With the rejection of the Brexit withdrawal agreement by an overwhelming majority of parliament, there are no signs that Brexit-related upheaval is ending anytime soon. Bill Smith, Managing Director and Head of EMEA, BMO Financial Group, moderated a call in January of 2019 with some of BMO’s top advisors, at home and abroad, to discuss the impact.
“The one consistent theme is uncertainty,” Steven Bell, Managing Director and Chief Economist, BMO Global Asset Management and the former Economic Adviser at the UK Treasury said, “and the uncertainty won’t end on March 29.” Under Article 50 of the withdrawal agreement, March 29 is the date the UK is scheduled to leave the European Union.
Many details of Britain’s withdrawal from the EU have already been agreed upon, but that agreement doesn’t deal at all with a future trading agreement, which still needs to be worked out. According to Bell, this adds to the uncertainty.
Weak, but stable
The Brexit effect can be seen, according to Bell, in the weakness of Sterling, which has failed to boost the UK’s exports. “Response to the weak Sterling is the most disappointing in the last 50 years,” he said. “Moreover, investment is lower than the fundamentals might suggest, due to the uncertainty.”
Stephen Gallo, Director and Head of European FX Strategy, BMO Capital Markets, noted that the number one question directed to him through all of this has been, “Why is the GBP so stable, despite all of the uncertainty?” There are a number of reasons.
According to Gallo, “big FX hedging and investor flow has been done for a very long time, so participation in the market is low,” and within the shorter-term trading community, the Sterling is virtually untouchable thanks to the sheer number of Brexit permutations possible.
“The Sterling somewhat positively correlated with emerging market and developed market equities,” Gallo continued. “It’s also somewhat positively correlated with Euro dollar, which in turn has also displayed some co-movement with the aforementioned risk appetite variables.” He sees the Euro-Sterling: at 0.8750-0.9050, unless there’s an outcome that materially changes the situation.
There are multiple scenarios possible as we approach the March deadline, each with its own set of effects on the UK economy. Complicating every permutation is the so-called “Irish backstop”, noted Bell, because in order to get a deal, the British parliament has to pass an agreement in some form with a backstop and the rest of the EU, the Irish government in particular, has to accept it.
Deal or No Deal
If a deal is reached by March 29 there would be a smooth Brexit with a transition period lasting until the end of next year. Gallo assigned this scenario a 10% probability of happening, “because Prime Minister May has given no indication she plans to soften her Brexit stance, and the EU has given no suggestion it will dilute the Irish backstop agreement.”
Brexiters fear that this scenario could leave the UK dependent on the EU, locked into a customs union, with rules over they lack influence and restricted in the free trade deals they could strike with other countries. This scenario creates barriers to a return of sovereignty on laws, trade, and immigration which could fuel political instability in UK for months to come, in Gallo’s view, and damage the Tory party possibly irreparably. Nonetheless, if this scenario were to come to pass, he sees the Sterling at 1.35.
Extension of Article 50
Gallo sees three separate plausible permutations of the extension, and assigns it a 50% probability, which is the closest possibility of forming a base case.
- New deal, soft Brexit
- New elections and/or new referendum
- Second extension of Article 50
This seems to be the most realistic,” Gallo said, “because it keeps the Brexit war ongoing, but reduces the chance of an immediate catastrophic economic outcome.”
Steven Bell explained that all the difficulties associated with securing a deal or managing with a no-deal make for a significant possibility that Article 50 will be extended beyond the March 29 deadline. “The EU 27 is willing to grant an extension if the UK were to hold a second referendum, but that’s not an easy option,” he said. “Results could include a serious and possibly permanent split within the Conservative party, and some commentators fear civil unrest as a result.”
Gallo sees the Sterling trading at 1.32 in this scenario.
The Bank of England would likely ease policy if there were a disruptive no-deal Brexit, Bell noted. That could involve means base rate cuts, the resumption of the funding for lending scheme, more Quantitative easing, and a cut in the countercyclical buffer for banks.
Gallo sees the Sterling instantly falling to 1.20, and he noted he would have to look at the economic data and Bank of England for more directional guidance. He assigns this outcome a 40% probability, which could be extended to pull the odds of a no-deal scenario at the end of an Article 50 extension, too.
“The reason for this level of probability is because it’s hard to see how any kind of consensus around this deal can be arranged in the lower house,” Gallo said, “not just to legally prevent a no-deal, but also to land on an alternative Plan B, which is required in order to prevent a no-deal from happening.”
Impact on rates
Ian Lyngen, Managing Director, Head of US Rates Strategy, BMO Capital Markets, noted that while Brexit is still on the radar, it has a far lower potential of recasting the outright level of treasury yield at this stage.
“Brexit was very important to investors and how we viewed outlook for treasuries back in 2016, but its relevance to US treasury yields has steadily declined since then,” he said. “Potential impact on the treasury market is now in the single digit base point, down from 2016 when Brexit appeared to be the start of a more populist policy stance that’s now spread across much of the globe.”
It’s unlikely the UK would stay in the customs union with the current Conservative government in the event of a hard Brexit, Bell said, therefore it will be able to negotiate its own trade deals. Many hope for a deal with the UK modelled on the Comprehensive Economic Trade Agreement with Canada, but that was a tough process negotiating and ratifying with individual countries. “There’s a long way to go from where UK is now to securing that kind of trade deal with a lot of countries,” he added.
What this means for the equities market
Bell explained that overall, with the range of uncertainties, the net effect on the market measured in sterling of a plausible set of outcomes would be modest, but the impact of an early general election would be more significant. “Negative Brexit scenarios would see Canadian or dollar-based investors lose money on an unhedged basis in UK equities,” he continued, “and local investors might actually make money like they did on the Brexit referendum, because the falling sterling boosted the market.”
The only thing Bell is sure of is that the uncertainty will continue.