The UK will move into an agreed transition period for 11 months during which the precise details of the future trading relationship will be worked out. It remains unclear how achievable such detail will be in such a short space of time and so far the UK government is actively not countenancing any suggestion that the transition period can be extended. This increases the risk of a partial deal on trade, perhaps in goods or certain sectors or even, if the two sides really cannot agree, a no-deal Brexit. In short, Brexit is certainly nearer, but it is far from done yet.
What impact does this have on financial markets?
Financial markets have been discounting the passage of Withdrawal Bill since the minute the exit polls suggested that Boris Johnson was going to win a comfortable majority. This means the market reaction at the end of January is likely to be modest. In fact, markets are already returning to trading off economic news and the chances of an imminent interest rate cut. Looking further forward, a focus on any comments relating to the shape of the future trading relationship means politics will still be an important driver. As before, the harder the Brexit the more sterling is likely to weaken, which will at least soften the blow to UK equities.
What impact does this have on European investors?
Brexit uncertainty has been reduced. Prior to the UK election there had been several possible outcomes including another Brexit referendum, a left-wing Labour government and possibly no Brexit at all. There is now a Conservative government with a comfortable majority and Brexit is going to happen, but it remains to see how hard it is and how close or not regulatory alignment will be. Only when this becomes clearer will we be able to fully assess the true impact on European investors.
Do you see any heightened risk? And which opportunities?
Brexit risk is certainly lower than at various times last year, but it has not gone away. It seems a sensible base case scenario to expect a partial trade agreement on goods or at least some sectors, but an agreement on provision services, especially without regulatory alignment seems unlikely. This is not quite a no deal, although that remains a risk, and the shape of Brexit looks like it will be a harder rather than softer version. The only good news here is that financial institutions will have had more time to prepare for this risk.
What are the next steps for investors?
The end of the transition deal on 31 December is the real day that the UK actually leaves the EU. Before then, perhaps as early as the summer, markets should begin to get some messaging on the likely shape of the future trading relationship. And if the talks are not going well, it is quite possible that by September they may also need to start discounting a no-deal Brexit.
In contrast to 2019, the parliamentary backstops that were in place to prevent such an outcome are not present in 2020. There is no longer a safety net in that regard. Before then, UK markets are likely to revert to traditional fundamental drivers. A combination of weak growth, a legacy of Brexit’s uncertainty past and lower inflation, is expected to produce an interest rate reduction from the Bank of England this quarter, perhaps even this month.
What is the impact on currencies?
Sterling has served as the market bellweather of UK political risk. Reflecting this, our valuation metrics, based on the purchasing power parity of a large basket of online prices collected by PriceStats, suggest the currency has been anywhere between 5 percent and 15 percent undervalued since the referendum. It is curious then, that despite the lingering uncertainties about the actual shape of Brexit, Sterling’s valuation premium has disappeared against the US dollar and actually reversed against the euro. The implication is that there is a lot of good news already discounted by the currency, which will be vulnerable if the actual Brexit that emerges in 2020 is a hard one.
What approach should investors take when investing in UK stocks, bonds and assets? Is it worth it (and on what?) or not (why)?
A cautious approach is still required until the actual shape of Brexit is known. The high proportion of foreign earnings in the FTSE does provide the main UK indices with some protection, as does the possibility of sterling weakness if Brexit turns out to be harder than expected. Meanwhile, assuming that the BoE’s interest rate reduction is a one-off precautionary measure, as the details of Brexit are ironed out, gilts may struggle to build on last year’s returns.
What will change for Europe?
It will take years to properly assess how the UK’s departure from the EU will impact both economies and political processes. Much, however, will depend on agreeing an amicable trade deal in the next nine months to ensure as smooth a departure as possible. Before then, it is notable that the Brexit process has been sufficiently difficult politically for the UK, which may discourage other EU members from following a similar path.
