The odds of a hard Brexit are getting alarmingly high. Here, we set forth some possible scenarios as to what may unfold ahead of the October 31 deadline. The most likely outcomes are not good and so we see UK assets continuing to underperform.
UK Prime Minister Boris Johnson will travel to Germany and France this week to stake out his hardline stance on Brexit. Reports suggest he will underscore that the UK will leave the EU October 31 “do or die.” Johnson will reportedly visit German Chancellor Merkel and French President Macron on Wednesday and Thursday, respectively, to tell them that the EU must offer a new deal or else the UK will take the hard Brexit option.
A leaked UK government report paints a dire picture for a hard Brexit. The so-called “Operation Yellowhammer” was prepared by the cabinet and sets forth possible scenarios for Brexit. It warned of shortages of essential items in the case of a hard Brexit, including food, fuel, and medicines.
Political intrigue continues. Speculation is building that Johnson will call early elections. On other hand, press reports suggests opposition leader Corbyn will call a vote of no confidence when Parliament returns from recess. If Corbyn gets enough support for the motion, it could trigger a general election.
Reports suggest the UK government may delay naming the next Bank of England Governor until after the October 31 Brexit deadline. Current Governor Carney is scheduled to step down in January after twice extending his term due to Brexit. Chancellor Javid may also delay his 2020 budget presentation if early elections are called. Stay tuned.
A BRIEF HISTORY LESSON
In 1921, Ireland was partitioned under the Government of Ireland Act. Northern Ireland consisted of six counties while Southern Ireland (now just Ireland) consisted of the remaining twenty-six counties. Whilst the two were originally meant to be self-ruling, the Anglo-Irish Treaty of 1921 allowed Northern Ireland to devolve back to British rule. Not surprisingly, it chose to do so and functioned as a self-governing region of the UK until 1972.
Under the 1921 act, a 300-mile hard border between the two came into effect. Customs controls were introduced in 1923 and continued until January 1993, when customs checks between EU member states were eliminated by the creation of the single market. The sectarian divide in Northern Ireland developed along class and culture lines rather than religious ones. For decades (if not centuries), these divisions grew and grew until they reached critical mass.
The so-called Troubles started in 1969 and lasted nearly three decades until 1998. The violent conflict arose between the Protestant unionists (loyalists who wanted to remain in the UK) and the Catholic nationalists (republicans who wanted to become part of Ireland). Over 3500 were killed and at least 30,000 were injured during the Troubles.
1972 is widely recognized to have been the worst year for the Troubles. It started off with Bloody Sunday in January and continued throughout the year with more deaths and injuries. The heightened violence led the British government to suspend the Northern Ireland Parliament and reintroduce direct rule from London that year. Yet the violence continued.
By the late 1980s, there were growing signs that a political settlement was possible. The end of the Troubles came with the signing of the Good Friday Agreement in 1998. Self-rule was returned to Northern Ireland. It will remain part of the UK until a majority in both Northern Ireland and Ireland feel otherwise. During the Troubles, security forces routinely manned the border and asked travelers for identification. Due to both the Good Friday Agreement and the creation of the single market, the hard border in Ireland disappeared from view. Until now.
The fact that a hard border harkens back to the time of the Troubles helps explain why the UK is so strongly opposed to the Irish backstop. For the EU, however, the Irish backstop is necessary to ensure that the proper trading controls are maintained with a post-EU UK. Basically, the backstop requires a hard border to be put in place if no UK-EU trading arrangement has been negotiated by the end of the Brexit transition period.
The House of Commons Treasury Committee asked the Bank of England (BOE) to come up with a scenario analysis for Brexit last year. In response, the BOE issued a report last November entitled “EU withdrawal scenarios and monetary and financial stability.” It wrote “Our analysis includes scenarios not forecasts. They illustrate what could happen not necessarily what is most likely to happen. Building such scenarios requires making key assumptions about the form of the new relationship between the UK and EU, the degree of preparedness across firms and critical infrastructure, and how other policies respond.”
In its scenarios, the BOE focused on the different possible outcomes for the future relationship with between the UK and EU. These included Close (relatively free movement of goods and some services), Less Close (customs checks and greater regulatory barriers), Disruptive (UK replicates existing trade agreements with non-EU countries), and Disorderly (no transition as UK loses all exiting trade arrangements that it currently has with non-EU countries).
The Disorderly scenario also assumes greater financial market pressures. Here the “UK’s border infrastructure is assumed to be unable to cope smoothly with customs requirements. There is a pronounced increase in the return investors demand for holding sterling assets. There are spillovers across asset classes.” As one can imagine, the outcomes for growth, unemployment, and inflation were all much worse under the Disruptive and Disorderly scenarios. The BOE was roundly criticized for what many viewed as scare-mongering. However, Governor Carney stressed that the report a simply its response to the Parliamentary request.
