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Brinkmanship and extensions

25 March 2019

Every few months, I spend a few days of the week travelling across the UK with Tatton’s relationship management team updating regional gatherings of financial advisers. This time around, it was not surprising to find most of the conference rooms filled with anxiety about the risk that Brexit may bring to their clients’ investments. Our market update presentation only touched on Brexit towards the end, where we had somewhat reluctantly dedicated a slide to the possible investment outcomes of various scenarios. But we put most attention on the latest global monetary and economic developments.

It may seem imprudent to UK investors that we are seemingly so blasé about the heightening political Brexit drama, and spend much more time watching the latest data points from China’s economy, and studying in far more detail the latest policy releases from the US central bank, the Federal Reserve (US Fed). In a private capacity, that is certainly not true in my case, particularly when you have strong roots in both the UK and the European mainland.

Compared to the wider investment community however, our concern over Brexit outcomes is higher than average. That is what it looks like from currency and stock markets at least, which reacted so much more to the latest economic assessment of the US Fed than to the UK seemingly drifting closer and closer towards a disorderly Brexit. £-Sterling lost comparatively little on the disconcerting news that the UK Prime Minister and EU27 leaders had agreed to what at first seemed like a blackmail of Parliament to either agree the government’s exit treaty (which they had already overwhelmingly rejected twice) or face a disorderly Brexit that would hurt the UK’s short-term economic health and wealth very considerably.

The fact of the matter is that the EU’s granting of the Brexit deadline extension and in case ‘the deal’ is rejected a third time, permitting Parliament to take control to find an alternative solution supports professional investors’ view that, when push comes to shove, a majority of MP’s will support whichever motion will cause the least harm to their country and constituents. It appears almost not to matter whether in the end this means that ‘the deal’ somehow passes when presented for the third time, or whether Parliament itself takes control of the further process and forces a lengthy Brexit rethink by taking up the EU’s offer to pursue a  different exit route. Importantly, even before the deadline extension, capital markets have displayed astonishing confidence that a disorderly Brexit will be averted.

Unfortunately, capital markets do not have a crystal ball and, as the Greek Euro crisis of spring 2015 proved, they are not always as proficient in foreseeing political developments as their players may want to believe. This time, the probability that they are correctly anticipating that the two sides will not push the conflict over the precipice (not even temporarily as the EU did in the case of Greece in May 2015) is much higher, given that – compared to then – so much more is at stake for so many more voters across the EU. A massive pan-European crisis just weeks before the European parliament elections in May 2019, and a recessionary shock which would cause unnecessary hardship on both sides, seem irrational.

Whether the Brexit-opposing majority of the UK’s political class (as well as the business and academic community) will dare to force the UK public into a lengthy rethink of their 2016 Brexit vote, or will defer such debate to the coming two years of trade negotiations under provision of ‘the deal’ framework, is currently unclear. Despite all the very unnerving brinkmanship and shouting from all sides, it looks like we are heading for a softer Brexit than many thought possible, even if the small risk of a crash Brexit has ever so slightly increased (as the clock runs down and the margin for error gets smaller).

We will end our assessment of the Brexit risk here, but would like to point out that thus far both our prediction that the decision would be taken right to the wire and that March 29 would not mark the Brexit date have so far proven correct.

The more important ‘extension’ from an investor’s perspective had nothing to do with Brexit but instead the US Fed’s decision to return to a less restrictive monetary policy than had been followed for the past two years, and thereby ‘extend’ the era of low(ish) interest rates. It may look like a normal dovish turn, but their pausing of further interest rate rises and liquidity withdrawal (by ‘retiring’ money through QT sales of government bonds they had bought under their QE program) amount to a fundamental policy shift. In light of continued tight labour markets and the resultant upward wage pressures, the Fed is signalling that they are now more focused on stimulating economic growth than preventing future inflation.

After more than 30 years, this is very significant for investors. It has the potential to re-accelerate US economic growth and to weaken the US$ enough to stimulate global trade, after the 2018 slowdown it suffered from a strengthening dollar and hawkish Fed. That stock markets fell in the aftermath on Friday, erasing the week’s gains and a bit more, was a consequence of the Fed’s lower US growth forecast, which coincided with evidence from Europe and the US that the economy is indeed slowing. As usual, it will take the ‘fast brigade’ a little longer to get their heads around major policy changes. But initially, all change seems unnerving.