Insights


Brexit Focus Moves from the UK to Europe

  • As the Brexit deadline approaches, fallout from the drama has shifted from London and is now boosting challenges for the European project.
  • Brexit is now hurting economic performance in Europe as well as the UK.
  • We believe the three most likely scenarios would prolong the standoff, though they vary in immediate impact.

Esther M Baroudy
Portfolio Manager
Elliot Hentov
Head of Policy and Research
James Binny
Global Head Currency & Head of Investments Ireland

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.

  1. No deal crash out on the 29th of March : while highly improbable, such an outcome would not only cause maximum short-term disruption, but would fail to bring clarity. The UK would still need to negotiate a long-term trading relationship and resolve a variety of issues such as the Irish border.  
  2. A short-term extension and the ultimate passing of May’s deal: this is probably the preferred outcome of the British and EU leadership. It would lead to market relief but the rebound of the real economy would be constrained by the fact that it only allows for an 18-month transition period (from the end of the extension to year-end 2020) during which the long-term UK-EU relationship would remain uncertain – particularly given impending leadership changes in the UK and the EU.
  3. A long-term extension during which the UK explores another popular vote (either general election or referendum) or perhaps pursues a cross-party consensus for a softer Brexit. Any of these processes will continue to maintain uncertainty and reinforce underlying weaknesses in the economy.

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


Brexit Focus Moves from the UK to Europe


Disclosures

Important Risk Disclosures

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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