In Prime Minister Theresa May’s own words, we are entering the “end game” of the UK’s long-running Brexit saga. As predicted however, rather than heralding a period of greater clarity, levels of uncertainty are rising sharply with any outcome from ‘hard Brexit’ to ‘no Brexit’ still being plausible. The inextricable link between UK politics and the future relationship of the UK with the EU 27 further clouds the investment landscape.
Deal or No Deal? Without going into the merits, or otherwise, of the proposed terms of the UK’s formal withdrawal from the EU, we don’t think we would be courting controversy by saying that what is currently on the table pleases practically no-one. Those leaning Remain suggest that the terms are grossly inferior to those currently enjoyed by the UK’s existing EU membership. Those in the Leave camp suspect they will not in any practical sense be leaving the EU at all. Listening to Theresa May’s dogged three-hour defence of the deal in the Commons yesterday, it seemed clear that she had little support in the House. Before the end of the day a formal challenge to her leadership had been launched. It speaks to the febrile state of Westminster politics to note that Dominic Raab is currently the bookies’ favourite to succeed PM May – but Jeremy Corbyn is currently their front-runner as the next Prime Minister.
The Market Has Taken Note. Unsurprisingly, these recent developments have put UK risk assets under further pressure. Sterling has fallen sharply, while Gilts have rallied. Within the equity space, those sectors that have greater exposure to the UK domestic economy, such as banks and housebuilders, have under-performed, while more export-oriented sectors such as oil and mining have done relatively well. It is notable that some ‘bond proxy’ sectors such as telecoms and utilities, that might otherwise be expected to outperform in this environment, have also come under pressure. As regulated industries, they carry significant political risk under a Labour government.
What happens next? Theresa May will likely have to deal with a leadership challenge. It seems probable that the 1922 Committee Chairman will shortly receive the necessary 48 letters from Tory MPs to initiate the procedure and voting could take place next week. At present however, it seems the PM has a good chance of surviving that vote; she has vowed to carry on even if she secures the slimmest of majorities. While she might be temporarily strengthened, her proposed deal will still have to pass a Commons vote in early December. As already stated, that seems unlikely given the low level of support in the House. With no other deal negotiable in the time remaining before Brexit Day (even assuming the EU were willing to do so), then the PM might find her position untenable. A possible third option, created via a second referendum, might then be introduced, though May has been adamant that she would not do so thus far. If such a possibility were to emerge, however, then UK markets might start to anticipate a ‘no Brexit’ scenario as quite likely.
What’s the probability of a ‘hard Brexit’? There is no reliable market-based measure of the likelihood of a ‘hard Brexit’. However, as hinted above, investor positioning around sterling probably serves as a reasonable guide as to whether that probability is increasing or decreasing. As a reference point, a Reuters poll of economists conducted last month suggested that there was a 25% chance of ‘hard Brexit’. Since then, it is clear that such an outcome has become more probable; currency markets are now paying the highest premiums for protection against a drop in sterling since June 2016. With these factors in mind, it is not unreasonable to suggest that the UK market is now pricing closer to a 50% probability of ‘hard Brexit’.
The UK remains unloved by investors. Recent asset manager surveys suggest that institutional investors remain resolutely underweight of UK equities and had little appetite to ‘buy the dip’ in October. In a similar vein, CFTC (The Commodity Futures Trading Commission) data indicates that speculators have remained short of sterling since late June in anticipation of further weakness. While these factors do suggest that UK markets might react more to better than expected news than bad news – as so much is ‘already in the price’ – the lack of political and economic clarity makes it difficult for investment managers to be more constructive on UK risk assets.
What about the Bank of England? The market has had a working assumption that the Bank of England (BoE) was now most likely to next raise rates in May 2019, being the first Inflation Report issued post Brexit Day. Only a few days ago, a quarter-point rate rise at that date was deemed 60% likely. That has collapsed to just 36% today. As suggested in the commentary on the BoE’s 1 November rate meeting, although the BoE appeared quite upbeat on the prospects for an orderly Brexit, the fact that they unanimously agreed to keep rates on hold suggested that downside risks were much greater than they were willing to admit. Moreover, while they suggested that rates might move up or down in the (unlikely) event of hard Brexit, the market clearly does not believe them. It will be interesting to hear Governor Carney’s latest thoughts on the matter when he appears before the Treasury Select Committee on Tuesday next week.
The opinion expressed in this communication are those of our Chief Market Strategist which may differ or be to the contrary of those expressed by other individuals within the WHIreland Group and they are subject to change without notice. Past performance is not indicative of future performance and overseas investments are subject to fluctuations in exchange rates. The value of investments and the income from them may go down as well as up and investors may not get back what they originally invested. We have issued this communication for information purposes only and it does not constitute financial, professional or investment advice or a personal recommendation, nor does it constitute a solicitation or an offer to buy or sell any securities or related financial instruments in any jurisdiction. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained in this communication, nor is it intended to be a complete statement or summary of the securities, markets or developments which may be referred to.