'Soft Brexit' Looks Increasingly Likely

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Includes: DBUK, DEUR, DGBP, DRR, ERO, EUFX, EUO, EWU, FKU, FLGB, FXB, FXE, GBB, HEWU, QGBR, UEUR, UGBP, ULE, URR
by: Russell Investments
Summary

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."

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.

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

Feb 2019

Mar 2019

"No Brexit" (Remain)

10%

15%

"Soft Brexit"

10%

40%

"Current agreement Brexit"

50%

30%

"No-Deal Brexit"

30%

15%

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.

Global influences

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.

Strategy outlook

  • 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.

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