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The risk of the UK exiting the European Union without agreeing its future relationship appears to have risen in recent weeks. We consider the ramifications of such an outcome for the UK economy and sterling-denominated assets.
With less than 18 months remaining for the United Kingdom to negotiate its exit from the European Union, and seemingly little agreement between the two sides, financial markets may have to wake up to the possibility of a ‘hard Brexit’ sooner rather than later.
Michel Barnier, the EU’s chief Brexit negotiator, on October 11 said talks over the terms of the UK’s divorce from the bloc were “deadlocked”, with huge divisions between the two camps remaining after five rounds of negotiations, especially over the so-called Brexit bill.
To date there has been little sign of alarm in markets, with both the pound and sterling-denominated assets largely unaffected by the lack of progress in the negotiations. That is unlikely to be the case for much longer if the impasse persists.
According to Aviva Investors’ UK economist Stewart Robertson, fears the UK will crash out of the bloc in a disorderly fashion are overblown and the likelihood is the two sides will eventually agree some form of deal. However, it would be unwise to rule out the latter eventuality entirely, especially given the damage likely to ensue if it were to happen.
“It’s in both sides’ interests to reach some sort of agreement. As such, we think the risk of the UK crashing out is slim,” he says. “But even if the UK government strikes a deal with the EU, it will need to get it approved by parliament. To do so, it will have to get hard-line eurosceptics or a chunk of the opposition on board, which is not going to be straightforward.”
The WTO option
Robertson is dismissive of the argument, advanced by some eurosceptics, that the UK can simply quit the bloc and revert to World Trade Organisation rules without suffering significant economic damage.
“Potentially, trade will literally grind to a halt. The goods that someone was going to export from Britain the day before March 19 2019 won’t be able to move because the law has changed,” Robertson says.
Although authorities on both sides may agree some emergency measures to allow passage of those goods that were in transit to take place, Robertson believes it is inevitable trade will get hit hard; in the extreme stopping for a brief period of time and halting economic growth too.
Robertson says while it is true the recession forecast by the UK Treasury and others ahead of the June 2016 referendum was averted, that was due in no small measure to a sharp fall in sterling and further monetary easing by the Bank of England.
Already, there is evidence the mere prospect of Brexit is taking a toll on the UK economy. Having been the second fastest growing economy within the G7 in the second quarter of 2016, a year later the UK was growing slowest. Meanwhile, thanks largely to a plunge in the pound’s value following the vote, UK inflation is now comfortably the highest among the G7 nations; with the Consumer Prices Index hitting three per cent in September.
Good for gilts
Robertson believes in the event no deal is reached, the Bank of England would be prepared to overlook rising inflation and ease monetary policy – despite the fact that on November 2 it raised interest rates for the first time in over a decade, from 0.25 per cent to 0.5 per cent.
That view is shared by Edward Hutchings, senior UK sovereign portfolio manager at Aviva Investors, who believes the danger posed by a breakdown of the Brexit negotiations is just one reason to own UK government bonds at present.
“While the Bank of England is embarking on a rate-hiking cycle with some justification, it’s debatable whether it’s the right thing to be doing given the fragility of the economy. If you get to the first quarter of next year and businesses are still none the wiser on the Brexit negotiations, investment will start to fall steeply,” he says.
In such an event, Hutchings argues the bank would be almost certain to reverse any rate hikes it makes in the coming months and possibly recommence quantitative easing. He says while it is too early to be buying gilts solely on the potential outcomes of the Brexit talks, if the UK were to crash out of the EU, inflation-linked bonds would do especially well. “You’d have the best of both worlds: falling conventional yields and rising inflation.”
However, he cautions there are also plenty of risks facing the gilt market, which are no doubt deterring some buyers at present. Chief among them is the perceived fragility of Prime Minister Teresa May’s government. If she were to go Labour leader Jeremy Corbyn could gain power, which would likely lead to a big fall in gilt prices given his wish to embark on a massive programme of government spending.
Hutchings says the risk of a sharp fall in sterling if the UK crashes out of the EU is also likely to be deterring foreign buyers, who make up between 25 and 30 per cent of the market.
Bad for airlines and banks
From a stocks perspective, Trevor Green, head of UK equities at Aviva Investors, believes crashing out of the EU without a deal would present a material risk to some companies and their shares, among them airlines, which could potentially lose the right to fly to European destinations.
The head of Ryanair, the Irish budget airline, recently warned flights between the UK and Brexit are imperilled by Brexit. Chief executive Michael O’Leary said if Britain gets pushed out of the EU, “it is absolutely the legal position that flights must stop”.
