U.K. Investors Have Too Much Faith in Their Government
The U.K. government will soon invoke Article 50 of the Lisbon Treaty to begin divorce proceedings from the European Union. The Scottish government is seeking to hold a second independence referendum before Brexit talks wind up. An otherwise uneventful Bank of England meeting had one interest-rate dissenter with others potentially sympathetic as inflation stirs.
But if you look at markets you would never know that the myriad implications of Brexit are spreading, vine-like, through the U.K. Investors shouldn’t assume this disconnect will continue, especially if Brexit turns out to be less like a process and more like a Wile E. Coyote moment.
The only thing of note that’s really happened since the June 2016 referendum is sterling’s depreciation. But most of the 17 percent drop against the dollar and 12 percent decline against the euro happened in the weeks after the June vote. Sterling has traded within relatively narrow bands in recent months.
In stock and bond markets, the overall trends so far have had nothing to do with Brexit. If anything, decent U.K. consumer spending and economic gains have sustained some outperformance by equities, without harming the bond market too much, in spite of faster inflation.
The FTSE 100 Index, which for the most part is a play on sterling, is at a record high and about 23 percent higher than the post-referendum low. The benchmark has outperformed the Stoxx Europe 600 Index. The broader and more domestically focused FTSE 350 Index has rallied more or less in tandem.
Yields on 10-year gilts plunged to 0.5 percent in August, but even though they have risen to 1.25 percent today, they are still below levels that prevailed before the referendum. By contrast, similar maturity Treasuries and Bunds are 70 and 30 basis points higher, respectively.
The benign state of affairs in markets, however, only "works" in a best-case outcome in which the U.K. succeeds in multitasking on several fronts. It has to:
- Successfully negotiate and conclude the Article 50 terms of the U.K.’s exit from the EU,
- Successfully agree in principle on the U.K.’s future economic relationship with the EU, phased in over several years of transition,
- Successfully decide which laws adopted over the last 40 years of EU membership to keep, modify or reject,
- Successfully keep an aging U.K. economic expansion out of recession while mitigating the adverse economic consequences of Brexit on living standards, and
- Successfully avoid the disintegration of the U.K., with Scotland seeking a second referendum and the return of hard borders with the Irish Republic threatening the peace process in Northern Ireland.
The Westminster government and Parliament are constitutionally bound to approve a Scottish referendum, which Prime Minister Theresa May has ruled out for now. She doesn’t want her hands tied and won’t want to consider a referendum until Brexit has happened. Scottish campaigners have other ideas and will try to make May’s job as hard as they can.
Financial markets are making no allowance for the possibility that one or more of these tasks could go badly wrong, especially since serious questions have emerged over the government’s competence in preparing for Brexit, and over its inability to stand firm on a tax proposal in the face of pressure from its own supporters. Time is short. Article 50 negotiations have to be concluded by March 2019, or else the U.K. will leave the EU without any agreement. In reality, it is more like one year, given French and German elections may delay a proper start until the fall of 2017, and approval processes in the EU may require an agreement on the table by October 2018.
Then there’s a so-called hard Brexit to consider. That’s favored by many Conservative members of Parliament, and could happen even sooner than 2019 if negotiations over the divorce proceedings or the future relationship break down. It would expose the economy to bigger demand and supply shocks, while creating a legal and regulatory quagmire for U.K. companies, citizens and markets; an existential limbo for EU citizens resident in the UK (and vice versa); and huge uncertainties over security and foreign policies.
Outside the EU and the single market, the U.K. would need time to establish its own membership conditions for approval in the World Trade Organization, adjust to higher trade tariffs, re-orientate its EU-focused services exports, and commit to time-consuming talks to build new trade relations with countries outside Europe that could never substitute for leaving the biggest free trade area in the world.
Given the binary nature of a hard Brexit versus a best case outcome, it would make sense for investors to position for both a further decline in sterling and the larger risk premia in, for example, U.K. equities, corporate credit and real estate. Long gilt positions with respect to Europe and the U.S. might pay off in this environment, but perhaps not before they too had succumbed to risk angst linked to a weaker pound.
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