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Assessing Brexit risk

06 September 2019

5 minute read

By Henk Potts, Senior Investment Strategist

As markets increasingly prices in a no-deal Brexit and the chances of a UK recession rise, what is the outlook for the UK economy and financial markets?

In 1907, the British poet GK Chesterton wrote in his poem “The Secret People”: “Smile at us, pay us, pass us; but do not quite forget. For we are the people of England that never have spoken yet”. The poem is a reminder not to take the British public’s vote for granted. Too many economists and investment strategists were guilty of that in the run up to the 2016 referendum and have been rushing to change their forecasts ever since.

Britain’s vote to leave the European Union (EU) has widespread economic, constitutional and financial market implications. Recent political developments suggest that Britain is inexorably moving towards a general election. As such, a broad range of scenarios could still materialise, including a deal or indeed a second referendum. However, if the polls are to be believed, Boris Johnson may well be returned as prime minister with a working majority, very much keeping the possibility of a no-deal Brexit in play.

Economic outlook looks fragile

Since the start of the year the UK’s growth pattern has become more volatile as the risk of a no deal Brexit has developed. In the first three months of the year growth came in at a surprisingly robust 0.5% quarter on quarter (buoyed by stockpiling ahead of the original 31 March Brexit deadline). This was followed by a contraction of 0.2% between April and June (as companies ran down inventory).

Recent data shows that the manufacturing sector is in recession, but that consumer confidence and the services sector remains resilient. So we expect growth for 2019 to come in at 1.1%. However, persisting Brexit uncertainty suggests the outlook for the UK economy continues to look fragile.

No-deal Brexit to add to economic fragility chart

Markets pricing in a no-deal

Since Prime Minister Boris Johnson, a hard-Brexiter, took the keys of Downing Street from Theresa May in July, markets have increasingly priced in the likelihood of a no-deal exit from the EU.

During the Conservative leadership campaign, Johnson vowed to renegotiate a better withdrawal agreement with the EU than his predecessor. But the EU remains resolute in refusing to re-open the negotiations.

The prime minister has made the removal of the Irish backstop a precondition of new talks, a demand the remaining EU27 have dismissed, thus putting the two sides at deadlock and increasing the chances of a no-deal.

Higher recession risks

No-deal would have significant implications for the UK economy. Brexit uncertainty is likely to reduce business investment and hold back household consumption. We anticipate that the UK economy would enter a recession in next year under a no-deal, contracting by 0.5% in 2020.

Under the uncertainty and weaker economy of a no-deal, sterling would likely come under renewed pressure. The weaker currency and imposition of tariffs would probably result in a spike in inflation to around 2.8% at the start of the next year. The fall in business confidence could constrain hiring, pushing the UK unemployment rate much higher than the 44-year lows seen this year.

Given the risks of a downturn in the economy and the delicate political backdrop, it’s not surprising that the government has been highlighting possible fiscal stimulus measures. The prime minister has trailed potential new initiatives including tax cuts and spending increases for the health service, nationwide broadband, new rail links and no-deal Brexit planning. If implemented, these measures would support growth over the next few years, particularly if a recession occurs.

The impact for UK businesses of a no-deal Brexit could be substantial. Companies trading with the continent would face trade barriers like new tariffs, additional customs checks and import/export certifications. Firms would also be subjected to additional regulatory restrictions, limitations on talent pools for new hires and different tax structures. And new trade deals with other jurisdictions would further complicate the picture.

So a no-deal is likely to result in higher costs, increased complexity and potentially radically different business models.

Possible benefits of Brexit

In trying to identify the potential economic benefits of leaving the EU it is worth remembering that much of the referendum debate centred on democracy and sovereignty, which are always hard to quantify.

That said, the UK could profit from reduced payments to the bloc and ultimately greater business flexibility. The country’s fisheries industry may also get a boost.

However, the major arguments for leaving the EU are: firstly, the ability to break away from European bureaucracy allowing the UK to strike its own trade agreements; and secondly, if you believe the European project is going to fall apart, then it would advisable to abandon the “sinking ship” as early as possible.

A no-deal Brexit would have a range of implications for investors. Foreign exchange has primarily been the instruments that traders have used to express concern about Brexit, and we would expect sterling to weaken.

We would anticipate that the FTSE 100 would outperform the more domestically-focused FTSE 250 as exporters benefit from a fall in sterling. The weaker currency should also translate into higher breakeven inflation as imports get more expensive. Finally, the Bank of England would likely cut rates by 50 basis points, with more cuts priced in thus pushing real and nominal rates sharply lower.

While exiting the EU feels like a dramatic moment for the British people, remember that the UK economy accounts for less than 5% of global output and only a small part of our investment universe. As always, the best way to navigate political and economic uncertainty is through a globally balanced diversified portfolio, held for the long term, while taking advantage of tactical opportunities.

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Market Perspectives September 2019

Find out our latest key investment themes. Expectations of more dovish central bank policy could do nothing to prevent a sharp, negative, swing in senitiment in August as recession fears returned to markets. Furthermore, US-China trade tensions seem unlikely to be resolved soon.

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