From Brussels With Love

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Includes: DEUR, DGBP, DRR, ERO, EUFX, EUO, FXB, FXE, GBB, UEUR, UGBP, ULE, URR
by: Neuberger Berman
Summary

Every week seems to bring some unprecedented constitutional drama from the U.K.’s House of Commons.

Can May return from Brussels with enough love - or at least sympathy - to get a majority of MPs behind Withdrawal Agreement 2.0?

Sterling appears undervalued relative to long-term fair value measures like purchasing power parity, and the U.K.’s fundamental economic data has been improving.

By Elias Cohen, Portfolio Manager—Global Equity Team; Ugo Lancioni, Head of Global Currency; Nikola Petrovic, Portfolio Manager—Investment Grade Fixed Income; Benjamin Segal, Senior Portfolio Manager, Head of Global Equity Team

As Brexit Day looms, Theresa May has until Valentine’s Day to wring concessions from the EU.

Today’s CIO Weekly Perspectives comes from guest contributors Elias Cohen, Ugo Lancioni, Nikola Petrovic and Benjamin Segal.

Every week seems to bring some unprecedented constitutional drama from the U.K.’s House of Commons, as shifting alliances jostle and the March 29 Brexit deadline looms ever closer. Last week stood out, however, as a series of important votes on Tuesday evening cut across party lines and sent out a series of very mixed messages.

The one thing we know for sure is that Prime Minister Theresa May has until February 14 - Valentine’s Day - to persuade the European Union to offer some kind of concession on its fraught “backstop” language concerning the Northern Ireland border. That is a big chunk of the Withdrawal Agreement negotiated over the past two years, which was crushingly rejected by Parliament two weeks ago. Without that concession, she will have to give MPs another chance to debate and vote on their Brexit preferences.

Will we see a rerun of last Tuesday, or a new direction? Can May return from Brussels with enough love - or at least sympathy - to get a majority of MPs behind Withdrawal Agreement 2.0?

Amendments

What MPs did last Tuesday was table and vote on a series of amendments to a motion from the Prime Minister seeking authority to change the Withdrawal Agreement. Most were voted down, but one was passed that notes that “Parliament rejects” the U.K. leaving the EU without an agreement, and another was passed that requires the Northern Ireland border “backstop” language to be replaced by “alternative arrangements.”

The first appears to reduce the probability of a “no-deal” Brexit. The second, which asks for something that the EU has consistently ruled out, arguably increases it - that was certainly the view of European Commission President Jean-Claude Juncker, among others.

It is possible that Theresa May could bring back some kind of legal language around the border backstop that might be enough to command a majority for her Withdrawal Agreement on Valentine’s Day.

It is perilous to rule out any eventuality at this point, but we would argue that a lack of enthusiasm either for the Agreement or for a hard Brexit could lead to a vote to delay leaving the EU beyond the current March 29 deadline. Campaigning is already underway for the May elections to the European Parliament, which will have to ratify any eventual Withdrawal Agreement, and that provides another keen incentive for delay—possibly for as long as a year.

Let’s not forget that politicians will tend to kick a can down a road if they are given the choice.

Slow Burning

What does all this mean for investors?

On the Currency and Fixed Income teams, our outlook is that, from current levels, a smooth Brexit would present upside potential of approximately 3% for sterling, no Brexit approximately 10% upside potential and hard Brexit approximately 10% downside potential. We now put the probability of a smooth Brexit at 60%, hard Brexit at 30% and no Brexit at 10%. Weighting the potential moves by their probabilities brings you pretty much to where the pound is trading today.

Does can-kicking count as a smooth Brexit? Not really. Even if this eventually leads to a negotiated withdrawal, an abandonment of some of the U.K. government’s “red lines” or even a cancellation of Brexit, at the corporate level there will be little choice but to press on with hard-Brexit preparations already in progress. That means pulling still more investment from the U.K., reshaping global supply chains around the U.K., and cutting U.K. jobs. Think of it as a slow-burning mix of the hard- and smooth-Brexit probabilities.

Sterling appears undervalued relative to long-term fair value measures like purchasing power parity, and the U.K.’s fundamental economic data has been improving - although some of this is due to the number of tourists being attracted by the weak pound, and demand being brought forward by stockpiling initiatives aimed at minimizing disruption during a possible hard Brexit. Ultimately, we remain cautious until the risk of hard Brexit is removed or priced in, and that could be months away.

