LONDON, January 14, 2019 (Newswire.com) - Brexit is unique. There is no precedent of a developed economy withdrawing from a trade agreement as major and complex as the European Union. There are many potential issues affecting UK’s financial stability arising from this ongoing process. The political and economic consequences of Brexit in the long run are currently unknown and will depend on Britain’s ability to negotiate future trading relationships and other government policies.
A range of outcomes, from a no-deal-no-transition exit from the EU in March 2019 to the UK ultimately staying in the EU, with many scenarios in between, are still on the table. While discussions are in progress, economists and politicians, as well as market participants, try to specify what the different scenarios currently in question mean for the economy and financial markets. We will cover three of the most likely outcomes and highlight their hypothetical implications for UK interest rates, currency and economic development.
Scenarios:
1. Deal – Softer Brexit
a. The current base case still revolves around a certain form of a deal to be achieved and agreed with the EU, leading to an orderly transition over the next couple of years.
b. This would most likely be a scenario in which the UK retains a close economic partnership with the EU, including comprehensive trade arrangements.
c. The pace of GDP growth is likely to be slower than in the status quo scenario of the UK staying in the EU but should show some modest advancements.
IMPLICATIONS FOR RATES: Gradually rising interest rates in a sluggish economic growth environment. The base rate would probably not get much past the 2% mark in the next 2-3 years.
IMPLICATIONS FOR CURRENCY: Sterling is likely to appreciate (~1.35 level) and inflation is, therefore, likely to be a little lower as a result of this currency move.
2. No Deal - Hard Brexit
a. Hard Brexit is conceivably the most disruptive scenario both politically and economically.
b. Most people seem to believe that a no-deal outcome is only likely if May is removed from the office (a vote of confidence is expected in case of a defeat in the upcoming deal vote).
c. According to the Bank of England reports, no deal could potentially lead to GDP falling 4.7% in the first year, house prices declining 33%, commercial property prices falling 40% and unemployment peaking at 9.3%.
IMPLICATIONS FOR RATES: Significantly higher interest rates; base rate potentially rising to 4% in year one according to Mark Carney. However, the Bank of England’s statements stressed that the monetary policy response to EU withdrawal will not be automatic and could be in either direction. Hence, there’s also a possibility that the BoE decides to cut rates in the event of a particularly recessionary no-deal outcome, particularly if a currency-driven spike in inflation is deemed to be only temporary.
IMPLICATIONS FOR CURRENCY: Sterling depreciation (difficult to know how far sterling would fall; could be a 1.10-1.20 range).
3. No Brexit (Remain) / Second Referendum / General Election
a. This is an outcome that’s become more likely since the summer but it’s extremely uncertain in what shape or form this scenario would take place.
b. While there is no clear majority for the current version of Theresa May’s deal, there is also no clear majority for anything else – not for a second referendum, not for a fresh election (Labour’s goal), not for a “no deal” scenario – but all of these options remain relevant and possible.
c. Completely reversing Brexit would have the potential to lift the cloud of economic uncertainty over Britain almost immediately but will cause short term uncertainty.
IMPLICATIONS FOR RATES: Higher interest rates as a result of a faster pace of economic growth; base rate could conceivably get to/surpass a 3% level.
IMPLICATIONS FOR CURRENCY: Brexit cancellations would be the ultimate favourable resolution for sterling and the currency could see a 10-15% appreciation towards pre-referendum levels (~1.40-1.45 cable).
What’s next
It is now up to the parliament to approve the current withdrawal deal so the necessary legislation can be passed to allow the UK to formally leave the EU as planned on 29th March 2019. If Theresa May is defeated on 15th January, it’s possible that the government may have to ask the EU for an extension to the two-year Article 50 deadline to either look at the existing deal again or try to come up with an alternative most people can agree on. Brexit is far from over yet and a big uncertainty hangs in the air in the meantime.
VAR portfolio exposure
Weak sterling tends to be beneficial for the largely internationally exposure FTSE 100 but in the case of hard Brexit, the market may see a period of sentiment-driven volatility despite the usual currency correlation. Therefore, we continue to be cautious on the UK market (particularly FTSE 100) and our exposure predominantly involves event-driven ideas, which are less correlated to the overall market.
Source: VAR Capital
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