Macro Monthly Brexit: Are we there yet?

As Brexit draws closer to the October 31 deadline, the risks have become more quantifiable and the investability of UK risk assets has improved sufficiently for us to consider what opportunities exist.

21 Oct 2019
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Highlights

  • An historic weekend sitting of the UK parliament was expected to vote on and approve the deal that prime minister Boris Johnson had agreed with the European Union (EU) regarding the UK's withdrawal from the EU just two days earlier. Instead, UK Members of Parliament (MPs) voted to delay the decision.
  • Importantly, the weekend vote is not a fundamental rejection of the deal that Johnson has negotiated and the delay request can be withdrawn if parliament subsequently approves the deal.
  • Nonetheless, the mathematics of gaining parliamentary approval for the deal are challenging.
  • A complex array of potential Brexit outcomes and a feverish political atmosphere in the UK have represented meaningful barriers to the efficient deployment of investor risk capital in UK assets.

The graffiti artist who memorably daubed "if you are not confused, you don't understand the situation" across a Belfast wall in the late 1970s, could not have expected his sardonic indictment of British and Irish politics to remain so relevant four decades later albeit in a different political context. The twists and turns of Brexit continue. An historic weekend sitting of the UK parliament was expected to vote on and approve the deal that prime minister Boris Johnson had agreed with the European Union (EU) regarding the UK's withdrawal from the EU just two days earlier. Instead, UK Members of Parliament (MPs) voted to delay the decision.

Under the terms of the controversial Benn Act, this delay forced Johnson to write to the European Council to ask for an extension to the current October 31 Brexit deadline until January 31. Johnson complied but did not sign the request. Instead he sent two accompanying letters outlining his strong opposition to any further delay to Brexit. Johnson's combative approach is likely to be subject to a legal challenge in the Scottish Courts in the coming days. And despite Johnson's opposition, EU leaders are likely to approve the UK's request in order to avoid a no-deal scenario. But they may help Johnson by running down the clock on granting that extension in order to put pressure on parliament.

Importantly, the weekend vote is not a fundamental rejection of the deal that Johnson has negotiated and the delay request can be withdrawn if parliament subsequently approves the deal. Johnson's government is therefore likely to bring his Withdrawal Agreement back to parliament for a vote in the coming days. Whether they do or not depends on a number of factors. These include whether MPs against Brexit formally propose material changes to Johnson's deal, such as remaining in the EU Customs Union or having a second referendum on EU membership. In these circumstances, the prime minister will likely abandon the vote in the short term and negotiate an extension, rather than risk the proposals being adopted.

Either way, the mathematics of gaining parliamentary approval for the deal are challenging. Johnson's Conservative party does not have a majority of MPs. And in accepting a compromise solution for the complex issue of the Irish border that was acceptable to the EU, Johnson has alienated the Democratic Unionist Party (DUP) whose 10 MPs have previously voted with the government. Johnson has clearly gambled that he can persuade a sufficient number of Labour and independent MPs to support his deal to compensate for the DUP. But any vote is likely to be close and to depend on a handful of MPs.

Events of the past 48 hours are also likely to inspire Johnson to redouble his efforts to trigger a general election in order to achieve the parliamentary majority he currently lacks. Based on current polls, he will get it, but in the volatile world of British politics, that too is far from certain.

The bottom line

We do not believe that we are alone in generally steering clear of large active positions in UK risk assets in global multi asset portfolios for most of the period since June 2016's Referendum. A complex array of potential Brexit outcomes and a feverish political atmosphere in the UK have represented meaningful barriers to the efficient deployment of investor risk capital in UK assets.

But as we have drawn closer to the October 31 deadline, the risks have become more quantifiable and the investability of UK risk assets has improved sufficiently for us to consider what opportunities exist. In June we took the view that UK asset and forex prices were overly discounting the probability of a no-deal Brexit and introduced a long GBP position against the EUR. We also believed that there was materially greater upside in domestically-oriented UK stocks such as mid-cap housebuilders, financials and retailers relative to their international counterparts than there was downside in the case of a no-deal. We therefore introduced a tactical long in the more domestically-focused FTSE 250 midcap index against its large cap and more internationally exposed FTSE 100 counterpart at around the same time.

Finally, we believe there is likely to be upward pressure in most scenarios on nominal UK 10y gilt yields. Growth and inflation expectations are likely to rebound strongly if and when Johnson's Brexit deal passes parliament. In the unlikely event that the UK leaves the EU without a deal, we expect an aggressive fiscal expansion regardless of the outcome of any general election. We are therefore short UK duration in multi asset portfolios where gilts are a large part of the benchmark.

As ever with Brexit, the probabilities of various scenarios can change quickly and meaningfully. But our key takeaway of the most recent events is that the likelihood of no deal has reduced materially compared to earlier in the year. Since October 10, the upward spike in domestic UK equities, sterling and gilt yields likely reflect other investors repricing of no-deal risk. This has clearly been positive for all three trades, but the scale of the moves also reduces the scope for material further alpha and raises the question about what is now priced in relative to the risks.  We will continue to monitor the risk/reward tradeoff carefully in the context of the Brexit news flow and each client's specific mandate.

At the margin, we believe that deal approval is also likely to be positive for UK and for European ex-UK equities in a relative context globally—with uncertainty over Brexit a driver of international investors' reluctance to invest in the region despite strong valuation attractions.

However, while uncertainty may be reducing it is not disappearing. The successful passing of the Withdrawal Agreement would represent a conclusion to only the first part of the Brexit process. What comes next are negotiations about exactly what kind of trading agreement the UK and EU will have going forward. The talks are likely to be protracted and complex.

The long first chapter appears close to an end, but the Brexit story is far from finished.

 

 

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