Brexit crossroads: Possible paths ahead and their impacts on assets
Things have been very fluid in the last 24 hours, but we believe markets still ascribe a low probability to a Brexit deal by end-October. Beyond that may loom new negotiations and elections, potentially a final turn in the Brexit saga. The consequences will be important for the UK, but also for the rest of Europe. In this Q-series report, UBS economists, strategists and equity analysts sift through a multitude of moving parts to crystallise key asset signals. We take a fresh look at the cost the economy and markets have already paid since the 2016 referendum, the degree to which Brexit Risk is priced across different markets and how risk-reward now sits along the paths ahead. We\ highlight most/least favoured UK stocks, as well as Brexit-impacted companies globally.
Key assets imply Brexit Risk is at the 94th percentile
Rather than just focussing on the currency, we construct a Brexit Risk index by aggregating five key variables across asset markets, weighted by their sensitivity to Brexit news. This tells us that the market-implied Brexit Risk is currently at the 94th percentile of its distribution since the beginning of 2016. UK real rates and the relative performance of domestic versus international stocks are modestly more stretched in their history than the trade-weighted GBP or EURGBP volatility.
The cost to the economy: GBP 525 mln per week and counting
In a Middle-Ground outcome of extension/negotiation, the cumulative output loss (vs pre-Brexit trend) from 2016-2023 is estimated at 6½% GDP (3.7% so far, or GBP 525 mln per week). Sustained subpar growth would likely require BoE to cut to 50bp. A nodeal Brexit has the benefit of clarity but would likely see the UK in recession, suffering a cumulative output loss of 9% by 2023e. We think unemployment would likely rise to 5.0% (450k jobs lost), the BoE would move back to the ZLB and restart QE, and trade weighted GBP could depreciate 12-14%. The third possibility—revocation of Art.50 possibly after another referendum—could lead to a temporary surge of growth on pent-up demand, but the upside in the GBP may be less than some investors think.
GBP rally limited in a good outcome; hit to EUR underestimated in a bad one
We estimate that ‘relative to a no-Brexit counterfactual’ the GBP real effective exchange rate is only 7.6% weaker in the last three years. If Brexit is reversed, we think EURGBP is unlikely to revert to its pre-referendum level of 0.70; the global, especially Eurozone, economic momentum has changed considerably since. But the market is justifiably more worried about a no-deal Brexit, and here we find it intriguing that GBPUSD vol is at the 90th percentile of its post-crisis history, while EURUSD vol stands just at its 3rd percentile. This treatment of a no-deal Brexit as a hit entirely idiosyncratic to the UK makes little sense to us in the context of a potential 60-70bp impact on Eurozone growth from an already weak level. EURUSD puts present a cheap way to hedge against a poor Brexit outcome in the next three-six months.
Assuming there is no debt event, which seems unlikely given the lead time, the biggest impact for Australia short and long term will be the fate of EUR.
If it does fall as much as UBS reckons then that’s a commensurate rise in DXY against which AUD will struggle mightily as the entire EM and commodity complex comes under pressure.
Long term, a successful Brexit sets up Italexit and, at a certain point, the structural flaws in the EUR may render it uninvestable.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
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