What will happen?
Next week should prove decisive in determining the future course of Brexit. The planned sequence of votes in the House of Commons next week, starting with a decision of Mrs. May’s proposed deal (by March 12), followed (if needed) by decisions on avoiding a “hard Brexit” and then on a potential extension of Article 50 should pave the way either for an orderly exit on (or close to) March 29 or to a delay to the process. We summarize the proposed process in the decision tree on the PDF version of this article, which you can download here. At this point, we cannot rule out a “hard Brexit” although we think it is unlikely.
Sequence and likely market reaction
Market volatility could increase in the run-up to the Brexit votes, particularly if we get unexpected newsflow (with the backstop still an area of concern). News around the exact wording or timing of the parliamentary votes to be debated next week could also unsettle markets.
If Mrs. May’s proposed deal is agreed to, we would expect a decrease in market volatility in the near term, because it will increase certainty around the Brexit process. GBP would likely rally in the short term, perhaps temporarily reaching 1.35 vs. the USD although our three-month target stays at 1.31 and our 12-month target remains 1.28. UK equities (FTSE 100) would gain by perhaps 2-5% despite a higher GBP, but with some sector differential; European stocks (EuroStoxx 50) could make larger gains of 5-7% without such a large short-term currency brake; the S&P 500 could rise 0-2%. Gilts yields would be likely to rise, perhaps to around 1.50%. As regards the Brexit process, the aim would be to wrap up an initial agreement at the next EU summit, scheduled for March 21, but the UK government might need to request a short technical extension so the legal framework can be put in place.
If Mrs. May’s deal is rejected on March 12 (or before) then volatility is likely to increase in the immediate aftermath of the vote, although probably not dramatically as a rejection has seemed a likely option for some time. A vote the following day to reject the possibility of a “hard Brexit” would likely not reduce volatility fully back to former levels as considerable uncertainties would remain about how any new Brexit agreement is to be negotiated and agreed to, and what will happen during the likely Article 50 extension necessary to do this. Unsettling political questions would remain, including: i) Mrs. May’s hold on power and the likely leader of future negotiations with the EU; ii) the possibility of government fragmentation and an early election; iii) the degree of pressure for a new referendum; iv) perceptions around the shifting probabilities of No Deal and No Brexit. Such uncertainties would be likely to keep GBP and UK equities depressed for the foreseeable future. The longer the likely delay, the greater these uncertainties would be: markets might be happy to live with a delay of one month, but a longer delay could spell deeper trouble for the UK economy and UK assets.
If Mrs. May’s deal is rejected, the House of Commons fails to reject the possibility of a “hard Brexit” and the parliamentary process then fails to agree on an Article 50 extension, market volatility could increase again sharply, not just in UK markets but across European markets more broadly. We will communicate with clients extensively through publications and internal calls to explain our view and portfolio positioning. GBP would fall further (perhaps to 1.20 vs. USD and 0.90 vs. USD) with a BoE rate cut possible.
Equities (UK and Europe) would also be down further, with the FTSE 100 falling by -5-10% and the EuroStoxx 50 by -8-10% (UK stocks could outperform because of the GBP effect on the overseas profits of large global blue chip companies in the FTSE100 Index.) Gilt yields could be around 1.20%. Such an outcome next week (which we think is unlikely) may not however be quite the end of the story: further votes would still be possible before the March 29 deadline. However, we think that progress here would depend on Mrs. May immediately formally abandoning her Brexit plan and handing over power to the House of Commons to decide the issue, perhaps through another sequence of votes.
As regards real estate, our colleagues at Deutsche Bank Research believe that, based on the core view that a No Deal Brexit will be avoided, sentiment is likely to bounce back modestly in H2 2019 but they do not believe that a return to recent peaks of double-digit price growth is on the cards. Instead, house prices are more likely to track nominal incomes, or just above, keeping price-to-income ratios relatively stable. Divergent regional trends should continue. Prices in London should receive a fillip from a Brexit deal being agreed, but will face medium-term structural headwinds if the UK's relationship with the EU27 in services trade is less close than at present, as well as to falling EU migration. In summary, they expect a bounce back in house prices by late this year/early next, assuming a Brexit deal is done.
We do not think that a “hard Brexit” is likely (current probability: 25%). Of course, parliamentary votes may not go as planned and next week’s votes could be different from those planned. It is also possible that Mrs. May seeks again to delay the vote on her proposals, although we think that this is unlikely. But the underlying truth remains: a majority of UK MPs are opposed to a hard Brexit, and this majority should be able to use the parliamentary process to stop it. We think that the 25% probability of a “hard Brexit” will be outweighed by the 60% probability of some form of negotiated deal eventually (not necessarily Mrs. May’s and possibly involving a delay) and a residual 15% probability of no Brexit at all.
As noted above, agreement of a deal next week is likely to give a lift to GBP and UK assets; conversely, a prolonged delay to Brexit (beyond a short extension to deal with legal technicalities) would likely to be damaging to UK and, to a lesser extent, European assets – despite the possible eventual outcome of such a delay being, perhaps in theory, a new deal that might better support UK fundamentals. This is one of the many paradoxes that will face UK legislators next week: we will keep you informed as to how the parliamentary process develops.
Download this CIO Insights Memo as a pdf here.