“The undefined
negotiated by the unprepared
to achieve the unspecified
for the uninformed”

Investment Strategy:  Fourth Quarter – The Great Unknown..

The Great Unknown..

Thank you to Schroder Investment Management for finding the most apt best definition of Brexit.

I’ve tried to avoid writing about Brexit in the last few newsletters because trying to follow the tortuous progress has been an exercise in frustration. I’m also acutely aware that I have absolutely no idea, and nor does anyone else, what is going to happen in the run-up to March 2019 and beyond. The debate has been divisive and ill-informed throughout, with little concrete sense as to its implications for future economic growth, trade deals, citizen’s rights, immigration, border controls and security with the potential for a ‘no-deal’ exit leaving us in economic and political isolation. By avoiding writing about Brexit I have been ignoring the biggest of elephants in the smallest of rooms so (hopefully) accurately and (hopefully) without offending anyone’s strongly held political views, here goes…

The process for the UK exit from the EU is for a withdrawal treaty and framework agreement for future trade to be in place acceptable to both sides by March 2019, followed by a transition/implementation period of a further 21 months. The UK published its white paper proposals outlining its proposals for Brexit and future relationship with the EU in July (the Chequers Agreement) leading to another furious round of Tory party infighting and resignations. This poor reception in Westminster, and subsequent rejection of the proposals by the EU, increases the chances of a ‘no deal’ Brexit in which the UK will crash out of the EU and be treated as a ‘third party’ and excluded from both the single market and customs union with no trade agreement to replace them. This would be such a damaging result for both the UK and the EU that the most likely scenario remains the cobbling together of a vague, detail light fudge which keeps the UK in the EU customs union post March 2019 until a more concrete arrangement is eventually in place. We could still end up with an ‘accidental’ no-deal if there is no majority in the UK parliament for whatever form of exit deal is reached with Brussels. There are increasingly vocal calls for a ‘People’s Vote’ on whatever arrangement is reached, in effect a second referendum, but this remains unlikely.

To kick-off, and apologies if I am teaching you to suck eggs, it may be useful to have a bit of jargon busting to explain terms bandied around ad nauseum, but frequently incorrectly.

Customs Union: A trade agreement under which member countries have no internal import taxes and set a common tariff on goods imported from outside the union. The EU customs union includes EU member states and some small non-EU members and forbids members from negotiating trade agreements separately from the EU.

Single Market: The European Union is treated as a single territory with a free market in goods, money, services and people, the EU’s famous ‘four freedoms’ which they see as indivisible. The single market includes EU member states and four other countries, notably Norway. It is a more embracing union than a Customs Union, most notably in the free movement of people, which was a defining argument in the UK referendum.

European Economic Area (EEA): The 28 European Union countries plus Norway, Iceland and Liechtenstein, which enables those three countries to be part of the EU’s single market. They abide by the rules of the EU single market and its freedom of movement of goods, money, services and people.

European Free Trade Association (EFTA): An organisation made up of four countries: Iceland, Liechtenstein, Norway and Switzerland. They are allowed to trade freely with the single market in return for accepting its rules but crucially as they are not in the EU customs union they can negotiate trade deals with third-party countries.

What would happen if there is ‘no-deal’?

UK would have to trade on basic WTO (world trade organisation) terms which would mean that UK exports to the EU would be subject to the same customs checks, tariffs and regulatory barriers that the EU currently imposes on trade with all other countries. The UK would fall out of all pan-Euro regulatory and legal bodies on air travel, medicine, food, maybe even national security. Importing and exporting food in particular would quickly become a nightmare, replacing frictionless trade with a regime of inspection, regulation and certification; the dreaded ‘M26 lorry park’ scenario.

Is this ‘Operation Fear’ part 2?

As usual with Brexit the biggest problem is to find an informed and unbiased view and the Daily Mail for one continues to post a rosy picture of life in a ‘no-deal’ Blighty. The post Brexit landscape is such an unknown that trying to draw any sort of picture is an exercise in speculation. For sure though a ‘no-deal’ exit would cause major disruption but as this is so markedly not in the interest of either the UK or the EU then it remains an outlier. Membership of the EEA remains the favoured ‘soft Brexit’ option for business friendly eurosceptics, or maybe EFTA as this is a completely separate club over which Brussels has no influence. At the moment neither option appears to be on the table.

