24 Oct Deal or No Deal
With just six months until the Article 50 deadline of March 2019, it is worth reflecting on the current state of EU withdrawal negotiations and the possible impact a range of options may have on the financial markets and subsequently on our portfolios.
It is currently very difficult to assess the progress of a deal, with contradictory messages coming from both sides. Just yesterday Theresa May told MPs that 95% of the deal was done, which was immediately contradicted by the European Parliament’s Brexit Co-ordinator, Guy Verofstadt, who said it was 90% complete. Whilst that in itself sounds encouraging, who of our readers (if any) would board a plane if the airline said it was 90-95% operational? What is clear is that the clock is ticking and originally the intention was to have a draft agreement in place by October or November this year ahead of the EU summit in December, leaving enough time for ratification before the UK leaves the EU in March and the official two year transition period begins.
The Prime Minister has attempted to appease all members of the Conservative party in developing what has become known as the “Chequers Deal”, although the nature of the proposed negotiating position appears to have driven a further wedge between the pro and anti-European factions within the party. Leavers feel that this is almost as restrictive as being a fully paid up EU member, whilst Remainers suggest it provides all of the disadvantages of leaving the single market but with no tangible upside. What is clear is that with its lack of acceptance within Europe and its unpopularity with the Cabinet, the ‘Chequers Deal’ is probably a non-starter.
National sovereignty was the main driver for many during the referendum campaign and ultimately determined the result, in so far as those that felt too much power was being handed over to Europe moved to regain control over law setting, immigration and international relationships. But financial markets care little about national sovereignty and much more about the future nature of trading relations and in that respect there have been many geographical comparisons made.
Do we desire a “Norway option” or “Canadian Style Relationship”? The truth of the matter is that we are neither Norway nor Canada in the scale of our relationship with Europe and in this respect there may well be a greater ambition to reach an agreement on both sides. The economic costs of a no deal for the UK are significant, however, the EU will not wish to contemplate a “divorce” without the comfort of the considerable maintenance payment, being touted as £39bn.
It would seem that that it is in fact the “Irish problem” that presents the major sticking point in negotiations, indeed Mrs May expressed the issue as a “considerable sticking point”. The UK remains steadfast that there should be no division of the Union, no border between Northern Ireland and the rest of the UK, whilst the EU maintain there should be no hard border between the Republic and the North. The EU have also confirmed the border as the biggest stumbling block, but Mr Verhofstadt has said he is confident a deal could be agreed before the December summit.
There is undoubtedly a game of brinkmanship playing out at present and with deadlines ever closer we can only assume that this will intensify as time goes by. This, as we have said before, is unchartered territory, and the sheer complexity of the issue means we see a wide range of possible outcomes, from a perceived ‘good’ deal at one end of the scale to ‘no deal’ at the other. Of course the likelihood is the end-game lies somewhere in between, but towards which end of the scale is what everyone wants to know. Whilst we have a view on which end of the scale we may well end up, what is certain is that the reaction to any deal is hard to predict precisely because we cannot be certain that financial markets will behave rationally.
It is impossible to model all eventualities, so in the following pages we concentrate on three very broad outcomes; 1 – A deal, 2 – No Deal and 3 – A delay. Our views on how financial markets respond to these scenarios assumes, they are behaving rationally.
If we envisage the announcement of a reasonable deal for the UK, three outcomes would initially be expected. An appreciation of Sterling, a pick-up of corporate investment (and possibly consumer spending) and consequently a more benign or positive outlook for the UK economy.
This would undoubtedly be good for more domestically focussed companies and therefore we may see a rally in the mid and small cap stocks. However, since the referendum in 2016 we have seen the fortunes of the FTSE100 (large cap stocks), whose earnings are largely driven from overseas activities, inversely correlated to the value of our currency. An appreciation of the currency could therefore in theory cause a fall in the FTSE 100 overall. Whether this is then offset by the euphoria of a good deal would remain to be seen, but one would expect there to be some comfort from a positive outcome.
UK Commercial property would likely benefit from this outcome, in that companies would not be forced to leave the UK to maintain close relations with Europe and the concerns of company mass migration, particularly from the City of London, would abate. Added to which the removal of uncertainty and a temperate outlook for the UK economy may well instigate a new round of corporate investment, which is undoubtedly being withheld at present, leading to higher capital values and upward pressure on rents.
Moving now to Fixed Interest, an area we have notably been underweight. As we have explained previously, our concerns with this asset class lie in the expectations of rising inflation and interest rates.
In the event of a positive deal and subsequent appreciation of Sterling, in real terms those goods we import would fall in value meaning global deflationary forces would theoretically return to the fore and reduce the need to raise rates. But this outcome would certainly be seen as more positive for the economic outlook, which by contrast, tends to point to higher rates. This could provide the Bank of England with something of a conundrum and it would need to time its intervention correctly and proportionately to ensure economic growth didn’t then feed through to uncontrollable inflation.
