Hard Brexit Redux?

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Win Thin
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The risks of a hard Brexit are perhaps higher than markets appreciated. Here, we set forth some possible scenarios as to what may unfold after the January 31 deadline. Uncertainty is likely to be protracted and markets hate uncertainty. As such, we see UK assets continuing to underperform.

RECENT DEVELOPMENTS

Fears of a hard Brexit are still alive and well.  Prime Minister Johnson is pushing to guarantee a Brexit by end-2020 even if a new trade arrangement is not in place.  Under what was expected to be a negotiated Brexit by the January 31, the UK enjoys a transition period until end-2020 in which the current trading arrangement is maintained.  Given how long trade treaties take to negotiate, most observers believed that an extension beyond end-2020 would be needed, requested, and ultimately granted.  Johnson is now saying the UK will not ask for an extension and is willing to crash out of the EU then without agreement on post-Brexit trade.

Much of this is brinksmanship on Johnson’s part in order to secure a better deal. This past year, we’ve seen that the EU has little patience for this strategy.  To us, this strategy opens up another period of Brexit-related uncertainty. While our base case remains an extension of the transition period followed by a cooperative solution, it will be a bumpy ride in 2020 as both sides jockey for position.

Bank of England meets Thursday and is expected to keep rates steady at 0.75%.  We expect the bank to downgrade its macro forecasts yet again, and there is potential for the number of dovish dissents to grow. This will be the penultimate meeting under Governor Carney, who is likely to deliver sobering guidance once again.  The economy continues to struggle under Brexit uncertainty, and we see little scope for improvement near-term.  We see no justification for the BOE to hike rates anytime soon.  If anything, a case can be made for cutting rates in 2020.

BOE Governor Carney’s extended term ends on January 31. He was recently appointed as UN Special Envoy for Climate Action and Finance, which effectively kills any chance that he would extend his term for a third time. Reports suggest Chancellor Javid is keen to make a choice sooner rather than later. Here is a list of potential candidates (by no means complete and in no particular order) to replace Carney: Andrew Bailey (Chief Executive of the Financial Conduct Authority), Ben Broadbent (BOE Deputy Governor for Monetary Policy), Jon Cunliffe (BOE Deputy Governor for Financial Stability), and Minouche Shafik (Director of the London School of Economics and former BOE Deputy Governor).

Ahead of the BOE decision, there has been a raft of subpar UK data this week.  These include preliminary December PMI readings as well as October and November labor market data. Retail sales data will be reported the day of the BOE decision. The readings have been uniformly weak in Q4 and that is likely to continue as another year of likely protracted Brexit uncertainty (hard or soft?) will continue to weigh on the economy. Investment, hiring, and other business decisions are all likely to remain on hold.

A BRIEF HISTORY LESSON

The EU began life in 1951 as the European Coal and Steel Community (ECSC). Ironically, UK Prime Minister Churchill was one of the biggest proponents of European unity, calling for a “United States of Europe” in 1946.

The ECSC was created in 1951 when charter members Belgium, France, Italy, Luxembourg, the Netherlands, and West Germany signed the Treaty of Paris. Ostensibly, the organization sought to create a common market for coal and steel amongst its members in order to minimize the competition for natural resources. The ECSC was the first step to regional integration and was primarily meant to prevent further wars in Europe by increase economic interdependence.

The European Economic Community (EEC) was the first step in regional economic integration. The EEC and the European Atomic Energy Community (EURATOM or EAEC) were established in 1957 by the Treaty of Rome. Interestingly enough, both of these organizations were less supra-national in nature than what one would expect, as some member states complained of infringement on their sovereignty. The first goal of the EEC was to create a customs union for its members.

The first phase of EEC expansion was attempted in 1961, when Denmark, Ireland, Norway, and the UK applied for membership. Due to resistance to UK membership from French President Charles de Gaulle, all four were all initially rejected but then resubmitted in 1967. By that time, Georges Pompidou had succeeded de Gaulle and so the French veto was dropped. After a protracted period of negotiations, Denmark, Ireland, and the UK joined the EEC on January 1, 1973.

The EU Customs Union was established in 1968. Member countries apply the same tariff rates to imports from non-members whilst applying no tariffs to fellow members. This is the main difference between a customs union and a free trade area, as the latter allows its members to negotiate trade arrangements independently with non-members.

