New article from Tatton Investment Management: Investment perspectives for different Brexit outcomes

18 February 2019

After another week of fairly positive market action, the pattern of last year’s global stock market sell-off and ongoing recovery this year is beginning to look more and more like the previous correction episodes of 2013 and 2016. Just as then, the combination of economic growth deceleration and central banks’ attempts to put the monetary genie of quantitative monetary easing (QE) back into the bottle caused a more pronounced market upset than many thought possible or rational. At this rate then it seems reasonable to assume that the monetary overhang created by the remedies against the global financial crisis have created capital market ‘hangover’ potential which will be with us for some  years to come.

From such a perspective we could just decide to move on as we did back in 2013 and 2016 and look forward to another extension of economic expansion and rewarding capital market investment returns in this mega cycle. That is  if it was not for the Damocles Sword-like threat that is hanging over this recovery in the form of trade politics on either side of the Atlantic.

In the US it seemed that the market upset and economic deceleration has created enough pressure to persuade Trump and his administration to press on with their trade talks with China in earnest and avoid having to impose the threatened penal tariffs from 1 March. As long as a memorandum of understanding can be agreed by then, it seems that an extension of last year’s tariff truce will be enacted, with a view to scrapping all tariffs between the two countries soon thereafter.

Speaking of extension, we have entered Brexit territory once again – which is the other potential trade conflict overhanging the sunny recovery prospect. We understand that most of our readers just like most people in the UK would rather we did not have to discuss the dreaded subject here as well, but I am afraid, given the potential economic impact it has, we, as investment managers have to look at it. In the remainder of this article we will share with you our investment assessment of the different potential outcomes that are beginning to appear on the March 29 horizon.

Looking back over the past two and a half years, you would be hard-pressed to find any investment outlook piece on the UK that doesn’t bear the word ‘Brexit’. So all-encompassing is Britain’s European divorce that you get the impression that UK growth prospects are entirely decided by Brexit gyrations. And yet, just six weeks until we are meant to officially say good-bye, Britain’s future relationship with the EU remains as unclear as ever. The Prime Minister just lost another vote in the Commons (her 11th!) – not that this one mattered much as it merely asked the House to “reiterate its support” for the last Brexit vote on 29 January. However, to the rest of the EU it must prove once again that the country and its elected representatives are so deeply divided over the issue that it seems unlikely that the UK government could possibly unite either them or the people behind any form of Brexit deal that may realistically be on offer.

Given the tumultuous climate Brexit predictions are rarely worth the paper they are written on. Nevertheless, as investment managers we have to make assessments about what one or the other or third possible outcome may do to the UK economy and in turn to UK investment assets.

So here are four scenarios which we have to consider:

No Brexit: Parliament makes Brexit disappear, we all shake hands and the last two years just go down as a silly mistake. That’s the amendment proposed by SNP MP Angus MacNeil, which has gained the support of Tory veteran Ken Clarke. Stock and currency markets would bite your hand off if you offered this to them. However, unless the EU27 suddenly offered to forget about their ‘red lines’, like freedom of movement or the Irish Backstop, it’s about as likely as the fairy-tale Brexit stories printed on the side of buses in early 2016.

May’s deal: The Prime Minister’s Brexit deal somehow makes it through Parliament. The customs union is extended until we can agree a comprehensive trade deal, which achieves some near-term trading certainty and a sort of acceptable, longer perspective about Britain’s future. Markets and businesses would most likely take this pretty well, given the support they have expressed for such an outcome over recent weeks. Just how this could happen in a Parliament split between hard Brexiteers and staunch Remainers is a little trickier. The government would undoubtedly need to make some concessions to the Labour party – and get them approved by EU negotiators. Getting her deal through is clearly what Theresa May is still aiming for and if she can get some side deal to appease the Northern Ireland issue as well, then maybe, maybe this may still happen. Brexit day would very likely need to be postponed a few weeks to allow Parliament to catch up with all the legislation that still needs to be passed to make it happen.

Brexit delay (and possible referendum): B-day is pushed back, the proverbial can gets kicked down the road. But unless there is suddenly some real perspective as to  how more negotiating time may resolve the issue(s), then another referendum or even a general election is beginning to look likely. More political uncertainty would be the result and even social unrest is a possibility. Depending on what the perspective is for the delay, markets may take it as a repeat of 2018, when global themes dominated, but if it leads to more political stalemate, then UK investment assets may suffer further international discounting.

No deal: Parliament remains paralysed, and we go over the edge. Given some Brexiteers are trying to block attempts to prevent this, it seems a real possibility – one we get closer to every day. For now, we have to take heart in the fact that this is the least preferred option among both British and European leaders, as, of all available options, it will result in the most economic pain on both sides. We observe that there appears to be a solid majority in parliament that would force an extension of Article 50 rather than experiment with a crash Brexit. However, if it somehow happened in the end, then capital markets are relatively likely to frighten politicians back to a more constructive course in fairly short order. Whether the projected chaos would descend on us would very much depend on whether the two sides want to instrumentalise the suffering of ordinary people on both sides to further their negotiating aims. Last time that happened in the EU was during the Greece crisis – our assumption is that we will not sink that far again.

What has the uncertainty of Brexit meant for the UK economy thus far? Figures released by the Office for National Statistics (ONS) on Monday were shot through with the impacts of Brexit. UK growth last year was its lowest since the financial crisis, and we’ve now had four consecutive quarters of declining business investment. The results were worse than forecasters had expected, with Britain - during 2018 - underperforming everyone except Italy in the world’s leading economies. Most economists agree that Brexit has already cost the UK 1.5-2.5% of GDP, and household incomes are on average 4.1% lower than they would have been if Remain had won in 2016.

A year ago, we wrote that the UK was in a state of delicate equilibrium. Brexit drama was keeping the value of sterling down against the euro, which offered British exporters a price advantage over their European competitors and allowed them to take advantage of strong growth on the continent. Now, that equilibrium has been disturbed. Sterling is still weak, but now so too is the European economy. And price competitiveness is all for naught if your buyers can’t afford to buy.

On top of that, Brexit uncertainty has now reached a point where EU businesses refuse to make even short-term deals with their British suppliers unless they absolutely have to, for fear of being disrupted by a sudden change next month. The messy divorce is now hurting UK businesses not just through the lack of investment but also on their bottom line. Our most important trading partners are scared to trade with us, and there is no perspective on which to build future plans.

What does this mean for asset prices? In our outlook for 2019, we wrote that Brexit pessimism had skewed UK assets so much that they were effectively undervalued – and carried a hefty risk premium. But in the first few weeks of the year, two things have happened: Brexit risks have increased (as we get closer to the exit date with no plan in sight) and so have asset prices. In sterling terms, the FTSE 100 is up 7% year-to-date. This means that, while UK assets were undervalued relative to their risk before, this is far less so now. It’s entirely possible that the rebound in UK equities has further to go – even if Brexit gets worse. But as we get closer to the 29 March exit date, things will get more difficult.

For now, the economic news flow will continue to be all things Brexit. Hopefully, the next few weeks should give us some much-needed clarity. Until then, we hold our breath and bank on our belief that in the end the political actors want to avoid bringing harm on their electorates.

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