Ashburton’s Georgakopoulou: Brexit to become increasingly drawn out

Following the UK election result of a hung parliament, there have been incremental implications from a political, economic and market perspective.

It is challenging to infer how much of the result was due to the electorate prioritising their judgment on the various parties’ domestic agendas versus voting on the prospects of Brexit. However, as Prime Minister Theresa May was calling for a “greater control of Brexit” and increasing further negotiating power, we can say with some certainty that her vision of hard and clean Brexit has been voted down.

The election outcome weakens the UK’s negotiating hand via two channels; the first and most important is the weakening of parliamentary power. The second is the time lost during the last two months which can be seen as an opportunity cost vis a vis negotiating time. Since Article 50 was triggered, the clock continues to tick and it will depend on the goodwill of the Europeans whether an extension to the timeline can be granted to accommodate the UK’s political turmoil.

Once again, the polling ahead of the elections raised questions on the continued pitfalls of the methodology and on whether it captures the currently evolving electorate dynamics. This “surprise” outcome serves as another wake-up call that when in unchartered territories, the potential scenarios, time frames and outcomes are more than commonly perceived.

Fundamentally, we see today’s event as increasing the tail risks in both sides of the distribution. From here, we can build a higher probability scenario for a disorderly Brexit (negative tail). Equally, we can paint a scenario of a much softer Brexit (positive tail); or even a second referendum.

We should be prepared for the Brexit path to become an increasingly complex and drawn out process. The UK has debated its relationship with the EU for five decades now, with three conservative PMs losing their seat on European issues along the way; and PM May potentially being the fourth.

From an economic standpoint, the outcome is adding further downside to the UK economic outlook. We have been building our bearish UK macro thesis over the past quarter predicated on a handful of pillars, with the most central one being the health of the UK consumer. A combination of rapid consumer credit expansion in a context of record low savings ratio and a real income squeeze doesn’t bode well for future consumption. In addition, real estate, a key channel for the UK wealth effect, is showing visible signs of slowdown.

More fundamentally, the UK is in need of an economic rebalancing and change of its “growth model”. Political, economic and Brexit uncertainty will impact the corporate sector via the confidence channel and prove challenging for decision-making. This is in a context of a country running a sizeable current account deficit that relies heavily on foreign direct investment (FDI) financing.

From a market standpoint, the election outcome will impact UK assets through its economic implications as well as through the elevated political risk premium. Fundamentally, we see UK macro, interest rate policy expectations, valuation, and Brexit premium as the drivers of sterling. We used the recent strength over the last two months to position for currency downside as a means to express the UK’s weakening outlook. We also maintained this stance going into the elections as we perceived the upside of the market’s base case materialising as limited.

Whilst we expect more downside from here, we also acknowledge that sterling remains an attractively valued currency both vs. its long-term history and other currencies. Therefore, in the absence of a negative tail risk scenario materialising, sterling may have already put in a long-term bottom in price earlier this year.

We re-entered the UK rates market in early May after it repriced to attractive levels, finding value again almost a year after last taking profits. We continue to be constructive on nominal rates based on our macro view; we believe that market-implied inflation expectations (breakevens) have peaked and that outside the FX pass-through, there are little signs that demand inflation will see a sustained pick-up. We expect the Bank of England to maintain a highly accommodative policy for longer, looking through the inflationary pass-through effects of the currency.

As with Brexit, the impact of the UK election result will continue to unravel over the coming weeks and months creating volatility and an increased investment opportunity set.

Marianna Georgakopoulou is head of asset allocation at Ashburton Investments