Brexit – The impasse to be crystalized (part 2)
(this is the latter part of our weekly blotter.Please find part one here)
Why do markets start caring this week?
I have been amazed that this slow-moving train wreck which is Brexit has not had a more detrimental impact on UK financial assets and especially, the pound on a trade weighted basis. Back on September 30th, I wrote the following about why Brexit and other geo-political issues like Italian politics or the US mid-term elections haven’t mattered until now:
We have all had it drummed into us over the years that financial markets are discounting mechanisms that price future events efficiently. I have never been a believer in this. Prices of late, across an array of assets have been very focused on what is happening today. Brexit was not a worry because that was a Q4 2018 story. The Italian Budget? We know Italian politics is a shambles, but this won’t be a concern until later in the year. Predicting the outcome of the US mid-term elections is something we can deal with in November and while it is pretty clear that US profit growth will slow in 2019, Q3 and Q4 profits will be fine so let us concern ourselves with that when the slowdown actually occurs.
How far forward markets are prepared to look is impossible to answer but here is what I do know. This list of concerns, excluding US profits are worries for Q4 and we are entering Q4. As the widening of Italian spreads showed us on Friday, these major headwinds cannot continue to be pushed to one side*.*
Will the Brexit debacle, the US mid-term elections and the Italian budget start to affect the outlook for growth, profits or the cost of funding? The answer for me is unequivocally yes and not just within the specific geography. The widening of Italian spreads will lead to EM spread widening, Euro weakness and a flight into quality sovereign bonds. The increasing inevitability of a no deal Brexit either due to the EU and UK not reaching agreement or more likely, Prime Minister May’s inability to get any agreement through Parliament will lead to pound selling and USD strength.
Brexit is something that investors can no longer ignore. Markets can no longer ignore Brexit if Wednesday’s EU leaders meeting leads the conclusion that no resolution can be achieved the November meeting. A deferral, to say December would crystalize the fact that a hard Brexit is increasingly likely. While Mrs. May could survive the resignation of one, maybe two hard-line cabinet members, but any more than this and her leadership is in grave danger. The UK press is reporting that at least three cabinet ministers are “considering their positions” over concerns about an open-ended Customs Union with the EU over Northern Ireland. A leadership challenge at this stage would be a diabolical outcome for the GBP. In fact, any of these outcomes would see the GBP fall sharply against the USD and the currencies of all major trading partners.
This isn’t just a UK problem but an everybody problem. The independence of markets.
The only proof you require when assessing the lack of interest that financial assets have had with Brexit is the relationship between the GBPUSD exchange rate and the trade weighted pound. As you can see by the following chart, the correlation remains incredibly high which implies that the USD has been the dominant driver of the pound and the nuances of the UK economy and Brexit negotiations haven’t really mattered that much. If Brexit worries mattered, the trade weighted pound would be significantly weaker than the GBPUSD exchange rate. This simply has not happened.
The key question for the next week and beyond is can we have a sharp deterioration in the outlook for Brexit with an accompanying depreciation in the value of the pound without the dollar spiking more broadly.
This is where the idea of UK contagion kicks in. In the next report I will elaborate on the other risk factors for the next few weeks, several of them will come to a head in the next few days but I want to make the point that a significant rally in the USD driven by Brexit or the Italian budget will lead to the selling of risk assets more broadly. I see this as unavoidable. While the US earnings season has the chance to stabilize sentiment regarding US equities, a spiking USD due to European political dysfunction will leak elsewhere. Not because the widening of Italian spreads directly effects corporates around the globe but because a strong USD hurts, as do higher credit costs. Italy and Brexit are the catalyst for USD strength. USD strength is the catalyst for selling everywhere else.