There has been much hand wringing over the Brexit process. Deutsche Welle reported that Angela Merkel stated that Brexit would leave a very challenging €12 billion hole in the 2021-27 EU budget. Across the English Channel, Politico reported that Brexit Secretary David Davis assured businesses that “the UK will not become a ‘Mad Max-style world borrowed from dystopian fiction’ after it leaves the EU”.
The U.K. will not undercut EU businesses on workers’ rights and environmental protections, David Davis will pledge on Tuesday.
Speaking to an audience of business leaders in Vienna, the U.K. Brexit secretary will insist that Brexit will not “lead to an Anglo-Saxon race to the bottom,” committing the country to “meeting high standards after we leave the EU.” But he will call for a post-Brexit trade deal in which British regulations are recognized by Brussels as comparable to its own.
Now we find out that the UK has proposed to stretch out the end of the Brexit transit period from December 2020 to *ahem* as long as it takes (see proposal here).
In other words, we have the usual European chaos and the latest act of European Theatre. But in chaos, there may be investment opportunity.
Capitulation
As a result of the uncertainties surrounding Brexit, investors have utterly given up on UK equities. The latest BAML Fund Manager Survey shows that UK equity allocations have bottomed out at historically minimum levels.
The relative performance of UK equities relative to MSCI World has also been in a steady downtrend (all figures are in USD). However, there is a ray of hope, as relative performance is testing a relative support level and may have bottomed.
This is looking like a washout to me.
The bullish catalyst
Enter a possible bullish catalyst. Business Insider reported that Pantheon Macroeconomics analyst Samuel Tombs, who was alone in calling the June 2017 general election, thinks there is a 40% chances of a second Brexit referendum, and therefore a 25% chance that Brexit doesn’t happen.
Tombs’ assumption is that macroeconomic conditions drive politics in Britain. His successful 2017 election prediction was based on the correlation between consumer confidence (which was falling before the vote) and whether a sitting government gains or loses seats in a general election.
Since then, he has argued repeatedly that no government can withstand the economic pain of leaving the EU with a bad deal (or a “hard Brexit”), and thus politicians will cave and either choose a soft Brexit or weasel out of leaving the EU entirely.
Tombs concluded that:
“It is becoming increasingly clear, however, that none of the forms of Brexit that the EU is willing to tolerate can command enough support from her own party’s MPs, or would please enough of the population for the current government to stand a realistic chance of winning the next election. Mrs. May might find that the only way to break the log-jam and save her premiership is to consult the country again,” Tombs says.
“Accordingly, a second referendum will become an appealing option for Mrs. May towards the end of this year or in early 2019. It would have to be held once she has negotiated a deal with the EU, with the options presented to the public being accepting the deal or staying inside the EU. She could claim that the first referendum was held when the public didn’t have the full facts, and she could argue that the decision was so momentous that the public should be allowed to voice their opinion again. It’s not guaranteed that parliament would vote for a second referendum-at present, Labour does not advocate one-but it would be hard for MPs to claim that the public should be prevented from having another say.”
Mind you, it’s only at 25% chance of a Brexit reversal, but a 40% chance of a second referendum which would spark a risk-on stampede. Tombs likely timing of such a development is late 2018 or early 2019, but the tea leaves would be apparent before the announcement.
From a chartist’s viewpoint, the technical conditions of lagging UK equity relative performance is starting to show a bottom. UK equities need time to start building a base before a period of relative performance can be sustained.
Be prepared.
Sitting here in the UK, I can categorically state that things are extremely complicated and quite fluid.
Similar to Tombs I would quote Porter from CS (best Game Theory, credit strategist out there), he sees a 75% chance of another referendum but is very uncertain about the outcome of a referendum. Clearly if the economy is doing less well then Brexit will be blamed and may swing the vote. But remember a huge proportion of the electorate certainly did not and probably still do not, actually know what the ramifications of voting for Brexit are.
It was a protest against many different things…..
The Tory party is fragmented and being driven in part by the hard right, however May has no mandate to deliver a hard Brexit (MPs will vote it down) and there is clearly no point in a soft Brexit as you just become a vassal state waiting for a Fax from Brussels or Berlin to inform you what the new rules will be. You still have to pay into the EU budget to get market access and so on…..pointless.
So hard Brexit is not possible and soft Brexit pointless which leads to a second referendum. You also have to bear in mind Labour (hard left) are waiting in the wings and have just stated they want to stay in the customs union, so becoming a party of soft Brexit and trying to force a split in the Tory party.
So fast forwarding to asset prices, EURGBP has been trapped in a range of 87-89 for quite some time now, as nothing has really changed. Were Brexit to be terminated then GBP would rally 5-10% and as the FTSE has a large proportion of USD earners, it won’t perform too well. It’s the domestic sectors and the REITS focused on London commercial property that will do well. And if a new election is called the £ will be fearful of a Labour government…..so it’s complicated, very complicated.