Rival low-cost carrier easyJet is to establish a new airline, headquartered in Vienna, to enable it to continue operating flights within the EU after Brexit. But the company still faces legal uncertainty over whether it will be able to fly between the UK and Europe, and on what terms. Green has materially reduced his fund’s exposure to easyJet’s shares over the course of this year as a result.
There could also be implications for the shares of UK-listed banks. Some UK lenders stand to incur sizeable costs to relocate parts of their business to avoid losing so-called passporting rights, which allow financial companies based in the EU to sell products and services across borders. Secondly, their businesses are especially sensitive to any economic shocks that may ensue.
Green also sold out of positions in various retailers and leisure companies earlier in the year, due to concern sterling was in danger of depreciating further. A weaker pound would squeeze such companies’ profit margins as it would simultaneously raise import prices and – since it would lead to higher inflation – supress consumption. Robertson believes sterling – which fell almost 14 per cent from the referendum on June 23, 2016 to November 6, 2017 – could potentially drop another ten per cent in the event of no deal.
In terms of other consequences, Green says a sharp reduction in the flow of migrant labour presents a serious threat to the business models of a wide range of companies, from housebuilders to fast-food outlets.
On the other hand, he says, there are plenty of companies with significant overseas earnings – such as in the oil, mining, pharmaceutical and tobacco sectors – that stand to benefit from a potential further decline in sterling. Others, including the likes of consumer products maker Unilever and RELX Group, which provides information and analytics to a range of global businesses, could do well for the same reason.
Sterling: a global credit market
As for corporate debt, portfolio manager James Vokins says it is important to recognise the sterling credit market is one of the most global, with much of the outstanding debt having been issued by non-UK companies. The outcome of the Brexit negotiations has few implications for most of these bonds beyond any impact it has on the currency.
Nevertheless, since Brexit could hurt the UK economy, Vokins says investors need to analyse what impact a downturn would have on companies with significant UK earnings.
Like Green, Vokins is cautious of UK-focused companies in the retail and banking sectors whose fortunes tend to be cyclical – in other words, closely tied in to the performance of the wider economy. He is also wary of investing in debt issued by property companies.
“We’ve had a record amount of sterling corporate debt issued this year and around half of all deals brought to the market have been property related – many of which are unsecured, so investors need to be very selective in this sector,” Vokins says.
Real assets caution
Chris Urwin, head of real estate research at Aviva Investors, says Brexit is just one more reason to be cautious of the UK real estate market. He argues while the Bank of England’s recent forecast that 75,000 City jobs are at risk may be too gloomy, it is clear many jobs will disappear regardless of the outcome of the talks, which is reason enough to be cautious on the central London office market.
“It is a very cyclical market. Prices are already well above where they were at the top of the last cycle, and you’ve got supply going up at a time there is a lot of uncertainty over future demand,” Urwin explains, adding that retail is another sector that could be in for a difficult period. However, given that commercial real estate will be partially cushioned from the low returns available from competing investments, Urwin is more positive on the outlook for market segments such as regional offices and logistics.
Barry Fowler, managing director of alternative income solutions at Aviva Investors, says it is important to recognise that some private asset markets are much more sensitive to the performance of the wider economy than others.
“The majority of infrastructure investments are fairly safe, with a low probability of default on most debt transactions. For example, most private infrastructure deals are structured in such a way so as to protect investors,” he says.
However, Fowler concedes that if Brexit were to lead to severe economic disturbance, investors would need to ensure covenants were not being breached and, where they were, take early remedial action.
Echoing Urwin, he says real estate investments look more vulnerable given the market is in the late stages of its current cycle. Fowler is also concerned about what an economic downturn could mean for leveraged loans, saying he would be “much more circumspect” about this kind of lending activity.
Darryl Murphy, head of infrastructure debt at Aviva Investors, says while infrastructure investment in the UK is likely to continue and arguably increase to support the economy, a wide variety of assets could be adversely affected if Brexit triggers an economic downturn. He goes on to warn that the sector risks being cut off from access to valuable European Investment Bank financing, threatening a number of projects. “Even though there is a lot of private capital available to fill the gap, the government needs to plan ahead and in effect increase its ‘financing toolkit’ to bridge any potential market failure,” Murphy says.
For now, investors appear content to take the view that even if the negotiations between the UK and EU appear to be making little headway that is because both sides are playing a game of brinkmanship. But with the clock ticking towards Britain’s March 2019 exit from the bloc, without signs of progress it is only a matter of time before they start reacting more violently. Investors need to be on their guard if the talks continue to flounder.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 9 November 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.