Tuesday, December 8, 2020

Deal or no deal: Brexit keeps markets on their toes

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It’s been nearly four-and-a-half years since the British electorate voted for the United Kingdom (UK) not to remain in the European Union (EU), but what this means for the future of their trading relationship and global markets remains as unclear as ever.

The two sides seem to have been locked into the same game of poker for all that time with neither willing to reveal all the cards they hold, nor how they will finally play. But if a trade deal cannot be agreed before December 31st, 2020, the two sides will have to revert to World Trade Organization (WTO) trading terms. Whatever happens, investors will need to be prepared for a variety of scenarios.

It is all but impossible to predict. Both sides appear determined to strike a deal yet both seem equally determined that this deal should be to each of their advantages, or at least not to their disadvantage. For Europe there is the added, though not stated, position that the terms should not be so generous that others currently having fraught relations with the EU, such as Greece or Italy, decide that they too would be better off going it alone. For the UK, its determination to maintain access to European markets while refusing to accept its rules would also suggest a solution is nigh impossible.

If both sides are more determined than they have made clear that they want to strike a deal come what may, then perhaps there will be imagination enough around the negotiating table to reach a workable agreement. It is possible that both sides realise that while the COVID-19 pandemic damages trade and economies round the world, and US politics seems on the precipice of a period of uncertainty, now is not the time to add to the world’s difficulties.

A deal is still possible, negotiators say, and this would be a boon to markets

If a deal is agreed between the UK and the EU, this would likely result in an immediate uptick in world equity markets, particularly those in London and Europe, with a strengthening in sterling in particular and the euro against other currencies a possibility.

Sterling and the FTSE 100 have swung this way and that on every step both big and small of the Brexit negotiations since the end of March 2017, when the haggling began, and the UK stock market has lagged markets of other major world economies since the referendum result came through. Sterling jumped more than 0.8% against the dollar in a single day’s trading in October, for example, after EU chief negotiator Michel Barnier signalled that a trade deal was still possible “if both sides are willing to compromise and if we are able to make progress in the next few days on the basis of legal texts and if we are ready over the next few days to resolve the sticking points, the trickiest subjects.”

Not all of the UK market’s underperformance can be blamed on Brexit. Oil companies comprise a larger share of the UK market than most others and the oil price has been low this year due to COVID-19’s impact on fuel demand. COVID-19 has also persuaded many large British companies to hold back dividend payments amid the pandemic and this has deterred some investment from its stock market. Where COVID-19 has proved a boon for markets, however, such as those with a large technology sector, this has not helped the UK market as it is relatively light on tech shares.

The danger of ditching UK shares and sterling as the negotiations continue to fray investors’ nerves, is that any recovery if a deal is struck would be missed out on, in effect guaranteeing any losses so far incurred. It may, however, pay to ensure stock portfolios are adequately diversified across geographies so that any sharp movement in either direction is smoothed out.

Beyond this, there may be an upswing in risk-on investments of all kinds if a deal goes through. The initial reaction could be especially positive given the excess of negative news for investors elsewhere, particularly the damage done to global trade and economies by the coronavirus pandemic since March and the divisions in the US amid the presidential election.

After the first day’s reaction to any deal, investors would then pore over its details to determine what they entail for different industries and asset classes.  

Market moves in 2016 indicate how markets may move when negotiation outcome is announced

If a deal cannot be agreed, however, markets will take a backward step, particularly the FTSE 100, which could feasibly decline by a double-digit percentage. Beyond London and Europe, a failure to agree a deal would weigh heavily on global risk sentiment and thus asset prices, which would in turn weigh on business and consumer sentiment and prolong the global economic malaise of the COVID-19 period, further depressing both interest rates and commodities prices.

An indication of what might happen in the event of no deal is provided by the market’s initial reaction to the referendum result. On 24 June 2016, the first trading day after the referendum, sterling tanked, equities fell and gold jumped. Investors also sold off bonds of the euro zone 'periphery countries' (Italy, Spain, Portugal and Greece) and shares in European banks. The pound suffered most, at one point in the day tumbling 11% to its lowest mark against the dollar since the mid-1980s. By the close of trading in New York, sterling had bounced back some to be off 8% on the day.

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The FTSE 100 tumbled almost 9% at the open, but as the index’s constituent companies generate about 70% of their revenues outside the UK, investors thought again and by the close of trade the index was down just 3.2%. The FTSE 250 index of mid-cap companies, which is far more dependent on UK revenues, ended down 7.2%, however.

European markets weren’t much better, with the Euro Stoxx 600 dropping 7%. In New York, the S&P 500 fell 3.6%, led by the financial and technology sectors, as investors moved into safe-haven assets. Banks and asset managers were among those hit hardest as investors priced in a smaller pace of rate rises from the Fed. The Brexit vote outcome weighed on other global markets – Japan’s Nikkei 225 fell 7.9% and Australia’s ASX index slid 3.2% – and on bank shares around the world. Hong Kong-listed shares of HSBC and Standard Chartered fell as much as 10%, while the Euro Stoxx Banks index plunged 18%. UK banks were also punished, with Royal Bank of Scotland, Barclays and Lloyds recording double-digit declines.

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Although markets made some recovery after the first traumatic day’s trading, Brexit has continued to act as a brake on global investment and trade ever since, and thus on markets, joined later by fears surrounding the US-China trade spat.

Safe havens have been the beneficiaries. Gold rose as much as 8.1% on the day after the referendum and closed the global day up nearly 5%. The metal continues to push to new highs as trade and the COVID-19 pandemic rock other asset classes, and for much of the second half of 2020 gold has traded above or around USD 2,000 an ounce. Among other safe havens, the Japanese yen rose 3.7% on the first day of trade after the referendum result – at one point it was up 6.7% – and the yield on the US 10-year Treasury bond fell more than 30 basis points to 1.40%, its lowest level since 2012.

Emerging markets also suffered as investors sold off riskier assets, with currencies including the South African rand, Polish zloty and Mexican peso all down more than 3%.[1]

Portfolio diversification likely to be maintained even as deal is struck

With a deal between the UK and EU looking the most likely outcome, an immediate shift into risk-on assets would be the most likely initial outcome, although the longer-term market boost will depend on what type of agreement it forged and on the fine print.

Any initial surge is likely to be short-lived as there are likely to be some negatively perceived outcomes for some sectors in the UK or Europe and investors will need to assess just how negative these might be.

Investors for this reason are likely to move a little more into riskier assets if a deal is looking likely, but to maintain a high degree of diversification in their portfolios until there is a greater degree of clarity around the details.

[1] https://www.ft.com/content/50436fde-39bb-11e6-9a05-82a9b15a8ee7