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.
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.
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.
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.
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