With the Brexit deadline looming, we take the pulse of the negotiations, and assess the wide spectrum of political risks and their potential impact on the economy. We answer investors’ key questions, and highlight opportunities and strategies in this uncertain and volatile environment.
Q. What is the state of play of the negotiations?
The talks are unfolding along a two-pronged approach. One element relates to the terms of the divorce, the so-called Withdrawal Agreement, covering three issues: the financial settlement the UK will pay to the EU, the rights of EU citizens who remain in the UK, and options to avoid a hard border between Ireland and Northern Ireland. This prong also involves an agreement on a transition period—ensuring the status quo for 21 months after the exit on March 29, 2019—so that the UK can prepare itself for life outside the EU.
Most of the Withdrawal Agreement has been negotiated, except for the Irish border issue. The resolution of this depends on the future arrangement between the UK and the EU, particularly with respect to the trading of goods.
May blurs her “red lines”
Source - RBC Wealth Management
The other element of the negotiations deals with the blueprint of the UK’s future relationship with the EU. Prime Minister Theresa May laid out her strategy in July in a white paper, the government’s first detailed proposal on this topic since the referendum in June 2016.
May opted for a “soft Brexit,” i.e., the UK would maintain close economic ties with the EU by effectively retaining membership within the single market for goods and respecting EU regulations. But this plan means May has changed her previous stance on the “red lines” she had firmly laid out after the Brexit vote (see graphic above).
The white paper is largely being seen as an opening gambit for negotiations. Parts of it have already been rejected by the EU, whose main motivation is to preserve the union. Accommodating the UK’s demands may embolden other countries to seek exceptions and special arrangements as well.
By taking this approach, May has angered the most passionate Brexiteers in the Conservative Party, who are vocal proponents of a clean break with the EU. And in doing so she has become vulnerable given her thin parliamentary majority, and political uncertainty is likely to fester as negotiations heat up in the face of the approaching deadline.
Possible political scenarios until March 2019
Low visibility is an understatement
Source - RBC Capital Markets
Q. What are the milestones prior to the exit?
There is now less than a year before the UK leaves the EU. The timeline below is only indicative, as tensions apparent in UK politics may well give rise to unforeseen events.
Other than the ongoing negotiations and European Council meetings, the Conservative and Labour Party Conferences in the autumn could very well influence how the divorce takes shape.
Q. What is the base-case Brexit scenario?
Our base case is that a soft Brexit deal will be struck. After all, such an outcome is in the interest of both the UK and the EU. The UK would avoid the turmoil of leaving the EU without any provision as to what the future relationship might bring; and the EU would avoid the potentially destabilising effect of having a trading partner and close neighbour endure significant political and economic upheaval.
If the UK cannot adjust the proposals as laid out in the recent white paper closer to the requirements of the EU, we would expect the EU to counter with a “take it or leave it” proposal, with a customs union for goods flexible enough to keep the Irish border open. This would limit the UK’s ability to negotiate trade deals with third countries, but also limit the damage to the UK economy.
Faced with the choice of a hard, cliff-edge Brexit or fresh elections which could lead to a Labour government, we would expect Conservative Members of Parliament (MPs) to be pragmatic and put their differences aside and accept this deal, propped up by cross-party support.
Eric Lascelles, chief economist at RBC Global Asset Management, expects the hit to GDP from a soft Brexit would be five percent over a number of years, but he points out that one to two percent of this drag has already materialised, leaving less pain remaining.
So much to do, so little time
Key upcoming milestones in the Brexit timeline
Source - RBC Wealth Management, RBC Capital Markets
Brexit probabilities and implications
Base case is soft Brexit, but tail risks should not be dismissed
Source - U.K. Government, RBC Global Asset Management, RBC Wealth Management
Q. There is a lot of talk about a “no-deal” outcome—what would that entail?
Some Brexit-backing Conservative MPs believe a no-deal outcome would be advantageous to the UK, as it would ensure the country regains its sovereignty. They are frustrating May’s soft Brexit efforts as demonstrated by cabinet resignations and close parliamentary votes over the summer.
A no-deal outcome would occur should the UK fail to conclude the negotiation of the Withdrawal Agreement—the soft border with Ireland being the sticking point—and talks with the EU break down. This scenario could also materialise if the final deal does not garner enough support in Parliament.
Lascelles assigns a probability of 15 percent to this outcome whereby the UK would then be compelled to trade with the EU on the basis of WTO rules. This probability may well increase somewhat as events unfold. With trade with the EU severely disrupted in this scenario, Lascelles estimates a hit to GDP as high as eight percent over a number of years.
