An uncertain way forward
The EU may have formally agreed to the UK Brexit deal on Sunday but the way forward from here is as uncertain as ever. Indeed, the Bank of England has released a doom-laden assessment of a No-Deal exit.
The next key event is the vote by the UK Parliament on the deal scheduled for 11 December. At the moment, it is hard to see how Theresa May can cobble together a majority in favour of the deal as Labour, the SNP and DUP and assorted Conservative Brexiteers and Remainers are all planning to vote against it.
If Parliament does reject the current deal as seems likely - despite Theresa May’s desperate attempts to drum up support round the country over the next two weeks - then the government has up to three weeks to make a statement on how it wishes to proceed. A whole range of scenarios are possible:
- A vote of no confidence in Theresa May as leader of the Conservative party: it is far from clear what the result of this would be as while there may be little confidence in May, it is not clear who the successor would be and whether they would be any more able to secure a better deal.
- A second vote by Parliament on the deal: This could be based on a revised deal although it will be very difficult to achieve any significant amendments with the EU at the moment saying this is the only deal on offer. All the same, there is a chance that with time fast running out and the danger of No Deal increasing, MPs might reluctantly approve it second time round.
- An extension of the Brexit exit date: the UK could apply to the EU for an extension while it tries to get its house in order. Conceivably the EU might agree to this but probably for no more than a few months.
- A second referendum: the Conservatives are firmly against this and Labour is also equivocal. It is definitely possible but runs into the problems that it will be very difficult to conduct one before the exit date on 29 March and also might not yield a conclusive result. Even if there were a new vote in favour of remaining, there is the complication of whether the UK can actually unilaterally reverse Article 50 (the decision to withdraw from the EU) or whether it needs EU agreement as well – the ECJ will be ruling on this matter later this week.
- A general election: this can be triggered in two ways – either by two thirds of MPs voting for an election (in which case it can happen as soon as five weeks later) or by a vote of no confidence in the government which would require just a simple majority of MPs to vote in favour (but would then give someone else two weeks to try and command a majority in the House of Commons or failing that a general election as soon as five weeks after that). A general election seems unlikely near term other than in the aftermath of a No-Deal exit if for no other reason than there is little appetite to throw this additional bombshell into the existing mess with no guarantee that it would make matters any better. And for Conservatives it would clearly risk a Labour victory under Corbyn - a risk that even die-hard Brexiteers might not wish to take.
- An eventual No-Deal exit: just as there is no majority in Parliament in favour of the current Brexit deal, there is also no majority in favour of No Deal or indeed any of the other options. But this does not mean there is no risk of No-Deal because unlike the other options, which require positive action/a majority to come about, No-Deal is the default option.
Where does this all leave us?
- The eventual Brexit outcome is as unclear as ever. Our best guess, however, remains that we will not crash out with No-Deal and/or end up with a Corbyn Government - although both can be far from ruled out.
- As far as the markets are concerned, the big question is whether we exit with a deal or not - rather than the exact shape of any deal. Any deal will push out the threat of significant disruption to the economy to at least the end of 2020 because the transition period, under which the status quo will remain largely intact, will operate until then.
- If there were no deal, there would very likely be significant short term disruption to the economy and very likely a long term hit as well. The Bank of England’s lastest guess is that under the worst scenario of a disruptive No Deal exit, GDP would fall by a very substantial 8% over the coming year. While these numbers are little better than guesses and have been dubbed by a vehement Brexiteer as ‘Project Fear turned into Project Hysteria’, they do nonetheless highlight the real risk that No-Deal could lead to a sizeable short term hit to the economy – even if a contraction of the size under the Bank’s worst case ‘disruptive’ scenario continues to look very unlikely.
- The danger and/or reality of a sizeable hit to the economy, along with a significant risk that a No Deal would trigger a general election and possibly a Corbyn-led Labour Government, would very likely lead to a further significant sell off in UK markets even though the pound and UK equities are already trading at cheap levels.
- We would expect the market reaction on a No-Deal to follow the pattern seen after the 2016 Brexit vote i.e. sterling would be hit worst. A move down to the 2016 low of $1.20 or lower from $1.28 currently would seem quite possible
- FTSE 100 companies have some 75% of revenues coming from abroad and should benefit from these earnings for the most part not being directly affected by Brexit and being worth more in sterling terms if the pound fell. The FTSE 100 may well, as a result not fall that much – although would very likely underperform other markets significantly in common currency terms.
- Domestic focused and mid/small cap UK stocks would very likely suffer more than the FTSE 100 because their earnings would be more exposed to the domestic economic disruption than the FTSE 100 and will receive less benefit from a fall in the pound. Domestic focused companies would however have the advantage that the primary source of disruption would be to trade flows and they will be less exposed to such disruption than companies more dependent on imports and exports.
How are we positioned?
- We have been running for several months now significant underweights both to equities overall - because we are getting towards the end of the business cycle and the risks increasing as a result – and to UK equities specifically primarily because of the Brexit risk.
- We intend to continue to run with this cautious positioning given the continuing sizeable risks and uncertainties surrounding Brexit.
- Our focus is much more on limiting any hit to portfolios from a No-Deal rather than maximising any gains on a deal.
- If there were a No-Deal exit, our overall equity holdings will very likely suffer but probably rather less than might be expected. Our overseas holdings (which are close to 40% larger than our UK holdings) should hold up well in sterling terms as any Brexit-related sell off in overseas markets should not be that large and be offset by the boost in value coming from a fall in the pound. As for our UK holdings, the fall in value should be limited to some extent by the relatively high proportion of UK companies’ earnings coming from overseas.
- If, by contrast, the UK does end up exiting with a deal, the pound will very likely rally and UK equities reverse some of their marked underperformance. Our portfolios should benefit from the gains in UK equities although this should be offset to some extent by the value of our international holdings falling in sterling terms due to some recovery in the pound.
Bottom line: Our portfolios are positioned cautiously and while we are hoping for the best, we have taken action to prepare for the worst.
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