What is Brexit? It is similar to blowing up your house while trying to swat a fly. We expect that Brexit will be in the spotlight in coming weeks and will replace COVID as main concern of UK businesses as acrimony between the UK and the EU is increasing fast. The risk of a no deal Brexit is being priced in higher by the market, but it is bright clear there is room for higher volatility and more downside on UK assets as we are approaching the soft deadline of October 15 set by Prime Minister Boris Johnson to reach an agreement. Given uncertainty is jumping regarding the negotiations and post-Brexit UK (especially over taxation and the status of the country in international markets), we would not be surprised to see a reversal in economic activity in Q4 on the back of a new contraction in business investment and sluggish aggregate demand (Fig. 1). The short- and medium-term outlook for UK assets is becoming gloomier every day. The Brexit equity risk premium for companies most exposed to the UK market has risen again recently. While some investors may consider it is the best moment to buy discounted stocks, we think that too many risks are still present and a wiser way of investing consists in reducing exposure to UK assets in these uncertain circumstances. The GBP has lost ground versus its main counterparts over the past days and more bad news in the short term will certainly fuel the bearish momentum. With the EUR/GBP cross pushing past resistance at 0.9135 earlier this week, we expect the upward trend to continue with an upcoming test of the resistances at 0.9285 and 0.9387 (Fig. 2). We believe there are mostly three options on the table for the UK/EUR relationship: (1) a thin deal, which would be the best-case scenario, (2) no deal and (3) no deal in very acrimonious circumstances. As of now, the latest option seems to be favored by the UK government but the situation can evolve quite fast. This is like a roller coaster. In case of a no deal, the Bank of England will widen the scope of its support to the economy, first resorting to QE and temporary financing of the government via the “Ways and Means Facility”. This backdoor debt monetisation should limit the negative financial and economic consequences of a no deal Brexit and, in case of a thin deal, it could serve to finance the new interventionist policy that is winning in London (Fig. 3). The next important step for the UK/EUR relationship will take place on September 25 with a special EU Council over Brexit.
(Fig. 1) Macro : No deal Brexit noise in the context of post-COVID recession put at risk the slow recovery that started once the lockdown has been lifted. Increasing uncertainty about the future is likely to reinforce pre-existing trends towards higher savings and lead to a new contraction in business investment that could result in a reversal in economic activity in Q4 this year.
(Fig. 2) Markets : As Brexit uncertainty increases, the Brexit risk premium is doomed to increase in the coming weeks, with lower stock market performance from companies most exposed to the UK market. So far, the forex market has been rather quiet but we think there is room for further bearish GBP bets in the short- and medium-term.
(Fig. 3) Monetary Policy : The recent jump in inflation is unlikely to prevent the Bank of England from easing further monetary policy in case of no-deal Brexit. We favor two scenarios: (1) more QE or (2) more QE and negative interest rates. However, this latter option might still cause intense debate within the MPC due to the well-documented impact of negative rates on bank profitability and risk-taking.