Q. Is there a chance that Brexit will fall through?
At the other end of the spectrum, the scenarios of “no Brexit” or “barely Brexit” (a solution akin to the Swiss model) are possible, though Lascelles pegs both with low probabilities of 10 percent and five percent, respectively. Sentiment has not sufficiently turned for the former. For the latter, the EU is unlikely to allow the UK adopt a model similar to that of Switzerland, which it now regrets having agreed to.
Q. Why are many investors more concerned about a Labour government than about Brexit?
Due to infighting, the Conservative Party has now slid behind Labour in the polls. Mark Dowding of BlueBay, an RBC Group company, assigns a 25 percent probability of a far-left Labour government led by Jeremy Corbyn.
Elections could be called after a possible leadership challenge this autumn, though with her now-soft Brexit approach, May is likely to have the support of enough MPs—most of whom favour a soft Brexit—to survive. A further test would occur should the deal she brings back to the UK be voted down, as this would very likely be followed by a snap election.
A Labour-led government would likely aim for a soft Brexit. As a coalition or a minority government, it would probably soften its stance further, aiming instead to stay in the common market for both goods and services with some control over immigration. A second Brexit referendum would also be more likely under this scenario, given Labour’s increasingly softening stance towards leaving the EU.
While Labour’s softer position would be beneficial to the economy, in our view, its other economic policies would more than likely offset this.
The party intends to significantly increase fiscal spending. Despite raising the corporate tax rate to 26 percent from 19 percent as well as personal taxes by reintroducing the top 50 percent marginal rate, the Labour programme would likely lead to higher fiscal deficits.
Labour has also proposed amending the Bank of England’s (BoE) charter to mandate the central bank finance infrastructure and social care projects, a measure which would clearly be inflationary.
Overall, these policies would likely result in higher Gilt yields, higher inflation, and possibly a weaker pound should the new policies induce capital flight.
Q. How has the economy responded to this uncertainty?
The Brexit vote has already taken a bite out of UK economic growth. A cursory look at growth projections made by the Office for Budget Responsibility (OBR) in March 2016 before the referendum compared to the most recent estimates shows the OBR slashed its growth projections by a cumulative two percent over 2016–2019 (inclusive).
The two main culprits have been lower consumption, as disposable incomes have been eroded by higher inflation due to sterling’s downward spiral, and weaker business investment, which grew at about one-third of the pace initially envisioned since the referendum. The impact on the economy would have been starker still had the government not stepped up its own investment, and the BoE not loosened monetary policy.
U.K. growth has been lagging that of other countries since the Brexit vote
Source - The World Bank, IMF, Office for Budget Responsibility
Going forward, it is difficult for us to see how the UK can break out of the doldrums. Consumption is likely to remain underwhelming even as disposable incomes recover, given the tepid increase in real wage growth. High household indebtedness and a low savings ratio below five percent point to an already stretched consumer. Households may well opt to use their slightly higher income to build up savings or pay down debt.
Business investment is unlikely to pick up. The Q2 2018 Deloitte CFO Survey again ranked Brexit as the top risk facing UK businesses, with three-quarters of respondents expecting Brexit to lead to a deterioration in the business environment in the long term, the highest proportion since the referendum in 2016. Many companies are worried about their supply chains, and how quickly and reliably they will be able to import components from Europe. Many are freezing their investment plans, or leaving the UK as a result.
In a bid to prop up the economy, the UK government is loosening its purse strings earlier than planned and has announced wage increases for public sector workers. Fiscal austerity has subtracted some 0.2–0.3 percent from growth over each of the last two years.
Surveys of the impact of Brexit on investment
Business investment is impacted by the uncertainty.
Source - Bank of England February 2018 report
With this uncertain background, RBC Capital Markets expects GDP growth of 1.3 percent and 1.4 percent this year and next, respectively, and for the BoE to increase interest rates twice in 2019, bringing the Bank Rate to 1.25 percent, though this is contingent on a soft Brexit outcome.
Q. What about the currency?
The pound bore the brunt of the adjustment to financial asset pricing in the aftermath of the Brexit vote, falling some 20 percent against the U.S. dollar, and somewhat less on a trade-weighted basis, in the three months after the referendum.
After clawing back some of its losses, sterling is down 10 percent against the dollar since its April 2018 move in response to market perceptions about the outcome of Brexit negotiations and its impact on growth.
Renewed political frictions or a possible breakdown of negotiations with the EU could prompt further sterling weakness. We expect the currency could retest its lows in the event of a hard Brexit; conversely, a soft Brexit could slightly lift the pound.
