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Equity Research; Brexit “stabilisers” ahead

“Brexit” “what if” scenarios in the run-up

With 31st October 2019 fast approaching we are compelled to conclude a “no-deal” Brexit is more likely than not. Why is this?

Johnson handouts effectively end austerity

The new government has embarked on high publicity spending commitments and making grandiose tax cut promises. These variously include:-

If delivered, these measures amount to a stimulus package of tax cuts and spending increases. All of these items might not get to the final cut, but we believe Johnson will lift government spending as part of a re-election campaign.

UK debt to GDP (ex. BoE’s debt holdings) stood at 74.1% of GDP in July 2019. The UK budget deficit fell to £23.6bn in FY19 but will hit £29.3bn in FY20 due to Brexit. We see Johnson as a spender with little incentive for budget restraint.

UK monetary stimulus also likely

The decline in 10YR gilt yields over 2019 (1.3% to 0.47%) and in 2 year yields (0.42%) suggest a rate cut soon. A cut in Base rate to 0.5% in 2019 is likely.

Source: www.fixedincomeinvestments.com

An expected 0.25% reduction in the base rate will boost the UK consumer in Q3/Q4 2019 and cushion a “no deal” Brexit and/or combat a trend towards slowing GDP (-0.2%).

But whether a base rate cut helps capital markets is moot. The main critique of the 2019 monetary easing cycle is that rate cuts are far less effective and will achieve a fraction of the 2008/ 2009 impact. Central bank easing is a blunt tool that carries the full gamut of disproportionate impacts and societal problems. These are better understood than in 2008/ 2009.

In 2019/ 2020, central banks must guard against increasing the stock of negative yield government debt (c.$15trn), which is deflationary, reduces investment returns and represents a time bomb for the banking sector. It is a likely cause of the next crisis. If the response to slowing GDP growth is conventional rate cuts, then can only be employed very sparingly.

Four countries, Denmark, Germany, Netherlands and Finland have negative government bond yields across the yield curve spectrum. The extreme pricing of bonds brings the risk of a crisis when the trend reverses. Central banks might have to reverse QE i.e. turn sellers of their debt for yield curve normalization.

We conclude UK markets are largely pricing in both lower rates and a bad “no deal” Brexit

The August global re-pricing – a reaction to evidence of slowing GDP growth, the ongoing Sino-US trade dispute, and disappointing Federal Reserve monetary guidance was hard on UK/ EU capital markets with July peak to August trough losses (-8.1%/ – 11%) underperforming global (-6%)and US indices (-6.8%).

Index July 2019 peak August 2019 trough 1MTH (%)
US30 27,349.19 25,479.62 -6.8
US500    3,025.86   2,844.74 -6.0
UK100    7,686.61   7,067.01 -8.1
UK250 20,849.24 18,565.71 -11.0
DAX30 12,629.90 11,412.67 -9.6
CAC40   5,618.16   5,236.93 -6.8
Nikkei 21,756.55 20,405.65 -6.2
Hang Seng 28,594.30 25,281.30 -11.6
World Index 530.48 498.63 -6.0

In the re-pricing, investors ignored the higher chance of lower rates and no deal Brexit. The PM has increased the conviction that October 31st 2019 is firm and increased “no-deal” odds to c. 13/10 (www.oddschecker.com).

We see a hard Brexit as c.50% priced in with c. 1.5%-2.5% downside if it occurs. “No deal” is one of a host of risks, some with a greater downside magnitude (i.e. change of government). A UK rally is possible if i) global equities bounce or ii) a EU deal materializes that preserves UK/EU free trade or iii) Sino-US trade deal.

If the government survives, a hard Brexit followed by a General Election is the likely trajectory with a soft Brexit followed by a General Election a lower probability. H2 2019 will be eventful but is starting with low expectations, usually a good thing.

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