The Brexit journey remains fraught with potential stumbling blocks, but a new set of political markers offers hope that a thread-the-needle way forward is possible. As a result, our new base case is a "Soft Brexit."
Fits and starts
In our 2019 Annual Outlook published in December, we argued that while the tail risks of "No Brexit" and "No-deal Brexit" had risen, we remained confident that some form of Brexit would occur. We believed then that the most likely outcome would be that the deal already negotiated by Prime Minister May would be ratified via a second Meaningful Vote (MV2) in the House of Commons. What we didn't anticipate however, was the scale of the Parliamentary revolt against May's deal.
During the week commencing March 25, no form of a Brexit deal was approved by Parliament, and therefore a shorter extension to April 12 was given by the European Union (EU). By this deadline, the UK now has to suggest an alternative "way forward," most likely via a "new political process," which would need the EU-27's sign-off in order to be granted a longer additional extension.
More votes to follow
This process will likely entail indicative votes on the whole gamut of Brexit options, ranging from a referendum to a complete "No-deal" Brexit. We think that the most likely outcome of this process will be the selection by members of Parliament (MPs) of some form of a "Soft Brexit," either via a commitment to stay in the Customs Union, single market, or both.
Additionally, the potential exists that MPs are only able to coalesce around such an outcome by also committing to put this potential new deal to a referendum. As a result, we have marked down our subjective probabilities for Brexit, as it has currently been negotiated in the Withdrawal Agreement, from 50% to 30%. We also lower our probability of "No-deal Brexit" from 30% to 15% and raise our probability of "No Brexit" from 10% to 15%. Finally, we have raised our "Soft Brexit" probabilities substantially from 10% to 40%.
Brexit scenario probabilities
Probability of end-state scenarios
"No Brexit" (Remain)
"Current agreement Brexit"
Source: Russell Investments, for illustrative purposes only.
General election risks rising
The main risk to this new baseline scenario of a "Soft Brexit" is a general election. This would allow May to short-circuit the indicative votes, demonstrate to the EU that she has a new political process to find a way forward, and keep her deal alive by forcing MPs in her party to campaign in support of it. This would be a significant downside scenario for UK assets such as the sterling, as well as the UK economy itself. But as of the end of March, we do not think this is a particularly likely outcome.
Baseline scenario: "Soft Brexit" via indicative votes
Focusing on our baseline scenario that a softer form of Brexit is eventually agreed to, either via indicative votes and/or a second referendum, we see a number of clear implications for UK asset markets and macro fundamentals.
Equities and sterling impact
For the sterling, this new baseline scenario implies upside potential of between 5%-10%, particularly against the euro. For UK government bonds (gilts), the picture is more mixed, as while we would expect some upward yield movement in anticipation and upon completion of a final deal, it is no longer a given that the Bank of England will immediately begin to hike rates again. This is due to the fact that the UK economy has already experienced a significant demand slow-down triggered by Brexit-induced uncertainty. This has caused business to halt further investments and consumer confidence to wane. As a result, we have marked down our expectations of rate hikes from two in 2019 to only one.
This damage to the UK economy is likely to flow into the performance of locally-orientated versus internationally-focused equities. Previously, we were expecting the performance of local equities to follow that of the sterling. However, with the performance of the UK economy likely to continue to lag this year, the performance of local equities is also likely to fall behind the sterling's.
On an absolute basis, the performance of the much more internationally focused large-cap equity index will be driven by commodity markets, the global cycle and investor risk appetite. Commodity markets, particularly energy and metals, are likely to provide a positive tailwind to a subsection of UK companies. Additionally, the likely length of the U.S. Federal Reserve's pause to interest rate hikes, and the quantity of fiscal stimulus coming out of China, will both provide additional cyclical impetus to the UK equity market.
- Cycle: We significantly mark down our 2019 GDP growth forecast to a below industry consensus 1.25% on the basis of a delayed, but eventually softer Brexit deal. We believe this delay will continue to sap UK business confidence and investment. The Bank of England is likely to hike only once this year and twice again next year.
- Valuation: UK equities continue to look slightly cheap on our asset class scorecard. At 1%, 10-year gilts remain long-term expensive, and indeed more expensive as of the March 27 than at year-end 2018 given the significant fall in yields.
- Sentiment: For UK equities, price momentum has become neutral and the post-Christmas Eve rally has neutralised the contrarian indicators that were firing earlier this year. For gilts, our sentiment indicator is neutral as positive momentum is cancelled out by a negative medium-term contrarian score.
- Conclusion: A negotiated softer Brexit has become our new base case. For large cap equities, we continue to retain a slight overweight bias driven by positive valuations and neutral cycle and sentiment. For UK gilts, we continue to retain a negative score driven by valuation and cycle concerns.
These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.
Investing involves risk and principal loss is possible.
Past performance does not guarantee future performance.
Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.
This material is not an offer, solicitation or recommendation to purchase any security. Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.
The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.
Please remember that all investments carry some level of risk. Although steps can be taken to help reduce risk it cannot be completely removed. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.
Investments that are allocated across multiple types of securities may be exposed to a variety of risks based on the asset classes, investment styles, market sectors, and size of companies preferred by the investment managers. Investors should consider how the combined risks impact their total investment portfolio and understand that different risks can lead to varying financial consequences, including loss of principal. Please see a prospectus for further details.
Indexes are unmanaged and cannot be invested in directly.
Russell Investments' ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments' management.
Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.
Copyright © Russell Investments Group LLC 2018. All rights reserved.
This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.