsequently realised when the Bank of England voted to cut rates to 0.25% and restart quantitative easing at its 3 August, 2016 meeting – also supported a fall in yields.  

A similar dynamic is likely to play out in the event of a no-deal Brexit. The economic disruption that would ensue from a no-deal Brexit is likely to see growth forecasts revised down, and heightened investor angst would result in safe-haven flows in to government bonds. Although the fall in sterling would usher in another rise in import prices, the Bank of England can be expected to look through the temporary rise in inflation, prioritise support for the real economy and loosen monetary policy. All of these factors are likely to result in a marked fall in bond yields.

This said, with global yields now considerably higher than they were two years ago (most notably in the US, where 10-year yields recently hit a 7-year high of 3.24%), the 10-year gilt yield would probably not test the August 2016 lows.  

In contrast, if the government secures a Brexit deal, gilt yields can be expected to nudge higher. There would presumably be some unwinding of safe-haven demand, and the near-term GDP growth outlook would be considerably more favourable, not least as pent-up investment demand held back by recent uncertainty is unleashed.

Moreover, a smooth transition would enable the Bank of England to focus on rising domestically generated inflation pressures, and push ahead with gradual interest rate hikes. As it stands, the markets expect Bank Rate to rise to just 1.4% over the next five years from the current 0.75%. However, a lifting of Brexit uncertainty could see interest rate expectations revised higher, putting upward pressure on gilt yields.

Equities

Turning to UK equities, the potential impact of a no-deal Brexit is arguably more nuanced. On the one hand, a no-deal Brexit could be supportive, given that around two thirds of FTSE All-Share company revenues originate from overseas. A renewed depreciation of sterling would boost the value of foreign earnings when translated back in to pounds. For this reason, there has been an inverse relationship between the pound and UK equities for much of the post-referendum period. However, under a no-deal scenario, this favourable ‘translation effect’ would also have to be weighed against the negative impact of increased barriers to trade and heightened political uncertainty.

In this regard, investors would need to differentiate between 1) companies with operations in the UK that are dependent on sales to the EU and whose exports could be disrupted by a no-deal Brexit, and 2) companies that are merely listed in the UK and whose overseas revenues originate primarily from outside the EU.

As regards domestically-focused businesses, sales are likely to suffer under a no-deal Brexit, as higher import prices would further squeeze household incomes and capital expenditure would take a hit from the expected deterioration in business confidence.

Under a scenario where a Brexit deal is secured, the currency ‘translation effect’ would weigh on the shares of overseas earners as sterling appreciates. However, this negative effect could be offset by the positive impact of increased clarity regarding the prospects for UK exports to the EU.

Indeed, with survey data showing that global fund managers are heavily underweight UK equities, a good deal that reduces uncertainty could open the door to overseas investor inflows, potentially facilitating an appreciation of sterling alongside a rise in UK equities. On some valuation metrics, the UK stock market is attractively priced versus overseas equities, particularly those in the US.

For UK-facing companies, a Brexit deal should provide a boost given the likely improvement in consumer and business confidence that would follow. However, the prospect of a steeper path of interest rate hikes would be a potential headwind.  

The importance of a diversified portfolio

Uncertainty over Brexit underlines the importance of maintaining a diversified portfolio. At the current juncture, it is near impossible to predict with any confidence whether there will be a deal or not. Owning a range of both UK and overseas assets should help smooth out returns in the event of any Brexit-related volatility. Again, it is important to remember that Brexit is only one factor that will influence market performance during the coming months. However, an understanding of how different Brexit scenarios could impact UK assets will enable investors to adjust portfolios accordingly when it becomes clearer how the situation will eventually be resolved.

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.