We think the potential outcomes have narrowed sharply. Whilst the BOE analyzed several different degrees of cooperation and exit, we now believe the outcome tree has been cut to four possibilities ahead of the October 31 deadline: 1) extend the deadline, 2) a compromise Brexit deal (what BOE would call Less Close), 3) a no compromise hard Brexit (Disorderly), and 4) a second referendum. At this late juncture, the UK simply has not made any of the necessary preparations that would allow for either Close Economic Partnership or a Disruptive outcome. Below, we discuss each possibility as well as our perceived odds.
Extend (15%): While Prime Minister Johnson has pledged to exit the EU by October 31 “do or die,” one can never underestimate the capacity of politicians to kick the can down the road whenever possible. If the October deadline approaches and the two sides are still talking, there is a slight chance that it is extended for another six months (give or take). Sterling could see a relief rally back towards $1.30. However, continued uncertainty would likely limit any gains beyond that.
Less Close (20%): Johnson travels to France and Germany this week with a proposed compromise to the Irish backstop that would (hopefully) avoid a hard border. Whilst EU officials have called this a non-starter, Merkel’s comments today suggest a small chance of a compromise. Any solution that avoids a hard border in Ireland would be good, though there would still likely be some negative impact from customs checks and regulatory barriers. Sterling could see a sustainable rally back towards the $1.40 area.
Disorderly (60%): Johnson continues to threaten a no deal Brexit. Some see this as a negotiating ploy. Others see it as his plan to fulfill his campaign promise to see Brexit through. Either way, the odds of a disorderly outcome have risen sharply under Johnson. In our view, this would lead to a UK recession and plunging UK asset prices. Sterling could weaken 10% to $1.10 while the FTSE could plunge 25% to test the June 2016 lows.
Second Brexit referendum (5%): This is a clear long shot as it would likely have to happen under a Corbyn-led Labour Government. Corbyn remains hugely unpopular and Labour did very poorly in the May European Parliamentary elections. It came in third behind the Tories and Liberal Democrats, winning only 13.7% of the vote nationally and barely ahead of the fourth place Greens with 11.8%. Recent efforts by Corbyn to lead a caretaker government similarly fell flat. Lastly, there is no guarantee that a second vote would see a different outcome.
The outlook for the UK economy hinges critically on how Brexit unfolds. For instance, the Bank of England at its August meeting cut its growth forecasts for this year and next to 1.3% from 1.5% and 1.6% back in May, respectively. However, these forecasts assume that a hard Brexit will be avoided.
The UK economy is slowing just from protracted uncertainty. GDP growth is forecast by the IMF at 1.3% in 2019 and 1.4% in 2020 vs. 1.4% in 2018. GDP growth was 1.2% y/y in Q2, the slowest since Q1 2018. As such, we see some downside risks to the growth forecasts. It’s worth noting that in Q2, consumption and government spending were firm, but offset by much weaker than anticipated business investment.
Price pressures have fallen. Headline CPI rose 2.0% y/y in July, the third straight month at the BOE target and well below the 3.2% peak in November 2017. CPIH includes housing costs and rose 2.0% y/y in July, also well below the cycle high of 2.8% y/y in late 2017. If we get a hard Brexit and a potential 10% sell-off in sterling, inflation would undoubtedly spike.
While the BOE has in the past signaled a desire to tighten policy, we see no clear-cut justification for it right now. The next policy meeting is September 19 and no change in policy is expected then. WIRP suggests 5% odds of a cut then, but those odds rise to 36% for November 7 and 50% for December 19.
The Bank of England last hiked rates with a 25 bp move in Base Rate to 0.75% back in August 2018. That was the second move in this tightening cycle, with the first 25 bp hike coming back in November 2017. 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 widen to -4.2% in 2019 and -4.0% in 2020. The UK’s Net International Investment Position (NIIP) is currently around -6% of GDP. All told, the UK’s external vulnerability bear watching as the risks of hard Brexit rise.
From a global standpoint, we think a hard Brexit would quickly turn into a major risk-off event. We got a taste of this in June 2016, when the unexpected Brexit outcome roiled global markets. We foresee a similar market reaction, with equities likely to fall and safe haven assets likely to rise.
Sterling continues to underperform. 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 -4.7% YTD and is ahead of only the worst major performer SEK (-8.7%). We believe much of this year’s weakness is due to rising risks of a no-deal Brexit. In addition, UK fundamentals remain poor and so we expect this underperformance to continue.
After making a new multi-year low near $1.2015 last week, cable has stabilized. It remains heavy and so we see an eventual test of that low in the coming days. Break below would set up a test of the October 2016 low near $1.1840. After that, there are no significant chart points until the February 1985 low near $1.0520.
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 7.4% YTD and compares to 14.3% 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. The yield on 10-year local currency government bonds is -83 bp YTD. This is ahead of only the worst performers Japan (-24 bp), Norway (-68 bp), Switzerland (-81 bp), Sweden (-81 bp), and Canada (-82 bp). With inflation likely to spike higher due to a plunging pound in the event of a hard Brexit, we think UK bonds will continue to underperform.
Our own sovereign ratings model shows UK’s implied rating fell a notch to A+/A1/A+. This pushed it down into single-A territory and suggests even greater downgrade risk to actual ratings of AA/Aa2/AA.