In the final days before the UK is due to leave the European Union (EU), the drama is beginning to move from London, where attempts to get a deal through Parliament have so far been crushed, to Brussels. Instead of risks being centred on the UK economy, Brexit is now exacerbating the economic, political and geopolitical challenges for the European project.
First, we see a significant economic impact; the post-referendum drop in UK performance relative to the Eurozone has now ended with both economies growing below trend.
Figure 1 illustrates the drop in British consumer confidence following the 2016 vote and the recent drop in Eurozone confidence. Moreover, the 2016 depreciation of Sterling removed the UK as a source of external demand for the rest of Europe.
Figure 2 shows that the reverse has now taken place with UK exports to the EU no longer growing either. Using German exports to the UK as a proxy for the wider EU, it appears that British demand has been less of a contributor to growth in the last three years compared to the pre-2016 period.
Second is the political impact from Brexit on the looming European parliamentary elections in May. Complementing the drama in Westminster, a chaotic Brexit or the length and nature of any extension of the Article 50 process holds considerable influence over the outcome of these elections. Indeed, they are pivotal continental Euro-sceptics and populists to gain enough seats to shape the course of future European policy making. Third are the geopolitical ramifications of Brexit. Internal European political tensions are brewing at the same time as Europe is struggling to contend with the geopolitical tremors being created by external forces such as the US, Russia and China.
In short, the timing is bad and therefore Brexit bears a disproportionate risk to Europe. So far, markets have remained calm, pricing in the assumption that there will be a civilised resolution to the Brexit impasse. In fact, Sterling is the best performing G10 currency this year whereas the Euro has languished (see Figure 3). Options markets expect the volatility in Sterling to moderate after the end of the month – back to long-term averages – and expect the euro to continue to show extremely low volatility, much lower than it has historically.
Below we outline the three most likely outcomes at the time of writing. This suggests that the current status quo of stable uncertainty could continue for some time. In our view, all scenarios would indeed prolong the standoff, though they vary in immediate impact.
While scenario 1 is still a low-probability event, it would have a huge impact. If the UK does leave without a deal, we believe that the market is unprepared and that, not only would the pound fall but also the euro, while the US dollar would gain. There is also likely to be some flight to safety into the yen and Swiss franc.
With contributions from Sophie Brodie, Senior Investment Communications Strategist
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The views expressed in this material are the views of Elliot Hentov, Esther Baroudy and James Binny through the period ended 03/20/2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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