Brexit’s blues and Johnson’s gamble

investment insights

Brexit’s blues and Johnson’s gamble

Stéphane Monier - Chief Investment Officer<br/> Lombard Odier Private Bank

Stéphane Monier

Chief Investment Officer
Lombard Odier Private Bank

Key takeaways

  • Boris Johnson’s government plans to suspend the UK Parliament in the run-up to the UK’s departure from the European Union on 31 October
  • The move increases the chances of the UK leaving the EU without a withdrawal agreement and likelihood of a UK general election
  • Sterling is trading close to two-year lows, but with most negative news priced in, probably needs a new catalyst to fall further
  • The UK still lacks a credible vision for its post-Brexit economy.

When the UK’s electorate voted to leave the European Union in June 2016, Brexit’s advocates promised many economic advantages. No one promised three years of parliamentary stagnation, a weaker currency and a political crisis that may soon result in another a general election.

Boris Johnson, who became UK prime minister in July, last week announced that he would suspend Parliament as early as 9 September, five days into a new session, and then re-open with a new legislative agenda to bring forward proposals on health, education and policing on 14 October. To date, Mr Johnson has spent one day in parliament since becoming prime minister. Thanks to Brexit, the current parliamentary session that started in 2017, is the longest since 1945.

The prime minister is certainly right to argue that UK parliament needs a new domestic policy agenda. However, the timing and length of the suspension, known as a prorogation, has been widely condemned as an attempt to avoid scrutiny over Brexit. Before becoming prime minister, Mr Johnson promised that “do or die, come what may,” the UK would leave the EU on 31 October. He argues that, “there will be ample time” before and after a 17-18 October European Council summit to discuss Brexit.

A “constitutional outrage,”

John Bercow, the Parliamentary Speaker, whose position requires him to be politically neutral, called the prorogation a “constitutional outrage,” adding that “it is blindingly obvious that the purpose of prorogation now would be to stop parliament debating Brexit.” As we go to print, challenges to the move are before Scottish, English and Northern Irish courts and former Conservative prime minister John Major said he would mount a legal challenge.

Economic sloth

Economic indicators for the UK are sickly. Early last month the Bank of England cut its forecasts for economic growth in the UK from 1.5% in 2019 to 1.3%, and cut its 2020 forecast by 0.3% to 1.3%. The UK’s economy contracted 0.2% in the second quarter as productivity and capital investment slowed. These outlooks assume an EU withdrawal agreement. A no-deal would undermine even that sluggish outlook.

"In the event of a no-deal, no transition Brexit, sterling would likely fall, the risk premiums on UK assets would rise and volatility would spike higher," BoE governor Mark Carney said on 1 August. Preparations for a no-deal cannot “eliminate the fundamental economic adjustments to a new trading arrangement that a no-deal Brexit would entail."

Political calculations

Mr Johnson’s threat to prorogue parliament may just be a way to trigger an election. His government has inherited Theresa May’s precarious parliamentary composition. Its majority of one seat depends on the support of ten Democratic Unionist Party members from Northern Ireland. The prime minister needs to convince Brexiteers that he is prepared to leave the EU at Halloween without an agreement, while showing the rest of the Conservative party that he is working hard to reach a deal with the European Commission. A prerequisite for that is to revise the Irish backstop, which EU leaders have consistently said cannot be removed. The government continues to insist that it is proposing solutions to the Irish backstop issue.

The UK’s adversarial political system does not encourage compromise.

It is worth remembering that Mr Johnson has never said that his preferred option is a no-deal, only that it needs to be on the negotiating table. Indeed he voted in favour of Theresa May’s third attempt to pass the negotiated EU withdrawal agreement. Still, at the time of writing, he has also threatened Conservative parliamentarians who oppose a no-deal Brexit that they will be dropped from the party unless they support the government, strongly suggesting that he is looking to trigger an early election.

Vote ahead

The UK’s adversarial political system does not encourage compromise. It depends on a single party winning a working majority to govern effectively. In the absence of a majority, the only solution is for a government to return to the electorate in search of a stronger mandate.

