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Brexit drama vs. renewed global slow down fears

16 November 2018

It has undeniably been the most unnerving week in UK politics since the week following the Brexit referendum, when the British electorate unexpectedly rejected the EU status quo. Representatives of both sides have finally agreed on a withdrawal agreement that lays out how to achieve a least disruptive Brexit as possible, that doesn’t throw both sides into economic turmoil. And it’s sent both ends of the UK’s Brexit spectrum screaming in disgust.

So, is this a true compromise, which makes neither side happy? Or, it is dawning on the Brexiteers that the whole ‘cake and eating it’ idea really has no chance of becoming reality and instead of owning up to the blunder they have returned to their cloud-cuckoo-land in which this is simply the wrong Brexit plan? The Remainers on the other hand see the turmoil of the “Brexit means Brexit” government as their chance to reverse the referendum outcome and return to the safety of the old status quo.

It was therefore interesting to note that in all of this noise only the business community appeared to support Theresa May’s moderate route. Her gradual EU divorce would neither return the UK entirely to its pre-EU membership nation status, nor immediately expose it to having to re-establish new trade terms with the whole world. Or perhaps once again only the noisy fringes made themselves heard, and the majority in the middle kept stumm, because they realise that what is on offer may not be so bad – but is nevertheless only the best of a bad bunch and therefore a hard sell.
While there was much citing of adverse market reaction as if to prove the severity of the situation not just in terms of government continuity, our volatility chart below for the UK’s currency and stock market shows that capital markets were far more alarmed during the summer of 2016 and even the Q1 2018 stock market correction.

Pessimists will argue that stock markets have simply not correctly priced in the rising probability of a disorderly no-deal Brexit crash out. We would instead side with the markets and suggest that the balance of probabilities stands against such an outcome. There’s a higher likelihood that MPs will in the end support the lower risk option of ‘Brexit means Brexit’ on Theresa May’s terms. If they shy away from the historic responsibility and ask the electorate for a second opinion, it could cost them their seats – whereas the no-deal option remains too unpalatable for anybody seeking re-election.

We have suggested since the summer that the end process would get very unnerving, unpleasant and outright frightening, but in the end, we would get some form of a Brexit fudge rather than a disaster. The possibility of a second referendum may have risen over the week, but we still regard this as a low probability outcome, unless the EU suddenly offered some concessions around a pan-European migration framework which we attach a low probability to.

For the UK assets we hold in our investment portfolios, we believe that their comparatively low valuations reflect the most likely outcome of a lengthy muddling through towards a sort-of-Brexit but as a result offer a decent yield and plenty of upside potential. The downside risks inherent in this position is therefore well balanced by the possibility of a better than expected outcome.

I suspect our readers and clients are just as tired with having to read about the Brexit process as anybody else across Britain and so I am more than happy to leave all further political comment to the journalist experts and their weekend papers.

While the Brexit drama for once caught international attention, it was still not the centre of attention for capital markets. Instead, there was a certain air of 2015 déjà vu, as the oil price accelerated its fall to reach -25% since its early October peak and the price of credit for the highest risk borrowers rose, while the demand for safe haven government bonds drove their yields down – for the first time during this correction. As during any previous risk-off period, there are suggestions that the stock market is just pre-empting a looming downturn – one that’s not yet visible in the data. Cleary, the longer the current economic cycle lasts the higher the probability that such predictions eventually prove correct, particularly now that there is a real threat to the global trade framework through Trump’s trade war threats towards China and a lesser degree Brexit.

It is also undeniable that, beyond the US, economic growth has slowed compared to 2017, with emerging market economies bearing the brunt of China’s demand slowdown and Trump’s fiscally driven US$ strength. However, if the biggest risk to the global economic cycle is the risk of a disorderly unwind of the bond market from historically low yield levels, then lower oil prices, lower US government yields and a reduced rate of global growth are all factors which lower the probability of such a bond market ‘riot’ actually occurring in the near future.

So, while the various signs of slowing are eerily reminiscent of late 2015, neither the oil price decline nor the economic slowdown are anywhere near the levels of back then. The global economy is also in a more stable environment. But, just as the lower oil price and lower yields of 2015/2016 turned into a formidable stimulus for late 2016 and 2017, the current price changes could serve as stimulus for 2019. Unfortunately, the pain of price adjustments to the changed outlook comes first and the benefit follows only with a time lag. Therefore, unless politicians either in the US and China or the UK and the EU provide us with somewhat unexpected positive surprises and reduce trade tensions, then the prospect for positive investment portfolio returns for 2018 are dwindling.

Sorry for being the bearer of negative news, but it does appear that what started as a very strong economic environment may once again be turning into a mini downturn, which introduces unwelcome market volatility but ultimately extends this economic cycle for yet another year or more.