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A solid majority for the Conservative Party should have a calming effect on markets in the near term. Does the new majority mean that the obstacles to Brexit are gone and only sunny skies are ahead? Looking into the second half of 2020, political risks in the United Kingdom (UK) remain as the country redefines its relationship with the European Union (EU) and overcomes its internal political rifts. Medium-term investment choices should be driven by an assessment of how those two political processes unfold in 2020.
So What Happens Next?
The Prime Minister has already outlined the Parliamentary program for the next few weeks:
On 19 December, Parliament is to be recalled and there will be a scaled down opening and Queen’s Speech
On 23 December, Parliament will vote on Brexit
The bill to implement Brexit will be debated in January. The exit from EU is scheduled for 31 January. The House of Lords may make some technical amendments but will not stand in the way
The Future Relationship
On Brexit, the implications are relatively clear. The UK will ratify the Withdrawal Agreement with the EU and legally cease to be a member state on 1 February, which entails a transition period (during which time everything would stay the same) through 31 December 2020. The new government will only have a few months to decide whether it can manage to conclude a trade deal with the EU or opt for an extension of the transition period by two years. Failing either, trading will be on the World Trade Organization’s terms.
Given the size of the parliamentary majority – the largest Conservative victory since the Thatcher era – we are very confident that the tail risk of a no-deal crash out is negligible. The more difficult question centers on whether Prime Minister Boris Johnson will prefer a bare-bones trade deal (e.g., covering tariff-free trade in goods with EU access to UK fisheries) to an extension of the transition period.
There is a strong likelihood that the government will pursue an extension for several reasons. First, any extension period would still comfortably end well before the next election. Second, Johnson has proven himself to be a ruthless operator of party discipline. Third, the relative gains of any trade negotiation freedom would be intangible. Finally, a good proportion of the new Tory constituencies contains Leave-voting seats with a larger working-class profile. These voters care less about the free-trade element of Brexit than the political identity of British exceptionalism, which will have been largely validated by Britain’s exit from the EU’s political institutions.
Expect a Burst of Fiscal Spending
For similar reasons, this should lead to a multi-year fiscal expansion as the new government shores up its support in newly won constituencies through government largesse. The change in fiscal rules in early November was a preparatory step in that direction, aiming for a current budget balance by 2023 and allowing net public sector investment of up to 3% of GDP.
In practice, we estimate that the net fiscal expansion will equate to roughly 0.3% of GDP in 2020 and nearly 0.8% in 2021. When compared to the austerity of the 2010s and the projected fiscal path as per Figure 1, this is a material stimulus.
The projected constraints on fiscal rectitude in the latter years are based on the assumption that the Labour Party will undergo a renewal in the post-Jeremy Corbyn era. This does not imply a return to centrism but the continuation of an interventionist agenda, led by a more palatable leader. This will reinject political competitiveness into UK politics later into the term of the Conservatives, forcing them to re-embrace fiscal responsibility as a differentiator.
Short-Term Backdrop Favorable for European Equities
In addition to the moderate fiscal expansion, the reduction of Brexit uncertainty coupled with a recovery in global demand should invite a revival in UK business investment. Figure 2 shows just how severely business investment ground to a halt after the 2016 referendum. While it will certainly not catch up to the pre-referendum trend, investment growth should definitely turn positive in 2020, especially for domestic-oriented companies.
The composition of investment could also change over the course of the transition period. With the advent of 5G and its myriad new applications, we see a case for even more emphasis on software and technology. These are also areas that are indifferent to the ultimate UK-EU trading regime and should potentially attract more investment by US firms.
Business optimism remains near post-referendum lows, reflecting how uncertainty has hampered investment. Both metrics should move upwards in the coming months as optimism rises and feeds through into actual increases in investment. Nonetheless, full normalization would require clarity over the long-term future trading regime with the EU, which is unlikely to be forthcoming.
Sterling has surged on the Conservatives grabbing a sizeable majority in the election. Whilst many investors are not yet net long, they have covered large short positions and we believe that this will limit any further upside to Sterling until the macro data bear out a broader recovery. In the meantime, the near-term stabilization of Sterling’s exchange rate facilitates benign monetary policy settings. This should also lead to stable gilt yields, perhaps with a slight upward bias as the economy gathers momentum.
In contrast, the equity market should be more dynamic. In fact, much of the supportive outlook has already been priced in by the domestically focused FTSE-250, which has outperformed the FTSE-100 by roughly 8% since end-August. This relative outperformance is on the premise of political clarity with much less exposure to currency strength or the outlook for future UK-EU ties. Investors have responded by buying the FTSE-250 at double the pace of the FTSE-100 on a relative assets under management basis. Domestically oriented companies may have priced in much of the benefits of Brexit resolution and easier fiscal policy. Momentum could continue as short interest remains higher for the FTSE-250 than the FTSE-100.
Brexit clarity may give European markets an uplift more generally. A decent Conservative majority should help UK assets consolidate given reasonable policy underpinning. With the China/US trade dispute achieving part resolution, we could also see a short-term tilt towards continental Europe. In this regard, there are tentative signs of improvement in the important external sector. This is a key driver and our internal tactical models turned positive on European equities in late November. However, longer-term investors are likely to want to see evidence of material structural reforms in the Eurozone before taking a significant overweight stance in those markets.
Political Risk May Yet Return as Brexit Details Evolve During Transition Period
By the middle of 2020, Brexit clouds may again gather on the horizon: the lack of clarity over long-term trading relationships risks stemming the positive momentum.
While we expect an extension of the transition period beyond 2020, we may not know this until mid-2020 and a disruptive move towards a bare-bones free trade deal by year-end 2020 remains a possibility. Such developments would be market-negative, so investors will continue to look for political signals throughout the spring for the prospects of year-end disruption. In this regard, Sterling will again be the main pricing indicator of market confidence, with the currency potentially approaching last summer’s lows again in a worst-case scenario.
In addition, other post-Brexit policy plans, for instance around immigration or regulation, could offer potential for market disappointment. This could be two-fold as government plans may not fully materialize in the absence of the UK-EU trade deal, and as considerable trade-offs will exist between potential policy divergence and the costs of disruption.
UK Government Options on Future Relationship
Strike a trade deal
A temporary set of arrangements with the EU
Exit on WTO terms
An extension to the 2020 transition period (our most likely outcome)
The views expressed in this material are the views of Elliot Hentov, James Morgan and Esther Baroudy through the period ended 13/12/2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements.
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