Brexit Markets: at low tide
I am not sure how long I can sustain a maritime theme but for I am increasingly convinced that UK assets are at or very near to the point when the ebb tide has run its course and turns into a flood tide. Now is the time to look beyond all the politicking, most of which is quite healthy, and get off the beach. The most important conclusion from developments over last few days is that a ‘no deal’ rupture next March is looking less likely than ever. This has implications, mostly favourable, for equities, gilts and the pound.
Chart 1 May paddles her own canoe
Source: The Economist
Figure 1 should prove handy to Jeremy Corbyn who has confessed to not having read all 585 pages of Mrs May’s deal not read (full disclosure: I have not done so either) as well as countering some of the extreme comments swirling around. From an economic point of view, it invites both a half-ebb and half-flood tide interpretations. The most important omission is access to the Single Market but it would ensure an orderly departure with scope for some modest improvements during the next stage of negotiations (aka transition period). No wonder then, that big business, including professional and financial firms, has welcomed it: disruption was always the chief enemy. Over the longer-term they can relocate to the EU selected parts of their businesses and some already have (e.g. pharmaceutical companies) even if they would have preferred not to have to do so. Smaller firms will react according to whether and where they have overseas customers but even those with a non-EU focus will find that red-tape will not be cut and also that not much help will be coming from under-prepared and over-stretched Government departments. Business leaders may be publicly supporting Mrs May because their main priority is avoiding a ‘no deal’ exit but there can be little doubt that most would prefer Brexit to be abandoned altogether and may become more vocal if her deal is voted down in the Commons.
Chart 2 UK closing for business
Uncertainty has been weighing increasingly heavily on companies of all sizes and sectors and inhibited business investment. After a surprisingly strong Q2 and month of July, GDP growth ground to a halt in August and September, with even the Labour Market showing signs of fatigue. Both Manufacturing and Service Sectors are struggling and the PMI surveys point to little change over the next few months. Average Earnings may be perking up but Retail Sales were negative in both September and October. Ominously, the sacred Housing Market is in retreat. Resolution of the Brexit agony will help stop the slide into recession but the timing and scale of the inevitable recovery will depend on the final deal. The immediate focus has, therefore, to be on political developments.
Figure 3 Halcyon daze
Source: Morten Morland/The Times
The EU leaders were always going to give Mrs May a deal despite her initial efforts to alienate them and are now carefully claiming to have come second best in the negotiations just in case the Famous Five Cabinet Brexiteers or Mr Corbyn get any fancy new ideas. (Spain yesterday reminded everyone that the deal is not yet done by throwing ….er… a spanner in the works!). Moderate Tory Leavers and Remainers both now have cover to back away from blame for ‘no deal’ and closet Remainers have the potential upside of defeat in the Commons’ leading to a second referendum in which they could come out again. The biggest casualty of the recent turn of events is Mr Corbyn, who has been increasingly revealing himself as a Brexiteer. He has already promised to vote against Mrs May’s deal but in reality he had little choice: to support her would mean giving up his aim to liberate the UK from the ‘ordoliberal’ EU constraints on State controls and even abstaining would have the same result with the additional opprobrium of pusillanimity. Voting against on December 13th would bring the prize of humiliating Government defeat but also the responsibility to avoid economic chaos and even civil unrest. Protesting that he can negotiate a ‘cake and eat it’ deal before March would ensure a humiliation of his own from his own MPs.
Despite all the posturing, it is simply not credible that a majority in the House of Commons would permit a ‘no deal’ Brexit even in the improbable event of Mrs May or another Tory Prime Minister’s proposing it. What is not clear is what will happen if Mrs May is defeated in December. She might resign but none of the more sensible candidates to succeed her will want to blot their copybooks in the eyes of Tory Party members on whose votes they will be courting once the dust settles. Withdrawing Article 50 notice would probably be the next step and although it might be possible unilaterally. seeking the agreement of other EU members would be wise. It is hard not to believe that EU leaders already have a strategy of insisting on a time limit of only a few months with the important condition if a second referendum were to be held that a ‘no deal’ Brexit must not be one of the options on the ballot paper. It is, of course, possible that a second referendum would support Mrs May’s deal rather than Remain but it will not be easy to conduct a positive campaign. Accordingly, the Brexit endgame is narrowing down to a binary outcome: either Mrs May’s deal, which could well evolve into some sort of ‘Canada plus plus plus’ deal after an extended transition period or Remain.
Chart 4 Global investment: Atlantic divide
Source: BoA/Merril Lynch
UK assets: poised for a Spring tide?
A difficult question for investors is just how much bad news is priced in. Figures 5, 6 and 7 each show signs of general support rather than specific technical levels. However, Figure 4 suggests that many global investors have decided to deal with Brexit by avoiding UK assets and some appear to have the same approach to the Eurozone. This may change if the current rotation in US assets spills out to overseas markets. Yesterday US Tech stocks took another beating and last week all the main US indices fell while some Emerging Markets rose. The dollar has been under increasing pressure during November. UK (and Eurozone) equities have been under water since January but investors are still wary of both political and economic challenges and may need more evidence of progress on both fronts.
Figure 5 highlights the damage Brexit has done to UK ‘domestic’ stocks as measured by Goldman Sachs’ dividing a basket of selected stocks by the FTSE 100. KPMG have conducted a similar exercise with the same result. It is the case that over 70% of FTSE 100 constituents’ combined revenues are generated in currencies other than sterling. At times in 2018 the FTSE 100 has even responded positively to sterling weakness although that relationship currently seems not to be functioning. It is quite possible to argue that too many UK stocks-domestic, international or both-have been oversold. Even easier to argue is that they would benefit from a definite Brexit settlement on the basis of Mrs May’s deal and even more so if the UK was to remain in the EU.
The story with gilts is more complicated, not least because rising yields are the flipside of lower prices. The key question is why yields are higher now than they were before the 2016 referendum. Brexit is only part of the answer as Figure 6 shows that 10-year gilt yields are around the levels of 2 years ago (less than 5 basis points difference). The good news is that investors are still happy with the credit risk of the UK Government but this is tempered by few expectations of higher interest rates arising from faster economic growth. In fact, gilt yields are likely to rise whatever the Brexit outcome: either sharply if ‘no deal’ suddenly becomes more likely or gradually in the expectation that a relieved Bank of England will want to push Base Rate to more normal levels as the UK economy starts to pick up following a settlement.
Since markets took on board that politics rather than economics would determine the Brexit outcome the pound has been reacting to all the twists and turns of rumours, leaks, speeches and media appearances. However, Figure 7 shows that apart from a few exceptional periods (October and December 2016 and February 2017 when it hit a triple bottom) GBP/USD has not gone very far since the spike (sparked by Nigel Farage’s premature concession as referendum votes were still being counted) followed by the slump as some hedge funds cashed in. In fact, traders seem reluctant to take the rate below $1.27 and are likely to become even more so once they become convinced that ‘no deal’ is unlikely to transpire. The twitchiness will continue for a while and a Commons defeat for Mrs May could easily lead to a re-test of $1.25 but the balance of risk points to a much stronger pound.
Overall, it is possible to conclude that while a ‘no deal’ Brexit is not priced in, investors are clearly not yet convinced that it can be avoided. This represents a significant buying opportunity for discriminating stock-pickers of UK equities.
Chart 5 UK domestic stocks: precious stones set in the silver sea?
Source: Goldman Sachs/Bloomberg
Chart 6 Ten-year Gilt yields: waving not drowning
Chart 7 GBP/USD: Sorgenti dall’acque?
By Alastair Winer
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