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Would a "smooth" Brexit be more of a shock to the financial markets than a "no deal" Brexit?

02 August 2019

Boris Johnson pledged that "do or die, come what may" the UK will leave the EU on the 31st of October 2019. He said that the chances of leaving the EU without a deal are "a million to one" and that the deal on offer needs to change radically. However, the European Union is unwilling to reopen the deal. Whilst we await further clarity, the Government have announced £2 billion in additional funding to prepare for a "no deal" Brexit. In his first speech as Prime Minister, Johnson also announced a wide range of additional spending, including the recruitment of 20,000 new police officers to improving hospitals, in an effort to build up the country ahead of Brexit. The government's current philosophy is "boosterism", which is the process of promoting the country in the hope of creating confidence regardless of the Brexit outcome. Boris Johnson's new cabinet has been selected on the basis that they are all prepared to accept a "no deal" Brexit. As a result, the pound has fallen and the bond markets are pricing in a rate cut later this year. Despite this, the Bank of England's Quarterly Inflation Report forecasts are based on a central expectation that there will be a smooth transition, as well as talks of gradual rate rises and to a limited extent.

The pound has fallen 18% against the US dollar since the 2016 referendum and 7% since the original 31st March 2019 Brexit deadline. The further movement of the currency on a no deal Brexit is debatable, however if a deal was achieved, the upside could be substantial. Two year Gilt yields are now 0.41%, well below the Bank of England base rate of 0.75%. Therefore, a move to price in rate rises could be detrimental for gilts, particularly at the short end. The UK equity market is more complicated. The companies that make up the FTSE 100 Index have over 75% in overseas earnings and, as a result, benefit when the currency is weak. However, companies that have a greater dependence on the domestic economy have suffered as fears of a hard Brexit have risen. The chart below shows the underperformance of the FTSE Local UK Index relative to the FTSE 100 since David Cameron announced the referendum.

Figure 1: FTSE United Kingdom Local Index vs FTSE 100 Index since 31 December 2015


Source: Bloomberg

A "smooth" Brexit with an accompanying rise in the pound would help local companies but the rise could weigh on more stocks that are international. However international investors have avoided the UK since the referendum. If Brexit is resolved, we could see a substantial increase in overseas interest that would support the market as a whole. The UK equity market with a dividend yield of 4.7% and a prospective price earnings ratio of just 13, looks cheap relative to bond markets and other developed markets. Therefore, a "smooth" Brexit could see bigger moves than the "no deal" Brexit which the markets fear, but is this possible?

In selecting his cabinet from those happy to leave without a deal, Boris Johnson has alienated many in the Conservative Party who favoured remain or a deal. As such, he may have as much opposition from his own party as Theresa May did, but from a different faction. Parliament has expressed its opposition to a no deal Brexit but has not conclusively voted for an alternative. Parliament is now in recess until September when it returns before another break for the party conference season, meaning parliamentary time is limited. The European Union is standing firm that they will not reopen the deal. However, the European manufacturing sector is suffering badly from the effects of global trade disputes and a no deal Brexit could make this worse. Alternatively, these threats could be powerless if Parliament manages to block a no deal scenario. The Conservatives may want to avoid an election before Brexit as Nigel Farage's party could significantly distort the result.

The fog of Brexit remains as thick as ever making a firm prediction impossible, but the probability of a no deal Brexit has risen and the market is reacting accordingly. Any reversal of the decline in value of the pound will depend on moves to block leaving without a deal, which may have to wait until after Parliament returns from the break. If we see a further extension to Brexit with more delays and a possible election, this will simply prolong the pain. The Bank of England continues to use a smooth Brexit for its central forecast, but markets are closer to pricing a rougher outcome. Despite this, a smooth Brexit appears unlikely at the moment, but it has always been unexpected events that shift markets most.

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