Mr Johnson could choose to call a general election before 31 October, scooping up the far-right Brexit party’s votes in an effort to win a majority.

We see three scenarios that may play out over the coming weeks. Whether the UK leaves without a deal, which is now more likely, all scenarios point to the much greater likelihood of a general election:

  1. Parliament may try to pass a law to block a no-deal Brexit. If that were successful, Mr Johnson might respond by calling a general election, claiming to his party’s Brexiteers that MPs thwarted his no-deal efforts
  2. Parliament may gather support for a no-confidence vote, triggered by Labour leader Jeremy Corbyn. Speaker Bercow’s statement last week makes it likely that he would make parliamentary time to consider any no confidence motion. If that were to pass, there would be a two-week window for the opposition to try to form a government before a general election
  3. Finally, Mr Johnson may look at parliamentarians coordinating in favour of a no-confidence vote and decide to pre-empt their challenge to his leadership and Conservative Party cohesion by risking a general election before 31 October.

Asset reactions

In the short run, any test of Mr Johnson’s government in the form of a vote of no confidence, or eventually a general election and/or delay to the Brexit date would offer some limited upside to the FTSE and stabilise sovereign yields. More specifically, large cap stocks would underperform small caps given their sensitivity to GBP. However, any relief rally may be capped by the global economic backdrop.

The same applies to the bond market: even if gilts sold off in the short term, the move would be limited as the worst scenario is avoided because the global and domestic environment still requires the BoE to stay in easing mode. In the event of a no-deal Brexit, the risk-off mode will be exacerbated and flows would dominate valuations. We would expect to see 10-year government bond yields falling below 0%. In this context, rising inflation expectations would eventually lead to an outperformance of linkers over nominal bonds. In equity markets, we would anticipate a strong correction as both the domestic and international context worsens. At the margin, the export-oriented large caps would outperform small caps, helped by the weaker currency.

Since Mr Johnson’s announcement, yields on 10-year UK government paper were unchanged. Over last week, the FTSE250 gained 0.83% and the EuroStoxx50 added 2.9%.

The pounded sterling

Turning specifically to the currency, since mid-March when sterling registered its year-to-date high, every G10 and major emerging market currency has gained against GBP.

Still, with sterling close to a two-year low against the USD, 1.20 looks like a line in the sand for markets, for now. The UK currency has fallen 4.2% against the USD this year and 2.2% since Mr Johnson took office (over the same periods, GBP has declined 0.9% against the EUR this year and 1.65%). Sterling fell as low as 1.2015 against the USD on 12 August, its lowest since March 2017, and as low as 1.07 euros on 9 August. Since the Brexit referendum, the pound has slipped 16% against the EUR and 19% against the USD.

To fall much further, sterling almost certainly needs a new trigger

To fall much further, sterling almost certainly needs a new trigger as much of the negative news has been priced in, and many investors have already built large short positions (see chart 1). From a fundamental standpoint, the pound is looking quite undervalued. Nevertheless, the current chaos and uncertainty over Brexit is certainly weighing on sterling. In our central scenario of an averted no-deal Brexit, GBP would strengthen meaningfully against the majors i.e. USD, CHF, JPY and EUR. In the risk scenario of a no-deal Brexit, we would expect GBPUSD to fall to 1.10 and below, while GBPEUR may approach parity.

The longest and most complex part of the divorce process has not even started.

Lacking any real Brexit clarity, and any concrete political vision for the shape of the UK economy post Brexit, we believe that sterling-denominated investors should be as diversified as possible.

Lack of vision

Whether the coming weeks see a no-deal Brexit, a general election, (or both), or even bring the UK closer to a revised Withdrawal Agreement, the country still lacks a concrete, credible plan for its post-Brexit economy and role in the world.

The first thing a British government will have to do as soon as the country leaves the EU is to launch years of negotiations with the European Commission over the detail of the future relationship. After more than three years of confusion and political turmoil, it is easy to forget that the longest and most complex part of the divorce process has not even started.

Important information

This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.

Read more.