There are two topics that dominate conversations with investors at the moment: Trump and Brexit. This week, the talk surrounding Brexit has fluctuated between pessimism and optimism on getting a deal. Last week, the UK released its plans for a no-deal Brexit and there was talk of EU negotiator, Michel Barnier, being difficult to contact.
This Wednesday, Brexit Minister, Dominic Raab, announced that they were making progress towards an agreement, supported by Michel Barnier's claims that the UK could have a deal unlike any other country. Barnier actually said little that was new, highlighting that he respected the UK red lines, but that the UK had to accept that there could be 'no single market à la carte'. In other words, the UK is not able to simply pick and choose. The free movement of people is enshrined in the single market, but its termination has been a firm stance by the UK in the negotiations, therefore it is hard to reconcile the two statements. However, Barnier's comments were taken to be the EU being more open to a deal than press speculation has been suggesting over the past week. As a result, the pound rallied, causing a fall in the FTSE 100 index.
By Thursday morning, Barnier damped the speculation of a deal, stating Europe should be prepared for any scenario, including a no-deal. Against this background, there is little clarity on the outcome. From Raab and Barnier's comments, it does appear that the deadline is slipping beyond the October EU summit. In the end, I expect that the EU will want to do a deal but even if Theresa May and Dominic Raab agree one, getting it through the UK Parliament could be as tough as getting a deal in the first place. It appears that Barnier is suggesting a Brexit in name only, but the hard line 'Brexiteers' in the Tory party will not vote for that, so pushing a deal through may need Labour party support.
The sharpness of the currency move on Barnier's words on Thursday may indicate that the market has been speculating against sterling. Expectations remain that a 'no deal' scenario is likely to see sterling fall sharply, with a soft Brexit likely to result in a sharp rally. UK equities have a high proportion of overseas earnings; therefore, a rise in sterling tends to cause the UK equity market to fall. With such a binary outcome, as we get closer to the deadline, any hints in one direction or the other will increase volatility. While the knee jerk reaction in the currency and stock markets is clear, the wider implications are more complicated.
Regarding interest rates, many believe that they would fall again with a hard Brexit outcome, contributing to the currency fall. Mark Carney has cautioned that this may not be the case. A fall in the currency would be inflationary.Trade tariffs and administrative costs could increase inflation and the Bank of England may want to raise rates to counter this and defend the currency. International companies will continue to apply pressure on both sides to do a deal for the avoidance of the potential chaos that could occur without one.
Equally, in the event of a good Brexit deal, rates may not rise as the strong pound reduces inflation. Many international investors have shied away from all UK investments whilst Brexit negotiations continue. On a settlement, one way or another, these investors may come back to the market. Hence, the equity price falls caused as a result of a good Brexit deal may be muted.
As investors, we should try to avoid short-term speculation and focus on companies that have strong cash flows and are able to cope with a variety of outcomes. There will undoubtedly be a lot of noise as these events develop, but in the long term, the compound earnings of quality companies should outweigh the impact of whatever Brexit outcome is thrown at us. My view is that the EU and UK will eventually see that a deal of sorts is beneficial for both sides, as indicated by President Macron. However, many details will be left for further negotiations. Thus, no one will be entirely happy with the outcome.
Dominic Raab and Michel Barnier are due to meet today, therefore this situation is likely to change sooner rather than later.
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