Expansion continued apace. Greece joined the EEC in 1981, followed by Spain and Portugal in 1986. The Maastricht Treaty was signed in 1992 under which the EEC was renamed the European Union in 1993. The next expansion was 1995, when Austria, Finland, and Sweden joined. 2004 saw the largest enlargement, as the Eastern European nations of Czech Republic, Estonia, Cyprus Latvia, Lithuania, Hungary, Malta, Poland, Slovakia, and Slovenia were admitted. No country has ever left. Until now.

Under the existing EU customs union, the UK was able to enjoy tariff-free trade with its fellow members. After January 31, the UK will maintain the current trade arrangement during the transition period even as it negotiates its post-Brexit trade relationship. What happens after December 31, 2020 if a new deal hasn’t been struck? In this instance, UK-EU trade would revert to so-called WTO rules. While this sounds innocuous, it would reintroduce tariffs on trade between the UK and the EU, something that has not happened in over 50 years.

World Trade Organization rules require that the same trade terms must be applied to all countries. This so-called Most Favored Nation status basically means that the UK cannot offer better trading terms for one county and not another unless there is a trade agreement that allows it. Some UK politicians have downplayed the impact of crashing out of the EU customs union by saying WTO rules are fine. The UK currently trades with 24 countries under WTO rules alone that makes up nearly 40% of its total trade. With 68 other non-EU countries, the UK (as part of the EU) has free trade agreements in place that offer better trading terms. When it leaves the EU, it will lose those privileges.

Trading under WTO rules can have significant costs. Under those rules, the average tariff rate for machinery is 2%, aircraft 3%, vehicles 9%, footwear 10%, clothes 12%, processed foods 20-35%, and cereals and meat 45-50%. Therefore, it is quite clear that this is a shock outcome that should be avoided if possible.

BREXIT SCENARIOS

The House of Commons Treasury Committee asked the Bank of England (BOE) to come up with a scenario analysis for Brexit last year. In response, the BOE issued a report last November entitled “EU withdrawal scenarios and monetary and financial stability.” It wrote “Our analysis includes scenarios not forecasts. They illustrate what could happen not necessarily what is most likely to happen. Building such scenarios requires making key assumptions about the form of the new relationship between the UK and EU, the degree of preparedness across firms and critical infrastructure, and how other policies respond.”

In its scenarios, the BOE focused on the different possible outcomes for the future relationship between the UK and EU. These included Close (relatively free movement of goods and some services), Less Close (customs checks and greater regulatory barriers), Disruptive (UK replicates existing trade agreements with non-EU countries), and Disorderly (no transition as UK loses all existing trade arrangements that it currently has with non-EU countries).

The Disorderly scenario also assumes greater financial market pressures. Here the “UK’s border infrastructure is assumed to be unable to cope smoothly with customs requirements. There is a pronounced increase in the return investors demand for holding sterling assets. There are spillovers across asset classes.” As one can imagine, the outcomes for growth, unemployment, and inflation were all much worse under the Disruptive and Disorderly scenarios. The BOE was roundly criticized for what many viewed as scare-mongering. However, Governor Carney stressed that the report a simply its response to the Parliamentary request and not meant to impact public opinion.

We think the potential outcomes have narrowed even further. Whilst the BOE analyzed several different degrees of cooperation and exit, we now believe the outcome tree has been cut to three possibilities as a second referendum has effectively been killed: 1) extend the deadline, 2) a compromise Brexit deal (what BOE would call Less Close), and 3) a no compromise hard Brexit (Disorderly). At this juncture, the UK simply does not have time to make any of the necessary preparations that would allow for either the Close or Disruptive outcomes. Below, we discuss each possibility as well as our perceived odds.

Extend talks beyond end-2020 (65%): While Prime Minister Johnson is now pushing to exit the EU by December 31, 2020 no matter what, one can never underestimate the capacity of politicians to kick the can down the road whenever possible. If this December deadline approaches and the two sides are still talking, we think there is an overwhelming chance that it is extended for another year (or more). Sterling could see a modest relief rally to between $1.35-1.40 under this scenario. However, continued uncertainty would likely limit any gains beyond this area.

Less Close deal by end-2020 (10%): While we think this is the eventual outcome, the two sides do not have the luxury of time. For comparison’s sake, note that the UK-Canada free trade deal that was signed in 2016 took seven years to complete. By all accounts, a UK-EU agreement will be much more complicated than this. Sterling could see a sustainable rally toward the $1.45-1.50 range under this scenario, however unlikely it is by end-2020.