No deal or a ‘hard’ Brexit is particularly hard to model and predict. However, let’s again start with the currency. It would be difficult to imagine a situation where a no deal did not have an adverse effect on Sterling. In this case, we would expect the opposite outcome to that above. In other words, weakness in Sterling providing a positive boost to overseas earners which make up much of the FTSE 100. Of course this would be tempered by a much more tepid outlook for UK Plc as a whole, but the extent to which this would counteract the impact of a weaker currency is hard to estimate. Let’s not forget the FTSE 100 rose nearly 5% in June 2016 and 3.5% in July 2016, following the uncertainty handed to us after the referendum and the sterling devaluation which followed.
Smaller domestically focussed companies would be expected to suffer as the outlook for domestic markets deteriorates. UK commercial property would likely repeat some of the issues seen in 2016, where withdrawals from funds could lead to suspensions and inevitably there would be a lack of investment and perhaps those companies that were able to negotiate their way out of leases may do so in order to relocate. The expectation is of course that property fund managers would exercise a degree of forward planning to more effectively stage-manage an orderly process for investors looking to exit in the lead up to withdrawal in March.
So with a hard or no deal Brexit, what would the outcome be for the Fixed Interest markets? This is likely to be dependent upon the economic reaction and therefore policy response to that. Assuming Sterling depreciated strongly and the economic outlook deteriorated significantly, policy makers would be faced with the combined headache of rising inflation, driven by the cost of imports, but where economic growth remains very subdued, reverses or indeed we enter a recession as argued by the Royal Bank of Scotland recently. A fragile economy cannot cope with rising interest rates and therefore the main tool at the BoE’s disposal to curb inflation becomes redundant.
So in trying to balance economic stimulation with inflation, would they in fact be content to allow inflation to run a little higher for longer? Our view is that they would, but this raises the question of how the Bank of England would stimulate growth. Many commentators are suggesting a return to large monetary stimulus programmes such as Quantitative Easing (QE), as witnessed in the aftermath of the financial crisis.
Many have argued this would stoke inflationary pressure, a legitimate concern but it has to be said that previous uses of QE did not create any inflationary spirals. What it was effective in doing though, was to stimulate an ailing economy. We also witnessed its inflationary effect on asset prices as the bank bought up large swathes of government bonds and other fixed interest assets, which in effect meant that financial institutions received tranches of cash that they had to put to work. With cash rates being so low, the only home was further up the risk scale, so with a guaranteed buyer of bonds and a huge amount of idle cash around, we saw bond and equity markets perform extremely well post 2008. A cautionary note though, if we do see this kind of policy intervention again the question is whether there would be a repeat of the positive impact witnessed previously.
With the likely outcome seemingly clear and focussed or more distant and opaque as negotiations ebb and flow and mixed messages are given from both sides, it is hard to see how close we are to a deal or not. Mrs May has said that she is willing to consider extending the UK’s transition period beyond 2020, although did say this was “undesirable” and would have to end “well before” May 2022. The current political discourse it has to be said, points heavily to some kind of delay, referred to as ‘bridging’. There is clearly an appetite to reach a deal on both sides but with sizeable hurdles to overcome, it is possible both counterparties need further time to agree the structure of a deal and have that ratified.
In the event of a delay of the start of withdrawal or an extension of the transition period, the status quo would remain. We view the UK equity market as being undervalued against most major developed equity markets, which given the uncertainty is not surprising, but without any resolution that is unlikely to change.
Additionally, in the absence of any catalyst, the Bank of England is unlikely to want to make any significant policy decisions, preferring to keep its powder dry until a more definitive outlook appears. Of course any delay beyond March 2019 or extension of the transition period, will lead to widening divisions within the Conservative party and may present the opportunity for a leadership challenge, perhaps by one of the more hard-line Brexiteers, or even a general election and a change in the political landscape.
This would serve only to exacerbate the uncertainty and may move us ever further from a resolution as new negotiations are entered into and even the possibility of a second referendum.
We have long argued that investment management does not lend itself to becoming focussed on binary decisions. You do not pay us to visit the casino to bet on red or black. So in that regard we are not attempting to predict an outcome and position portfolios according to that prediction. The inherent complexity of the Brexit process, with so many ‘moving parts’ would make that pure folly. We are, however, reflecting on positions within the portfolios and working to understand how best to insulate portfolios in any event and to ensure we capture opportunities as they present themselves.
To that end we have a reasonable exposure to overseas equities where any Brexit shockwaves should be minimal. Additionally, we recently repositioned portfolios to ensure that we diversified from simple UK commercial property exposure to that of a more global nature, this is something we continue to have under review as we are still overweight in this area.
We maintain our underweight fixed interest exposure and believe that the flexibility in our chosen strategic bond funds will be useful as markets absorb whichever outcome is arrived at.
Finally, turning to the UK equity market, this is where we have made a very deliberate attempt to cover as many bases as possible. We favour UK equities as we believe they are undervalued as a consequence of the uncertainty, but we have reflected some of the outcomes set out above by ensuring appropriate exposure to both large cap and mid/smaller companies.
Historically, we have been successful in sheltering portfolios from the worst excesses of financial market downturns whilst also capturing a large proportion of market upside. Whilst this period certainly does present challenges and many unknowns, our portfolios have stood up to some very challenging times over the past ten years since the financial crisis and we will remain vigilant and focussed to ensure this record continues as we move towards a new chapter for the UK.