Sterling Sinks Despite Lower Risks of No-Deal Brexit

Last night’s UK Parliamentary vote was momentous. Parliament basically seized control of the Brexit process from Prime Minister May and passed a binding vote against a no-deal Brexit. And yet sterling and UK stocks are down today. Our base case remains one of a softer Brexit with a likely delay, whilst UK fundamentals deteriorate.

 POLITICAL OUTLOOK

The UK House of Commons narrowly voted to block a no-deal Brexit late last night. The 313-312 vote to pass the so-called Cooper Bill couldn’t get any closer. It is now being debated in the House of Lords, and reports suggest it will likely pass. The bill states that if no deal in place by the Article 50 deadline, then the government must ask the EU for an extension rather than crash out without a deal.

Meanwhile, Prime Minister May has reached across the aisle to come up with an acceptable deal. Talks yesterday between May and Corbyn were said to be “constructive” and will be continued. Taken together, these recent developments have fed into market consensus that there are lower odds of a no-deal Brexit. We concur and believe that the base case remains some sort of soft Brexit with a likely delay.

There’s been a lot of talk about preserving some sort of customs union with the EU. To be clear, a customs union allows its members to eliminate trade barriers amongst themselves whilst maintaining common tariffs against the rest of the world. On the other hand, a Free Trade Area allows each country to maintain different tariff levels against the rest of the world.

We cannot rule out fresh elections. May’s overtures to Labour have reportedly infuriated the hardline Brexit camp in her Tory party. The last general elections in 2017 saw the Tories loss their majority, requiring them to seek out the support of the Democratic Unionist Party (DUP). Yet polls suggest the Tories are more vulnerable than ever, and so fresh elections would bring big risks that should be avoided. We do not think markets would take kindly to a Labour government led by Corbyn.

 

A BRIEF HISTORY LESSON

The EU began life in 1951 as the European Coal and Steel Community (ECSC). Ironically, UK Prime Minister Churchill was one of the biggest proponents of European unity, calling for a “United States of Europe” in 1946.

The ECSC was created in 1951 when charter members Belgium, France, Italy, Luxembourg, the Netherlands, and West Germany signed the Treaty of Paris. Ostensibly, the organization sought to create a common market for coal and steel amongst its members to minimize the competition for natural resources. The ECSC was the first step to regional integration and was primarily meant to prevent further wars in Europe by increase economic interdependence.

The European Economic Community (EEC) was the first step in regional economic integration. The EEC and the European Atomic Energy Community (EURATOM or EAEC) were established in 1957 by the Treaty of Rome. Both organizations were less supra-national in nature than what one would expect, as some member states complained of infringement on their sovereignty. The first goal of the EEC was to create a customs union for its members.

The first phase of EEC expansion was attempted in 1961, when Denmark, Ireland, Norway, and the UK applied for membership. Due to resistance to UK membership from French President Charles de Gaulle, all four were all initially rejected but then resubmitted in 1967. By that time, Georges Pompidou had succeeded de Gaulle and so the French veto was dropped. After a protracted period of negotiations, Denmark, Ireland, and the UK joined the EEC on January 1, 1973.

Expansion continued apace. Greece joined the EEC in 1981, followed by Spain and Portugal in 1986. In 1993, the EU was created by the Maastricht Treaty. The next expansion was 1995, when Austria, Finland, and Sweden joined the EU. 2004 saw the largest enlargement, as the Eastern European nations of Czech Republic, Estonia, Cyprus Latvia, Lithuania, Hungary, Malta, Poland, Slovakia, and Slovenia were admitted. No country has ever left the EU. Until now.

 

ECONOMIC OUTLOOK

The UK economy is slowing. GDP growth is forecast by the IMF at 1.5% in 2019 and 1.6% in 2020 vs. 1.4% in 2018. GDP rose 1.4% y/y in Q4, while monthly GDP figures show the 3-month y/y growth slowing to 1.3% in January. Other monthly data suggest further deceleration in Q1. As such, we see some downside risks to the growth forecasts.

Price pressures have fallen. Headline CPI rose 1.9% y/y in February, the second straight month below the 2% target and well below the 3.2% peak in November 2017. CPIH includes housing costs and rose 1.8% y/y in February, also well below the cycle high of 2.8% y/y in H2 2017. While the BOE has signaled a desire to tighten policy, we see no clear-cut justification for it right now. The next policy meeting is May 2 and no change in policy is expected then.

The Bank of England last hiked rates with a 25 bp move in Base Rate to 0.75% back in August. That was the second move in this tightening cycle, with the first 25 bp hike coming back in November 2017. The Short Sterling futures strip shows that a hike is fully priced in by December 2020. After that one, the next hike is fully priced in by December 2022. Of course, the BOE rate path really depends on how Brexit takes shape.

The external accounts are improving modestly. The current account deficit was an estimated -3.9% of GDP in 2018, and the IMF expects the deficit to narrow to -3.2% in both 2019 and 2020. The UK’s Net International Investment Position (NIIP) is currently around -12% of GDP. All told, the UK’s external vulnerability seems relatively low.

 

INVESTMENT OUTLOOK

Sterling is outperforming in 2019 after underperforming last year. In 2018, GBP was -5.6% and ahead of only the worst major performers AUD (-9.7%), CAD (-7.8%), and SEK (-7.6%). So far in 2019, GBP is up 2.5% YTD and is the best major performer. We believe much of this year’s gains are due to relief that a no-deal Brexit will likely be avoided. However, UK fundamentals remain poor and so we expect this outperformance to ebb.

We are a bit surprised that it isn’t trading higher after last night’s Parliamentary vote. Risks of a no-deal Brexit were weighing on sterling, but so far there has not been much upside now that those risks have ebbed. While sterling is likely to see some knee-jerk bounces on positive Brexit news (long delay, softer Brexit), we think those gains will be hard to sustain given deteriorating fundamentals. This week, cable has been capped by the $1.32 area.

After making a new multi-year low near $1.2440 in January, cable went on a tear to trade at a cycle high near $1.3380 in March. It has given up about a third of those gains now and further losses are likely. The major retracement objectives from this year’s rally come in near $1.3020 (38%). $1.2910 (50%), and $1.2800 (62%). The 200-day moving average comes in near $1.2975.

UK equities continue to underperform. In 2018, MSCI UK was -13.7% vs. -11.6% for MSCI DM. So far this year, MSCI UK is up 11.9% YTD and compares to 14.9% YTD for MSCI DM. Our DM Equity Allocation Model has the UK at VERY UNDERWEIGHT, and so we expect UK equities to continue underperforming.

UK bonds are underperforming within DM. The yield on 10-year local currency government bonds is -19 bp YTD. This is ahead of only the worst performers Switzerland (-3 bp), Japan (-6 bp), Sweden (-7 bp), Norway (-9 bp), Denmark (-15 bp), the US (-18 bp), and Austria (-18 bp). With inflation likely to remain low and the central bank seen on hold until 2020, we think UK bonds will start to outperform more.

Our own sovereign ratings model shows UK’s implied rating steady at AA-/Aa3/AA-. This suggests downgrade risks to its actual AA/Aa2/AA ratings.