Confidence

Our Global Equity team prefers to avoid the volatility associated with the Brexit negotiations. The team favors those U.K.-domiciled companies that operate globally, and which appear likely to prove more resilient until the situation becomes clearer. It has a positive view on long-standing U.K.-listed holdings that offer exposure to secular growth themes, such as the use of big data, value-added distribution, specialty services and life insurance in North America and emerging markets.

With so many unknowns regarding currency, monetary policy, fiscal policy and consumer demand, however, the team is in favor of waiting for more attractive entry points before committing capital to domestically driven businesses such as banks and property developers.

Ultimately, uncertainty still reigns until February 14, and most likely beyond. Two-thirds of the U.K.’s GDP derives from consumption and one-tenth from business investment. With just two months to go, it remains to be seen whether the U.K. can navigate a smooth Brexit that limits the near-term damage to its economy, or whether it faces a period of sharply lower investor and consumer confidence.

In Case You Missed It

  • S&P Case-Shiller Home Price Index: November home prices increased 0.1% month-over-month and 4.7% year-over-year (NSA); +0.3% month-over-month (SA)
  • U.S. Consumer Confidence: -6.4 to 120.2 in January
  • FOMC Meeting: The committee made no changes to its policy stance
  • Eurozone Q4 2018 GDP: +1.2% annualized rate
  • China Purchasing Managers’ Index: -1.4 to 48.3 in January
  • U.S. New Home Sales: +17% to SAAR of 657,000 units in November
  • U.S. Employment Report: Nonfarm payrolls increased 304,000 and the unemployment rate increased to 4.0% in January
  • ISM Manufacturing Report: +2.3 to 56.6 in January
  • Eurozone Consumer Price Index: +1.4% year-over-year in January

What to Watch For

  • Monday, 2/4:
    • U.S. Durable Goods Orders
  • Tuesday, 2/5:
    • ISM Non-Manufacturing Index

– Andrew White, Investment Strategy Group

Statistics on the Current State of the Market – as of February 1, 2019

Market Index WTD MTD YTD
Equity
S&P 500 Index 1.6% 0.1% 8.1%
Russell 1000 Index 1.7% 0.2% 8.6%
Russell 1000 Growth Index 1.7% -0.1% 8.9%
Russell 1000 Value Index 1.7% 0.4% 8.2%
Russell 2000 Index 1.3% 0.2% 11.4%
MSCI World Index 1.4% 0.1% 7.9%
MSCI EAFE Index 0.9% -0.1% 6.5%
MSCI Emerging Markets Index 1.7% 0.0% 8.8%
STOXX Europe 600 1.2% 0.2% 7.0%
FTSE 100 Index 3.1% 0.7% 4.4%
TOPIX -0.1% -0.2% 4.7%
CSI 300 Index 2.0% 1.4% 7.9%
Fixed Income & Currency
Citigroup 2-Year Treasury Index 0.2% -0.1% 0.2%
Citigroup 10-Year Treasury Index 0.6% -0.5% 0.2%
Bloomberg Barclays Municipal Bond Index 0.4% 0.0% 0.7%
Bloomberg Barclays US Aggregate Bond Index 0.5% -0.2% 0.8%
Bloomberg Barclays Global Aggregate Index 0.6% -0.3% 1.3%
S&P/LSTA U.S. Leveraged Loan 100 Index 0.1% 0.1% 3.6%
ICE BofA Merrill Lynch U.S. High Yield Index 0.8% 0.1% 4.7%
ICE BofA Merrill Lynch Global High Yield Index 0.8% 0.1% 4.2%
JP Morgan EMBI Global Diversified Index 0.8% 0.1% 4.5%
JP Morgan GBI-EM Global Diversified Index 1.9% -0.2% 5.3%
U.S. Dollar per British Pounds -0.6% -0.5% 2.8%
U.S. Dollar per Euro 0.6% -0.1% 0.3%
U.S. Dollar per Japanese Yen 0.3% -0.5% 0.3%
Real & Alternative Assets
Alerian MLP Index 1.7% 1.0% 13.7%
FTSE EPRA/NAREIT North America Index 2.8% -0.7% 10.9%
FTSE EPRA/NAREIT Global Index 2.4% -0.6% 10.2%
Bloomberg Commodity Index -0.1% 0.3% 5.8%
Gold (NYM $/ozt) Continuous Future 1.8% -0.2% 3.2%
Crude Oil (NYM $/bbl) Continuous Future 2.9% 2.7% 21.7%

Source: FactSet, Neuberger Berman.

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