Market and Economic: Five-Year Outlook

UK: Economic fortunes in the hands of the politicians

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The UK financial markets, especially domestic currency markets (GBP/sterling), are highly sensitive to Brexit headlines. Until the summer, the debate had focused on a ‘soft’ versus ‘hard’ Brexit. Sterling tended to rally when ‘soft’ seemed more likely and vice versa. Now the issue is ‘deal versus no deal’.

The UK will leave the EU on April 1, 2019. If a deal has been struck by then, there will be a transition period until the end of 2020 when the UK will, in effect, remain within the EU from the point of view of trade in goods and services etc. Negotiations on a trade deal between the UK and the EU27 could then begin. Although it is unlikely that it would be fully ratified by the EU before the end of the transition period, businesses might have a reasonable idea of the shape of the future relationship. Uncertainty would be minimized.

In the no deal scenario, the UK would crash out of the EU, risking disruption to trade and an acrimonious relationship with the EU. The risks are especially high in areas subject to health and safety considerations such as food, medicines and air travel. For example, all UK food exports would have to pass through an inspection facility so that random checks could be made. No such facility exists at Calais, the main port for UK exports. No deal on trade means no deal on the ‘divorce bill’ whereby the UK has provisionally agreed to pay £39bn to the EU post-Brexit.

Some sort of deal is in the interests of the UK and the EU27. That does not mean a deal is certain, but it is our most likely scenario.

Given that, it is worth noting that the effect is likely to be a significant rise in sterling. This would reduce the sterling value of UK companies’ foreign earnings. We could therefore see the FTSE-100 weaken in this otherwise positive scenario.

A similar pattern would apply to UK government bonds (‘gilts’). Prices here would tend to fall in a ‘deal’ scenario and vice versa.

The reaction of sterling and gilts owes much to the likely response of the Bank of England. In a ‘no deal’ scenario, the Bank might cut interest rates, as they did after the Brexit referendum itself. But they would continue raising rates if there were a deal, just about any deal, that allowed for a relatively smooth transition. Indeed, we believe they would have already raised rates again but for the risk of a ‘no deal’ Brexit. The recent inflation report highlighted emerging domestic inflationary pressures, notably from wages. UK interest rates remain at emergency low levels and the Bank of England is set to follow their U.S. counterpart, the Federal Reserve, and normalize interest rates gradually though probably with a lower terminal rate than in the U.S. In this scenario, sterling would appreciate significantly.
 

GBP Broad Trade Weighted Index
Source: Bloomberg, as of September 2018.

 

Europe still on track

Growth in Europe has been disappointing. This time last year, the economy looked like it was booming, but 2018 has seen growth decelerate sharply as a harsh winter took its toll on activity. GDP growth was a meager 0.3 percent in the second quarter, a rate that even undershot the beleaguered, Brexit-blighted UK. But it’s far from being all doom and gloom. The eurozone is still growing at an above-trend rate, unemployment is falling and deflation is no longer a threat.

This means that the European Central Bank (ECB) can finally start to wean the region off monetary support by ending its asset purchase program (quantitative easing) at the end of this year and slowly start to raise interest rates from their negative level, probably sometime in the second half of next year.

The political and economic weakness of the eurozone’s third-largest economy – Italy – is a serious long-term threat. The government’s budget is currently marching in the wrong direction, cancelling the VAT increase and possibly unwinding the pension reform. But let’s not forget that Italy now has a current account surplus. It also has a cautious, high-saving private sector. And if Europe wants to keep the EU project on the road, it knows it needs to show Italy some love. Indeed, we expect talk without action by the EU Commission to the recent budget proposals by the Italian government.

The Italian coalition government has already realized that it needs to keep its ambitious fiscal plans contained. There may be new elections and a new government in 2019 but we believe that, on balance, investors are being sufficiently compensated for the risks in Italy.

The big issue, in our view, is not the threat from the EU authorities but rather the risk that Italian government debt is downgraded to sub-investment grade. Italy is currently rated two notches above sub-investment grade across the three main ratings agencies (S&P, Moody’s and Fitch). In August, Fitch followed Moody’s in adjusting the outlook for Italian debt to negative, escalating fears that they may follow through with a downgrade. At this juncture, it seems unlikely that either agency would downgrade Italy by two notches, while S&P has thus far taken a more sanguine approach, appearing to focus more on long-term dynamics. The 2.4% budget deficit initially proposed by the new Italian government was certainly on the high-end of expectations but it is worth putting this in the context of being well below the 6% number bandied about earlier in the year. The main risk appears to be both a downgrade while maintaining a negative outlook, leaving the market nervous regarding further downgrades to sub-investment grade.

Should two of these three agencies downgrade to sub-investment grade, many benchmarked investors (including the widely followed Bloomberg Barclays Global Aggregate) would be forced to liquidate holdings. We can be sure that markets will be volatile but overall, again, we think investors are reasonably well compensated for risk in Italian assets.

 

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