Theresa May, the UK prime minister, has announced her decision to step down, after her latest efforts to forge an EU withdrawal agreement failed to win support. May's departure will further increase uncertainty over the process of the UK exiting the EU, which is currently set for 31 October. The pound, which has lost almost 4% of its value against the euro and dollar over the past three weeks, remains under pressure near EURGBP 0.88 and GBPUSD 1.27.
What comes next?
The prime minister's departure has been set for 7 June. The announcement formally kicks off the process for selecting her successor as leader of the Conservative Party and prime minister. Former foreign secretary Boris Johnson, a top campaigner for Brexit ahead of the 2016 referendum, is currently the front runner. Johnson has indicated that he is willing to countenance a UK exit from the EU without a deal.
But a new prime minister could continue to face a political impasse. The Conservative Party lacks a majority in the UK parliament, relying on the DUP to support its legislation. Its grip on power could slip further as more MPs would likely resign the party whip if a new leader were to try and make no-deal official government policy. Meanwhile, with both the Conservatives and Labour, the largest parties in Parliament, facing internal divisions over Brexit, forging a consensus remains difficult.
We now see a rising chance that the UK will be compelled to ask the EU for a further delay to Brexit, the third time the deadline has been pushed back. This would, in turn, raise the probability of a snap general election or second Brexit referendum.
What scenarios are now possible?
- A no-deal Brexit: The Conservative Party appears to be leaning toward a pro-Brexit replacement for May, with former foreign secretary Boris Johnson currently the leading candidate. The temptation to support a leader who has expressed a willingness to consider a no-deal Brexit could be strengthened by the strong public support for the newly founded Brexit Party, which was polling at 37% versus 7% for the Conservatives just ahead of this week's European Parliament elections. We believe a no-deal Brexit could take the pound as low as USD 1.15 and 0.97 versus the euro. At these levels we think the negative impact of a no-deal Brexit on the UK economy would be fairly reflected.
- A further Brexit delay: Despite mounting public impatience over the process, many top officials and lawmakers remain fearful of the economic damage from a no-deal exit. This resistance could prompt even a pro-Brexit prime minister to ask EU member states for a further delay to the UK's departure, currently scheduled for 31 October. EU leaders may insist the UK take steps to resolve the political deadlock, such as a general election or second referendum on EU membership. Lingering uncertainty would likely cause firms to delay investment, and add more volatility to sterling, with intermittent relief-rallies as investors hope for a negotiated outcome. Under this scenario we would expect the pound to trade in a range between USD 1.28 to 1.34.
- Continued EU membership: UK voters remain deeply divided on Brexit. However, the latest YouGov poll has a 44% vote for continued EU membership in the event of a second referendum, versus 40% to leave. A UK decision to remain an EU member would likely cause a swift rebound in sterling, which is undervalued relative to its purchasing power parity level of around GBPUSD 1.58 and EURGBP 0.82. Obviously, even in this scenario these fair values cannot be taken as immediate targets. They are, at best, long-term targets that might only be achieved in case of the public and political willingness to pursue Brexit receding – a long-term process, if it is reached at all.
How should investors react?
Sterling continues to be the main channel through which investors express their views around the outcome of the Brexit process. Although there is likely to be significant uncertainty and volatility ahead, we remain alert for opportunities arising from the market reaction to the UK political situation. Sterling is undervalued, especially relative to our estimate of its purchasing power parity.
The appropriate response for individual investors will vary depending on their exposure to sterling and UK assets.
For global investors with limited exposure to the UK we believe it is time to prepare to be cautiously adding exposure to the pound. Sterling looks cheap, which in itself suggests a long-term buying opportunity. But we feel it is still too early to take large positions. The outcome of the Brexit process remains hard to predict, and volatility is likely to remain high. That said, after the resignation of May our bias is to buy the dips below USD 1.24 and start unwinding hedges as soon as the political situation allows. If investor anxiety pushes the pound as low as 1.15, the case for larger long sterling positions would strengthen.
For global investors with an existing exposure to UK assets, we recommend a careful review of positions using the above scenario analysis. We have long recommended such investors consider hedging to protect against further sterling weakness; we think it is too early to unwind these hedges.
Finally, for UK investors with a significant home bias we believe diversified dividend stocks are likely to outperform the rest of the UK market if the political situation remains fluid and markets remain volatile. Aside from this, UK investors face competing challenges. Sterling weakness may benefit the UK large cap equity market. However, rising risk premia related to policy uncertainty or a significantly stronger pound could cause UK large caps to under-perform their global peers.
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