Brexit: The clock continues to tick

On 23rd of June, the UK narrowly voted to leave the EU by a majority of 51.9% to 48.1%. As we approach the third anniversary of the referendum, it remains unclear what the outcome of Brexit will be.  An array of possible outcomes remain on the table – including UK MPs (Member of Parliament) passing the existing deal, an Article 50 extension, a second referendum, revocation of article 50, a customs union with the EU or a common market. MPs’ inability to find a compromise has resulted in no consensus being formed for a preferred option. This lack of consensus means that a no-deal scenario is still a possibility on 12^th April.

How did we end up here?

It was two years after the referendum vote when Theresa May announced her Chequers plan (July 2018), outlining the type of future relationship that the UK sought to achieve with the EU in Brexit negotiations. Following several high-profile resignations on the back of the announcement, including the Brexit Secretary David Davis, May’s plan was then rejected by the EU.

There has been resistance from both sides. For the EU, the main sticking point was not allowing the UK to ‘cherry pick’ from among the European Single Markets four freedoms (people, goods, services and capital) – while the UK sought to ensure the backstop was a temporary arrangement. Brexit negotiations concluded in November 2018 with a Withdrawal Agreement that was endorsed by the leaders of the 27 EU countries. The Withdrawal Agreement still required support from the UK parliament, which has proved too high a hurdle.

Theresa May’s trips to Brussels were unsuccessful in persuading the EU to allow any substantial concessions/amendments to the content of the agreement, in particular the backstop arrangement. MPs have voted against the agreement on three separate occasions by convincing, albeit reducing, majorities of 230, 149 and 58 votes. It has always been the Davy house view that the time frame on Brexit (initially 29th March) would be pushed out in order to avoid a no-deal scenario. EU leaders agreed to delay the exit date until 12^th April when it became apparent that May’s chances of successfully pushing the agreement through parliament remained slim.

What happens next?

That brings us to the current situation that we find ourselves in.  There have been two attempts by MPs to find a consensus on a preferred alternative to Theresa May’s Brexit deal - neither vote resulting in a majority for an alternative route. The customs union option came closest to finding a majority, (see Figure 1).

In the latest Brexit twist, Theresa May appears to have given up on her own deal and is seeking talks with the Labour leader Jeremy Corbyn for a ‘unified approach’.  If these talks are successful, it would require an extension to Article 50. Reports suggest that May will seek a one-year extension that could be cut off once the UK ratifies the withdrawal agreement. 

For the time being, a no-deal outcome remains the default option and is still a possibility on 12^th April. 

Source: BBC 01/04/2019

Preparing for the worst case

In a no-deal scenario, the immediate impact would likely mean that the UK economy will be pushed into a recession. The Bank of England would be faced with a choice of controlling the threat of currency induced inflation following a sharp fall in the value of sterling (by increasing interest rates) or attempting to stimulate the economy by reducing interest rates. It is likely that the threat to the economy would supersede.

UK government bond yields have moved lower over the past couple of weeks as the Withdrawal Agreement continued to fall short of the required number of votes in parliament and investor concerns increased. In a no-deal scenario, we expect 10-year yields to continue to move lower – potentially approaching the 80-90bps level.

Sterling has become recognised as the barometer for progress in Brexit negotiations and has maintained a close correlation to developments in Brexit headlines. We believe that a substantial amount of the potential gains from a successful progression to a transition phase is already reflected in the current price of sterling, particularly against the euro. While in a no-deal scenario, it is not unreasonable for sterling to fall another 10-12% versus the dollar and 7-8% versus the euro.

In UK equities, large cap UK firms generate a significant proportion of their revenue overseas and are less impacted by the state of the UK economy. We would expect smaller cap UK equities with a greater dependence on the UK domestic economy to be more vulnerable. Since investors are not pricing in a no-deal scenario currently, we expect the initial shock of such an outcome to trigger some weakness in European equities. Looking at the broader picture, any positive news flows on the US-China trade negotiations should more than offset the Brexit weakness.

A no-deal scenario would have significant consequences for the Irish economy. The Economic and Social Research Institute (ESRI) recently warned that a no-deal Brexit could halve Irish economic growth next year. Irish equities, similar to other regions, have rebounded strongly since the beginning of the year. It is likely that the negative impact on Irish equities would be more substantial than their European peers, particularly for companies with large UK exposure.

Davy model portfolios

While our multi-asset portfolios are not immune to the fallout of Brexit, they have consistently shown resilience in the face of adverse political fallouts and are well positioned to absorb the negative impact from a no-deal scenario. 

We have recently increased our allocation to global equities that score highly on quality characteristics. In a scenario with increased Brexit induced equity weakness and volatility, this quality focus should outperform the broader market and dampen any negative impact. Specific to UK equities, our GBP moderate growth portfolios hold a 15% allocation.  In euro portfolios, given that we are globally focussed investors, the allocation is less; however some of our global fund managers do hold large cap UK stocks within their funds. In both GBP and EUR portfolios, the majority of our exposure in this space is to larger cap UK companies. As previously mentioned, the performance of these companies is less correlated to the health of the UK economy than smaller cap, domestic focussed UK stocks.

If you have any questions on how Brexit could impact your portfolio, please contact your adviser for more information.