Q. After showing resilience during the politically volatile summer, what’s next for UK equities?
Several factors underpinned the hardy performance of UK equities during a summer dominated by political drama.
Firstly, the pound’s four percent fall relative to the dollar since May supported equities as currency weakness tends to have a positive effect on UK indexes, with some 70 percent of the FTSE 100’s revenues generated abroad.
Moreover, the Energy sector, which is heavily represented in UK indexes, has benefitted from stronger oil prices and improved cash flows. Further support materialised from the rebound in M&A activity in the UK with foreign investors taking advantage of the weaker pound, while share buybacks have increased. Corporate earnings expectations seem to have passed peak pessimism and are now recovering. Finally, relative to other stock markets, the UK has seen less of an impact from the ongoing trade disputes than other regions that have a larger exposure to sectors in the tariff crosshairs such as Technology and Autos.
All of this supports our recent upgrade of UK equities to Market Weight. After three years of underperformance, valuations are now attractive, in our view. The dividend yield has seldom been so high, exceeding the four percent threshold on only five occasions since the market trough of 2009 and offering some 1.4x the average yield of other developed markets.
UK equities trade on a price-to-earnings (P/E) ratio of 13.7x and 12.7x consensus estimates for 2018 and 2019, respectively. On a price-to-book value (P/BV) basis, the FTSE All-Share Index trades close to a 15-year low relative to the MSCI World Index. Barring a systemic shock, we believe value has emerged in the UK We maintain our long-standing preference for companies which generate the majority of revenues abroad, and we find particular value in Energy and Financials.
FTSE All-Share P/BV relative valuation to MSCI World
Relative valuation is at a 15-year low.
Source - Bloomberg, RBC Wealth Management
However, the non-negligible probabilities of a no-deal outcome or of early elections that could result in a Labour-led government curb our enthusiasm. In the case of the former, we believe domestic stocks would be hurt the most: the pound would likely weaken, increasing the cost of imported raw materials and squeezing corporates’ margins, while consumers’ disposable incomes would be eroded by inflation.
A no-deal scenario could also potentially affect companies which export a large proportion of sales to the EU. But many of those also have production facilities abroad, which should somewhat shield them from the negative impact of this scenario.
If there are early elections that produce a Labour government, we believe utility, bus, and railway companies would be threatened by potential changes in regulations (lower fares and prices), a likely higher cost of debt, and the risk of nationalisation. A higher corporate tax rate would particularly hurt small-cap stocks, in our view. Meanwhile, Financials such as investment managers would likely suffer from the high end of their client base facing a more difficult environment for pensions and savings.
Tune out the noise
We expect significant noise and spells of anxiety will affect financial markets as the Brexit deadline approaches and political uncertainty peaks. Markets will likely react more strongly to headlines which seem to herald the UK crashing out of the EU, while being sceptical towards those which point to a smooth exit, until a final deal is reached and ratified by both the UK and EU parliaments.
Our base case continues to anticipate a soft Brexit, and barring any shock to the economy, we expect reasonable returns from UK equities and maintain our Market Weight stance. We would focus on companies with international exposure until more clarity on the future business model of the country emerges.
Q. How should UK individuals subject to UK tax and pensions approach personal financial planning in light of Brexit uncertainty?
Dean Moore, head of Wealth Planning at RBC Wealth Management in London, points out that with UK tax revenues expected to fall following Brexit, an emergency budget would likely see the UK Treasury look to raise additional revenues. There may be pressure to reduce the current annual pension allowance of £40,000 for individuals eligible for UK pensions, or lower their £150,000 earnings threshold where the allowance begins to decline. The rate of UK tax relief may also be restricted and it would be worth considering maximising contributions to pensions and individual savings accounts, and carrying forward unused UK pension relief where possible.
UK expats living in the European Economic Area (EEA) currently benefit from the “triple lock” guarantee, which mandates that their basic state pension increases every year by the higher of the rate of inflation, average earnings growth, or a minimum of 2.5 percent. There is some speculation as to whether Brexit could change the status of EEA pensioners, as pensioners living in other countries, such as Australia, do not benefit from any such increase. Should this change occur, it will be necessary for UK expats living in the EEA to consider an increase to savings in order to offset the impact of inflation on a fixed basic state pension.
Non-U.S. Analyst Disclosure: Frédérique Carrier, an employee of RBC Wealth Management USA’s foreign affiliate Royal Bank of Canada Investment Management (UK) Limited; contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since she is not an associated person of RBC Wealth Management, she may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.