Equity Research; Brexit endgame

EU “withdrawal draft” is too close to call

The publication of the draft withdrawal agreement (585 pages) has clarified the type of “Brexit” that both the UK and EU envisage as operating in the transition period (a 21 month period post 29th March 2019) and how the relationship will be governed post the transition.

Key to understanding of the UK position is the UK’s need to prevent a “hard border” between Northern Ireland and Eire. To achieve this, the draft withdrawal agreement states the UK and EU will be in a “single customs territory” until the future relationship is determined.

The PM appears to be keeping open the option of extending the transition period, she has previously stated that if required “it would only be for a few months”.

What are the “known unknowns”?

There are a number of key variable short-term developments

a) The response of the “hard Brexit” contingent in the Conservative party. Last night Jacob Rees Mogg MP stated the PM had “surrendered to Brussels and given in to everything they want and tried to frustrate Brexit that it is not so much a vassal state anymore as a slave state”. Other “hard Brexit” MP’s such as Michael Gove have backed the withdrawal agreement. Within this group there is an element of “keeping the powder dry”. Even if the hard Brexiteers have the 48 MP support pre-requisite for a leadership challenge, it is not clear the group is sufficiently cohesive or coherent to act at this point. It is itself splintered by the approach to the UK/ EU draft proposals.

b) Conservative allies parliamentary support. The position of the DUP is probably splintered – Deputy Leader Nigel Dodds has criticized the deal and accused the PM of “breaking promises”. The position of leader Arlene Foster is not yet crystal clear. The 13 strong Scottish conservatives appear more onboard, the Scottish Secretary David Mundell has voiced support.

c) Labour Party support, the PM is appealing to Labour MPs to support this plan. Labour leader Jeremy Corbyn has said the existing plan “broke many of the PM’s own red lines”. Key to the success or otherwise of the PM’s plan is whether or not sufficient Labour MPs support the plan as offering the only credible alternative.

The EU has agreed to host an extraordinary summit on the morning of Sunday 25th November to “finalise and formalise” the Brexit deal struck with the UK PM.

In a clear indication of Brussels’ concern over the PM’s position EU President Donald Tusk has called on EU leaders not to “make too many comments”. Chief EU negotiator Michel Barnier has claimed the deal is “fair and balanced” and is working to support a positive reception amongst EU ambassadors.

Sterling? No bounce then

For over 2 years, currency pundits claimed a UK/EU deal would trigger rapid sterling appreciation. So far sterling has weakened on the perception that Parliamentary approval of the deal is going to be difficult. A rejection of the withdrawal draft would increase the risk of a “no deal” Brexit, and the UK crashing out of the EU on 29th March 2019.

In the short-term, the failure of the withdrawal deal would likely lead to the resignation of Theresa May as PM and a possible fracturing of the Conservative relationship with the DUP.

The assumption amongst some MPs that the EU will renegotiate and change the withdrawal agreement is in our view misguided.

If the UK crashes out sterling downside risk could be significant as there would likely be a hit to UK GDP and possibly lower Base Rate.

UK casualties are a “motley crue”

The equity casualties are a “motley crue” of UK focused businesses:-

  1. UK centric banks, Lloyds (-5.1%), RBS (-9.23%)
  2. UK retailers (Marks & Spencer -4.9% and Next -5.3%) with significant costs in USD and EUR.
  3. UK housebuilders (despite a reassuring Bovis trading update), Berkeley (-7.2%) Persimmon (-9.1%), Taylor Wimpey (-8.7%)
  4. UK utilities, SSE (-6.8%), Severn Trent (-4.2%), United Utilities (-4.3%) on the higher risk of a Labour government.
  5. Airlines (Easyjet and Ryanair -7%) due to Open Skies uncertainties
  6. UK outsourcer Capita (-14%) on the board’s admission that it failed to send 45,000 NHS letters

Short term this is not an equity market for the faint of heart and a great deal depends on the survival of the PM and this legislation, which is the only agreed offer on the table that provides for an EU exit with the minimum pain.

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