BREXIT UPDATE – DISCUSSIONS INCONCLUSIVE BUT BOTH SCENARIOS POINT TO POTENTIAL DOWNSIDE

To recap the current state of play – UK left the EU on 31st January and entered a “transition period” over by the end of 2020. There is no change of terms for either the UK or EU during 2020 and this transition period is supposed to give both parties time to negotiate trade terms effective from January 1st 2021.

While there is continuous press on the ongoing negotiations between the UK and EU, most talks on the end of the transition period agreement currently seem to be inconclusive. While there are rumours about the possibility of a deal coming in September, other sources deny this and argue that discussions have stalled and any agreement between the parties seems unlikely.

Currency traders appear to be ignoring Brexit as an issue all together as sterling continues appreciating (albeit in the backdrop of a persistently depreciating US dollar). During last week, Germany cancelled plans to discuss Brexit at a meeting of EU ambassadors taking place during the first week of September due to lack of progress in UK-EU negotiations. There was some hope that Angela Merkel could play an important role in breaking any deadlock but that possibility is now gone. Interestingly, sterling initially fell slightly on the news but recovered quickly and continues heading higher (as of Friday 28th August at 1.33 against the dollar).

JP Morgan analysts believe that talks will be difficult and any resolution on a deal will come late in the year with possibly only a very limited scope agreement. They also “expect market focus on the downside Brexit risks from ongoing talks to increase into the autumn”.

Similarly, economists at Merrill Lynch Bank of America are of the view that there are presently only two scenarios: 1. No deal or 2. A bare-bones/skinny trade deal, as there is not enough time left to negotiate more. Their base case scenario however remains to be some kind of a deal. In either scenario however, the believe that the UK would face large economic damage – cut of 5-10% off UK GDP in the long run (dependent on the precise deal/no deal outcome) and most likely also an interest rate cut to between 0% to -0.5% by the Bank of England.

In our view, Brexit still presents a considerable downside for the UK economy in the above highlighted scenarios, with no deal unsurprisingly causing more disruption in the near term. It is difficult to estimate the precise impact but we do not find it hard to imagine that all currency, asset prices and GDP growth would suffer; given this expectation, we continue to have a limited UK exposure in our portfolios.