How are markets reacting to Brexit?
With only three months to go until Brexit, the threat that the UK could leave the European Union without a withdrawal agreement continues to rattle markets.
Since the EU referendum in June 2016, sterling has swung between lows of $1.20 and highs of $1.43. It remains a barometer for how optimistic – or pessimistic – markets are feeling about the prospects of an exit deal between the UK and the EU.
This month, a delay to the parliamentary vote on the UK’s draft deal sent sterling into a slump, after it became clear the government was set to be defeated. It was followed by a vote of no confidence in the Prime Minister (which she survived), shoring up support for sterling, albeit temporarily.
The nervousness in markets is understandable considering the dizzying range of potential Brexit scenarios that could play out over the coming months. For investors, the challenge is to remain calm and ensure that portfolios are not too exposed to the risks of any potential outcome.
Potential Brexit scenarios
Prime Minister Theresa May is expected to present a revised version of her draft deal to parliament before a self-imposed deadline of 21 January. The 585-page withdrawal agreement addresses some of the biggest issues regarding Brexit, aiming to reduce the risk of an economic shock when the UK leaves the EU.
The element of the withdrawal agreement that has proved particularly controversial relates to complex proposals designed to avoid a hard border between Northern Ireland and the Republic of Ireland. Some MPs are worried that the proposed ‘backstop’ plan could effectively keep the UK in an EU customs union indefinitely.
Much will depend on how Theresa May can address the concerns of MPs before the next vote is held. Amid the political gridlock, there are broadly 5 potential scenarios that could play out, depending on whether the Prime Minister is able to secure parliamentary support for her deal. However, unforeseen factors could result in a new scenario emerging that is different again to the ones currently expected.
- In the first scenario, parliament approves the draft deal (or something closely resembling it), either in January or possibly later. While further debate would be required on specific details, odds suggest that this remains the most likely scenario, with a 40% to 50% chance that a withdrawal agreement will be in place before the March 29 deadline.
- A second scenario is that Theresa May could call a snap general election to secure a mandate for her deal through a newly-elected parliament. Alternatively, opposition MPs could push for a vote of no confidence in the government, also potentially leading to a general election. Either way, if a general election is called, the EU would likely need to agree to delay the 29 March deadline.
- If May loses the parliamentary vote (but a general election isn’t called), a third scenario could see MPs take a greater role in drawing up a revised version of the deal, potentially pushing for a different type of withdrawal arrangement. For example, they could push for Britain to sign up to the European customs union from 29 March, the so-called ‘Norway model’.
- In a fourth scenario, deadlock in parliament over the way forward leads to the Prime Minister calling a second referendum. While this route has been gaining traction in recent weeks, it remains fraught with risk and complications. It would also require the EU to agree to a delay in the 29 March deadline.
- Finally, Britain could leave the EU without a deal and only the most basic set of arrangements in place. The Bank of England has warned that a hard Brexit, its worst outcome in a recent impact review of different scenarios, could lead to an economic shock and a near-double digit reduction in GDP in 2019 (compared to its current forecast).
Last week the European Commission proposed a package of measures that reduce some of the worst impacts of this scenario, described as a ‘managed no-deal’. These cover financial services, air transport and other key areas. However, the scope is limited, and the risk of disruption remains extremely high.
What could be the impact on markets?
The political uncertainty surrounding Brexit has made it hard for investors to make bets on which way the market is going. However, a further concern for investors – that’s weighing down on sterling and government bonds – is the impact that continuing uncertainty surrounding Brexit is having on business and consumer sentiment. Recent data has suggested a slowdown in construction and industrial activity, for example. This could also limit the scope of further interest rate rises in the future.
Henk Potts, director of investment strategy at Barclays Private Bank, says: “The impact of Brexit on the economy and financial markets will really depend on what type of deal that we get.
“The biggest risk to the UK economy, businesses and, in turn, to markets will be the risk of a no-deal Brexit. Under that scenario, sterling will remain under pressure, inflation could spike up and UK employment could rise substantially.
“Alongside that, you are likely to see lower levels of household consumption and reduced business investment, which would suggest the UK economy would slow down quite dramatically over the course of the next couple of years."
The pound slumped 10% against the US dollar in the immediate aftermath of the result, and remains highly susceptible to swings in optimism and pessimism about the chances of Britain agreeing a deal with the EU.
Under a no-deal scenario – even the ‘managed no-deal’ being co-ordinated by the European Commission – sterling could fall to $1.10 or lower. If a deal is agreed, sterling is likely to rally. However, only back to the levels seen earlier this year of around $1.45.
Meanwhile, investors have been moving into safe haven assets such as UK government bonds, known as gilts, when disappointing economic figures have emerged, or fears spike about a no-deal Brexit. Since last October, 10-year gilt yields, which move inversely to prices, have fallen from 1.70% to 1.23%, suggesting investors have been seeking protection from the risks of a no-deal Brexit.
Much of the potential bad news is priced into UK stock markets, and valuations are looking attractive compared to other developed market equities. Of course, the recent performance of markets has not been entirely due to Brexit – the continuing trade dispute between the US and China is also unnerving investors, for example.
Even so, the FTSE 100 is down almost 11% over the last year and is now offering a well-covered dividend yield of nearly 5%. The FTSE 250 index of smaller companies is down 13% over the last year.
What could this mean for investors?
The risk of a potentially disruptive outcome from Brexit shouldn’t necessarily impact investing fundamentals. On that basis, UK stocks could be attractive to some. The FTSE 100 is an international market, with 78% of revenues coming from overseas, and low valuations suggest that the market looks relatively cheap. UK-listed companies that generate the majority of their earnings overseas could be boosted by a further fall in sterling, as the currency effect is translated back into pounds and pence.
However, bear in mind that UK-focused FTSE 100 companies, such as housebuilders, could likely suffer sharp falls in share prices in the event of a hard Brexit. Meanwhile, the FTSE 250 is dominated by domestically-focused companies that are more heavily exposed to the fortunes of the UK economy.
Whether or not investors are brave enough to bet on the UK market, they should remember that the UK economy tends to play a small role in the world’s capital markets. By employing geographic and sectoral diversification and investing regularly, the ups and downs of Brexit should have a limited impact on well-diversified portfolios.
Brexit is only one of a series of market themes that are unnerving investors at the moment. Indeed, central banks around the world are raising interest rates after an extended period of loose monetary policy, hitting asset prices globally. The interest rate rise by the US Federal Reserve last week saw the S&P 500 index of US stocks fall 1.5%, while the German DAX index fell 1%.
Potts says: “Diversification continues to be an important blanket of protection against the market volatility we are seeing, and this is likely to continue into 2019. Investors need to make sure they’re diversified across asset classes and across geographical regions.”
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