Squeal at no deal

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SINCE THE big fall in sterling in June 2016, when investors were surprised by the referendum result, financial markets have been remarkably stable in the face of Brexit news. The rule of thumb is that the pound has risen whenever it has looked like Brexit is being softened or postponed, and weakened when negotiations have looked like being deadlocked. But the moves have rarely been huge.

This pattern was briefly repeated on the evening of January 29th. When a backbench amendment suggesting that Brexit be postponed was defeated, the pound fell by a cent against the dollar. But it quickly bounced back. Many investors seem to assume that Britain and the EU will reach some kind of deal before the departure deadline of March 29th.

That suggests markets might get a nasty shock in a no-deal scenario. The currency markets are likely to take the greatest hit. Adam Cole, a currency strategist at Royal Bank of Canada, thinks the pound might drop by around 10%. At Axa, an insurance group, David Page thinks that the pound could fall to $1.10-1.15 (from the current $1.31) and to parity against the euro (the euro is currently worth just 87.2 pence). David Owen at Jefferies, an American bank, thinks the mid-1980s levels of $1.05 might be tested in the worst case.

The analysts stress that it is quite possible that the authorities will move to limit the disruption to trade. This could reduce the extent of sterling’s fall. Even if massive disruption is avoided, however, analysts think Britain’s long-term economic growth rate will be lower outside the EU than inside it, and that foreign direct investment will be hit; those factors alone suggests a weaker pound will be the result.

Another issue that will affect the pound’s fortunes is the attitude of the Bank of England. As the bank pointed out in November in a report on Brexit risks, a no-deal scenario would be a shock to both demand and supply, simultaneously pushing down output and pushing up inflation. If inflation rose fast enough, the bank could respond by increasing interest rates, thereby strengthening the pound. But analysts doubt it will do so. “Raising rates in the event of a hard Brexit would be the equivalent of losing a leg and deciding the best way to regain your balance is by chopping off the other one,” says Kallum Pickering of Berenberg, a German investment bank.

As for government bonds, they are seen as a risk-free investment, so their prices might rise (and yields will fall) in the aftermath of a no-deal Brexit. That is what happened in the immediate aftermath of the referendum result. But Mr Owen points out that Britain needs foreigners to finance its current-account deficit, which was 3.9% of GDP last year. Net foreign buying of gilts was £20bn in the fourth quarter of 2018, he says. If there was political turmoil in the wake of Brexit, investors might demand higher returns for the risk of holding British bonds. Investors are even more concerned about the risk of a Labour government under Jeremy Corbyn than they are about Brexit, Mr Owen adds.

The impact of Brexit on the British equity market is complicated by the fact that many of the leading companies earn most of their profits outside the country. If the pound falls, that will increase the sterling value of their overseas earnings and bolster the share price. In addition, British equities have been out of favour for some time. A recent survey of global fund managers by Bank of America Merrill Lynch shows that investors are more negative in their view of the London market than at any time in the past 20 years. The FTSE 100 index yields 4.6% and trades on a historic price-earnings ratio of 11.5, making it look quite cheap by past standards; it is also trading at around the same level as it was at the end of the last century, suggesting a lot of bad news is priced into the market.
The damage might fall more heavily on the FTSE 250 index, which is more focused on the domestic economy, and thus would be hardest hit in a no-deal scenario.

MSCI, an index group, made a more apocalyptic forecast in December, suggesting that British stocks could fall by 25% and European stocks by 10% in the event of a no-deal Brexit, largely because British GDP might fall by 9%. Such suggestions might seem outlandish. But Brexit is a very hard thing to forecast, as major disruptions to trading regimes do not happen very often. That may explain why many investors would rather not think about it at all. 

 

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