AXA IM's David Page - Irreconcilable Brexit risks political upset

David Page, Senior Economist at AXA Investment Managers (AXA IM):

The conclusion of Phase I of the Brexit negotiations in December allowed talks to move on to focus on the UK’s future relationship with the EU. However, the issue of the Irish border remains unresolved and UK commitments suggest a ‘default’ outcome that is much ‘softer’ than the Brexit currently being discussed.

These commitments appear inconsistent with the UK’s key Brexit objectives - moving beyond the jurisdiction of the European Court of Justice, striking free trade deals with the rest of the world and avoiding a physical border in Ireland. The resolution of this unstable agreement is likely to affect financial markets and its impact will depend, on when and how, this resolution occurs.

A resolution after the UK has accepted the current deal (and left the EU) is likely to lead to a softer Brexit than markets currently consider, and is on balance, now our central view. This will likely have modest and benign market implications. 

Yet, if this problem arises before the UK’s exit, it could de-rail the ongoing negotiations. This threatens a political crisis as well as a broad range of possible outcomes and market implications, which we consider a real risk for this year.

Significant uncertainty surrounds the outlook for Brexit from here. The impact this will have on the process and therefore the UK economy and financial markets is likely to depend on when, or if, this inconsistency becomes apparent. At AXA IM we consider three broad scenarios:

  • The UK government’s right to suggest that this issue can be resolved in negotiation and the issue is resolved with the agreement of a future EU trade arrangement.
  • The UK government’s solution is not accepted and requires alternative solutions, but this only becomes apparent after the UK has formally left the EU in March 2019.
  • The UK government’s solution is not accepted and this becomes apparent, or is anticipated, before the UK leaves the EU. (For full scenarios please click here)

We are sceptical of the UK government’s ability to deliver its vision of Brexit. Seeing a meaningful chance of a political shock materialising this year, as encompassed by our third scenario. However, we recognise a number of incentives to maintain the status quo. On balance, we consider the most likely outcome to be scenario 2. Our central expectation is for the UK to leave the EU as described next year and enter a transition phase that is likely to stretch beyond the suggested two-year timeframe as a longer-term trading relationship is determined.

While we still expect a bespoke trade deal with the EU, we now consider it likely to be much closer to the current relationship with the EU than the Canadian trade agreement - materially softer than has been discussed to date. Such an outcome would still fall well short of the openness the UK currently enjoys with the EU via its Single Market membership. We also suspect that a final arrangement will require some form of physical border in Ireland.

From a market perspective, we emphasise that in considering the outlook for markets this year, scenarios 1 and 2 would likely be indistinguishable. This suggests that prospects for UK asset volatility should be most elevated across the course of 2018. Beyond 2018, the UK’s progress out of the EU and into a transition arrangement would narrow the universe of possible outcomes, and with it dampen the potential for idiosyncratic UK asset volatility. 

Implications for financial markets

Economic and political uncertainty, particularly this year, suggests a difficult year for UK asset markets. UK asset volatility is likely to remain relatively high[1]. Indeed, in this environment, minor shifts in perception can result in material swings in outlook. For example, we go on to suggest that sterling could range between <$1.20-$1.45 to the US dollar (USD) under different outcomes discussed in this note. As such, even relatively minor shifts in perceptions - a 10% greater perceived chance of a “no deal” Brexit - could see the sterling/USD exchange rate drop by 3 cents alone.

Sterling is currently 11% lower in trade-weighted terms than before the referendum (9% versus the USD and 13% against the euro). At its weakest, it has been 16% lower in trade-weighted terms (19% USD and 18% euro). This was in line with our pre-Brexit outlook that sterling would face “significant depreciation”.

Equities have risen sharply in nominal terms since Brexit, with the FTSE 100 up 21% and FTSE 250 up 20%. This was contrary to our prediction that the equity outlook would “deteriorate” on the materialisation of Brexit. However, the UK market’s sharp rise falls short of the 30% increase in the S&P 500 and 45% jump in the Euro Stoxx index over the same period. It is more akin to changes in Japan’s Topix or China’s Shanghai Composite indices. In addition, this does not account for sterling’s depreciation. Allowing for sterling depreciation against respective currencies, the FTSE 100 has significantly underperformed market gains in the US, Europe, Japan and China since the UK voted in favour of leaving the EU.

Notes to Editors

Source 1: Since the Brexit vote, volatility has risen in sterling (relative to declines in other major currencies USD, EUR, JPY and CAD, save EUR:JPY); sterling government bonds (relative to declines in German, Spanish and Japanese bonds, although US bond volatility was higher) and was only modestly lower in equities: FTSE 100 and 250 volatility dropped by around 20%, compared with 50-100% declines in Eurostoxx, Topix and Shanghai composite volatility – S&P 500 vol was broadly unchanged over the period.

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