Brexit still hangs in the balance

Thought of the day

by Chief Investment Office 12 Mar 2019

UK PM Theresa May’s last-minute negotiations in Strasbourg, France on Monday yielded renewed EU assurances over the contentious Irish backstop clause, offering her fresh ammunition ahead of a “meaningful vote” on her Brexit withdrawal agreement in Parliament later today. The pound extended its gains on the news, notching two-session gains of 1.4% and 1.1% against the dollar and the euro, respectively.

It remains unknown whether the assurances will be seen as legally binding enough to swing sufficient numbers of UK MPs behind May’s withdrawal agreement. We expect the series of votes this week to end with an extension of the 29 March Article 50 deadline, although that doesn’t preclude May from eventually getting her deal approved.

The numerous potential Brexit outcomes make forecasting the most probable one very difficult. Sterling overnight implied volatility hit a post-June 2016 high on Monday, suggesting investors are bracing for a period of heightened turbulence related to the upcoming Parliamentary votes. But amid the uncertainty, we see the following likely scenarios:

  • A deal. A Brexit deal should lift the pound, though we expect only a modest appreciation versus the euro because a transition deal is largely priced in by the market. Companies with high exposure to the UK and sterling are more likely to do well under a successful deal scenario, as UK growth and sterling would likely rise. We would expect the more domestically focused FTSE 250 to outperform in that scenario. Our 12-month forecasts are for GBPUSD at 1.40 and EURGBP at 0.86.
  • A no-deal scenario. A hard Brexit would likely pressure sterling given the greater economic uncertainty, and GBPUSD could fall to 1.15 and EURGBP rise close to parity. In our view, the risk-reward trade-off to buying sterling only becomes attractive at GBPUSD 1.24 and below and EURGBP 0.92 and above. In this scenario, the FTSE 100, composed to a greater extent of companies whose revenues are more internationally generated, would be likelier to outperform the domestically focused FTSE 250.

The direct impact of Brexit on MSCI EMU earnings, irrespective of its outcome, is likely to be limited. Only 5% of MSCI EMU's revenues are directly linked to the UK and only a handful of Eurozone and Swiss companies have UK revenues that account for more than 20% of total revenues.

However, Brexit uncertainty has already been among the factors depressing Eurozone growth over the past year. The UK accounts for 13% of Eurozone exports, only fractionally behind the US at 13.5%. We think current economic forecasts for the Eurozone already account for a transition deal or a delay of Brexit beyond 29 March. We estimate that a hard Brexit would shave about one-quarter of a percentage point off 2019 Eurozone GDP growth.

In light of the Brexit risks, hedging EUR or GBP exposure, depending on the reference currency, seems reasonable for the next three to six months. In our global tactical asset allocation, we are neutral Eurozone equities and underweight UK equities as their volatility is likely to exceed their historical norms, and we see better value in emerging market USD-denominated sovereign bonds.

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