How the Markets see Brexit.

The relationship between Brexit and the currency markets has been straightforward, any movement towards a ‘softer’ deal has seen sterling strengthen, any sense of a hard Brexit or a ‘no-deal’ has led to sterling weakness. So far so good, hereafter it gets a bit murkier. The relationship between Brexit and the stock market has been far more opaque because the mixture of positives and negatives is rather convoluted, leading to the conundrum of supposedly ‘positive’ news on Brexit leading to falling rather than rising markets. This results from the Pavlovian response of the stock market to movements in the currency – a falling pound leads to a rising market, a rising pound leads to falling market. This is due to the international composition of the FTSE100 index with its large number of multinational energy, pharmaceutical and consumer staples companies whose earnings are predominantly in foreign currency and hence gain on translation back into sterling when the pound falls (and vice-versa). This explains the strong but at first sight counter-intuitive rally in the FTSE100 index post the vote in June 2016 as a consequence of sterling falling by 15%.

While the big beasts who dominate the FTSE100 seem to thrive on ‘bad news’ the opposite can be the case for the smaller, more domestically focused UK companies who inhabit the FTSE250 index, more so if they export heavily to European markets so tariffs and increased regulation/inspection would be the strongest of headwinds. For these companies, ‘good news’ on Brexit negotiations is actually also ‘good news’ for the stock price (and vice-versa). International investors have in general taken the view that ‘you Brits are mad’, and headed for the exits in droves until the dust has settled, not least because the Brexit induced civil war in the Tory party has ushered in the prospect of Jeremy Corbyn in No.10. This investor exodus has obviously been a negative over the last few years, though with the potential to join the ‘good news on negotiations is good news for the market’ camp. UK Gilt yields have remained blithely ambivalent since the referendum, largely marking time over the last two years and responding to global rather than national events.

With the lack of progress on negotiations, conflicting cross-currents of positives and negatives and binary difference between a hard or soft Brexit, it is perhaps no surprise that domestic UK investors have found the whole Brexit gig hard to compute, placing it in the ‘too difficult’ box and tried to ignore it. The corollary is that once the market believes it actually knows what is happening the reaction in UK asset prices could be dramatic. Crunch time is coming ever closer and the market will become increasingly nervous and volatile as this sad story twists and turns towards its climax.  Such is the current uncertainty, the likelihood is that any kind of ‘soft’ deal would likely be seen as a positive with (finally) some resolution and rapprochement leading to a return of international monies and offsetting the negative effects of a stronger pound. Conversely, a hard Brexit or ‘no deal’ could see a very damaging run on the pound, extremely volatile share prices and capital flight as the UK would likely tumble into recession as well as risking its centuries long reputation as a stable nation that meets its obligations and one of the best counties in the world to do business.

Trying to quantify the effect on sterling of either a ‘deal or no deal’ is an exercise in guesswork and as luck would have it Schroders have already asked the great and good of the City for their best guesses. In an informal poll the cognoscenti came up with an average of USD/GBP at 1.10 in the event of a no-deal but 1.40 should an agreement be reached. With sterling sitting towards the top end of this range the FX market at least is hence discounting the likelihood that an agreement of sorts will be made with the ‘no-deal’ scenario still an outlier.

We don’t see a ‘no deal’ as the most likely scenario, our best guess is a last minute cobbling together of a compromise heavily reliant on the 21 month ‘transition’ period to try and find something more workable and acceptable to both sides. Nevertheless, the chances of a ‘no-deal’ or else a very hard Brexit have increased over the summer. The Brexit clouds that had been hanging over the UK since the vote had begun to lift in the first half of the year with a sense that too much bad news had already been priced into the market. With lightweight and fraught political leadership from all parties, and an increasingly tetchy cross-channel war of words, then this in retrospect may seem to have been premature. The road to Brexit is likely to get ever bumpier.

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