UK Conservative win lifts pound, US-China deal touted

Thought of the day

by Chief Investment Office 13 Dec 2019

Investors this Friday will welcome a measure of clarity on two of the key political risks that have affected global markets through much of 2019, with a decisive electoral outcome in the UK and a Phase 1 US-China trade deal.

The UK’s Conservative Party has won a solid majority in the House of Commons, winning 364 of the 650 seats with one result still outstanding. The outcome gives Prime Minister Boris Johnson the authority he needs to pass a Brexit Withdrawal Agreement and push through the UK's exit from the EU. The pound rose 2.7% versus the US dollar and 2% against the euro, and in morning trade on Friday was still 1.9% and 1.3% stronger respectively.

Separately, the US and China have reportedly agreed in principle to a Phase 1 trade deal. Initial accounts suggest this will see the US holding off on its 15 December round of tariffs targeting USD 160bn of Chinese goods, and potentially roll back as much as 50% of some existing tariffs in exchange for significant agricultural purchases and other market reforms. We are awaiting more details on the apparent agreement, with only the US side providing any specifics at the time of writing.

What comes next?

For the UK, first and foremost will be the Brexit Withdrawal Agreement. We expect the House of Commons to quickly pass the necessary legislation to facilitate the UK's departure from the EU on 31 January. This would end nearly three years of parliamentary deadlock, providing some respite from uncertainty that has harmed business investment and consumer confidence.

The focus for markets will then turn to Phase 2 of the negotiations. If, at the end of the transition period, a trade deal between the two parties has not been agreed, then the UK could revert to trading with the EU on WTO terms. Beyond Brexit, other policy initiatives are likely to see modest fiscal easing, along with legislation that will prepare the UK for a future outside of the EU.

On US-China trade, assuming that the details are confirmed by an official announcement, a deal will come as a relief to investors. The magnitude of the moves to follow will depend on whether the deal meets or exceeds investor expectations, and whether it credibly removes escalating trade risk in 2020.

What does this mean for investors?

The UK electoral outcome is likely to be a modest positive for global investors as it has reduced the near-term threat of a hard Brexit. But the most immediate impact is likely to be on sterling. As we had expected ahead of the election, GBPUSD traded as high as 1.35 and EURGBP dipped below 0.83.

However, further gains in GBPUSD are likely to be capped around 1.40 due to uncertainty about Phase 2 of the negotiations. The deadline for extending the transition period beyond the end of next year comes on 1 July, so Brexit headlines might still drive GBP moves, with deadline concerns potentially creating a new trading range between 1.30 and 1.40 until June. For EURGBP, this should translate to 0.82 to 0.88, and for GBPCHF to 1.25 to 1.35.

Within our FX strategy, we are overweight the pound. Sterling, according to our measures of fair value, is a cheap currency (purchasing power parity for GBPUSD is estimated at 1.56), although it may take several years before the benefits of this discount can be realized. For non-sterling investors with a long-term exposure to the UK in their portfolios, we recommend holding these positions on an unhedged basis. From a US dollar perspective, sterling's valuation discount looks attractive. For those based in low-interest-rate currencies such as the euro or the Swiss franc, the cost of currency hedging UK equities appears too high over a one-to-four-year horizon.

On US-China trade, the news is certainly a positive for markets, but to make a full assessment we need more clarity on the timing, substance, and a confirmation. Given that the envisaged December tariffs would have been more harmful than previous ones for US companies, especially IT firms that ship goods produced in China to the US, we would expect the US market to benefit. Likewise, any avoidance of negative second-round effects like rising corporate defaults or weaker consumer sentiment would be supportive of our preference for Asia ex-Japan stocks and the Chinese stock market within our Asia portfolios.

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