Disorderly deal by end-2020 (25%): Johnson continues to threaten a no deal Brexit. Some see this as a negotiating ploy. Others see it as his plan to fulfill his campaign promise to see Brexit through. Either way, the odds of a disorderly outcome have risen sharply under Johnson. In our view, this would lead to a UK recession and plunging UK asset prices. Sterling could easily weaken 10% back to the September low near $1.1960 under this scenario, probably even further towards the $1.10-1.15 area. The FTSE could easily plunge 25% to test the August low and might even approach the June 2016 low for an additional 10% loss.

ECONOMIC OUTLOOK

The outlook for the UK economy remains fluid and hinges largely how Brexit unfolds. For instance, the Bank of England at its November meeting raised its growth forecast for this year a tick to 1.4% but cut its forecast for 2020 a tick to 1.2%. At its August meeting, the BOE cut its forecasts for both years to 1.3% from 1.5% and 1.6% back in May, respectively. All these forecasts assume that a hard Brexit will be avoided, and yet it’s clear that uncertainty alone is having a significant impact on the growth outlook.

Indeed, the UK economy is inexorably slowing. GDP growth is forecast by the IMF at 1.2% in 2019 and picking up to 1.4% in 2020 and 1.5% in 2021. GDP growth was only 1.0% y/y in Q3, the slowest since Q1 2010, while data so far in Q4 suggest further deceleration. As such, we see downside risks to the growth forecasts. It’s worth noting that consumption and government spending have held up but have been offset by much weaker than anticipated investment (Gross Fixed Capital Formation).   November retail sales will be reported Thursday and are expected to show further slowing.

Price pressures have fallen. November headline and CPIH inflation will be reported Wednesday and both are expected to fall a tick to 1.4% y/y in November.  Both would be the lowest readings since late 2016. If we get a hard Brexit and a potential 10% sell-off in sterling, inflation would undoubtedly spike. However, we suspect the BOE would err on the side of cutting rates to boost growth rather than hiking rates to limit inflation.

At the November 7 meeting, the BOE delivered a dovish hold. Carney warned that risks were “skewed to the downside” even as two members of the MPC dissented in favor of an immediate rate cut. The BOE last hiked rates with a 25 bp move in the Base Rate to 0.75% back in August 2018. That was the second move in this tightening cycle, with the first 25 bp hike coming back in November 2017.

The external accounts are deteriorating modestly. The current account deficit was an estimated -3.9% of GDP in 2018, and the IMF expects the deficit to narrow to -3.5% in 2019 before widening to -3.7% in both 2020 and 2021. The UK’s Net International Investment Position (NIIP) is currently around -14% of GDP, the worst since 2015. All told, the UK’s external vulnerability bear watching even as the risks of hard Brexit rise again.

INVESTMENT OUTLOOK

Sterling should go back to underperforming. In 2018, GBP was -5.6% and ahead of only the worst major performers AUD (-9.7%), CAD (-7.8%), and SEK (-7.6%). So far in 2019, GBP is +3% YTD and is ahead of only the best major performer CAD (+3.5%). This outperformance has mostly come in the past month as perceived odds of a hard Brexit had fallen. In addition to now-rising Brexit uncertainty, UK fundamentals remain poor and are likely to get even worse. As such, we expect sterling underperformance to resume.

After making a new multi-year high near $1.3515 last week, cable has sold off sharply. Sterling has given up all of its gains since lasts Friday and is on track to test the election day low near $1.3050. A break below that would open up a test of the November 22 low near $1.2825. With the euro holding firm, the EUR/GBP cross is showing a similar dynamic to cable and a clean break above the .85090 high from December 12 would open up a test of the November 22 high near .86055.

UK equities continue to underperform. In 2018, MSCI UK was -13.7% vs. -11.6% for MSCI DM. So far this year, MSCI UK is up 13% YTD and compares to 25.5% YTD for MSCI DM. Our DM Equity Allocation Model has the UK at VERY UNDERWEIGHT, and so we expect UK equities to continue underperforming.

UK bonds are underperforming. The yield on 10-year local currency government bonds is -51 bp YTD. This is ahead of only the worst performers Japan (-26 bp), Norway (-29 bp), Switzerland (-32 bp), Canada (-33 bp), Sweden (-43 bp), and Denmark (-47 bp). With inflation likely to remain low and the BOE tilting dovish, we think UK bonds could start to outperform a bit.

Our own sovereign ratings model shows the UK’s implied rating remained at A+/A1/A+. This continues to suggest strong downgrade risks to actual ratings of AA/Aa2/AA.