Market Bulletin (19/11/2018)
A good deal worse?
There are decades when nothing happens and there are weeks, said Lenin, when decades happen. Has the UK just been through one of those weeks?
There are reasons to think so. When Theresa May delivered first a Brexit deal and then Cabinet approval (of sorts) for that deal, sterling quickly strengthened. The prime minister could point to a not inconsiderable achievement – a 568-page draft withdrawal agreement that not only stood to deliver a UK exit but also met a couple of the leading aspirations on both sides: not least, sovereignty over UK borders and continued market access, at least for the short term.
Her pleasure was not widely shared by her parliamentary colleagues. Indeed, even after a marathon five-hour Cabinet meeting, she quickly suffered ministerial resignations, among them her Brexit secretary, deputy Brexit secretary and Northern Ireland secretary. The following day, the deal was pilloried from all sides as she faced three hours of questioning in the Commons. As a result, the pound fell 2.5% on Thursday, taking domestically focused shares down with it. The options markets now imply the balance of risks for sterling is skewed to the downside.
The causes of parliamentary opposition to the deal were multiple but the strongest Remainers and Brexiteers alike were united in their view that the terms represented an enormous transfer of sovereignty to the European Union, since until at least 2020 it entailed the UK accepting EU rules while rescinding its right to vote on them – surely the very reverse of ‘taking back control’. (Michel Barnier, as it happens, has since proposed extending that transition to 2022.) During transition the EU would enjoy a range of continued powers in the UK, from blocking mergers to ruling on agricultural culls. Although a panel could arbitrate judicial disputes, ultimate power would rest with the European Court of Justice.
Moreover, while a border down the Irish Sea was avoided, Northern Ireland would have to accept closer regulatory alignment with the EU than England, Scotland or Wales.
The DUP expressed immediate opposition; so, too, did leading Europhiles, Scottish Tories (due to clauses on fishing rights), the Scottish National Party, the Labour leadership, the Liberal Democrats, and the pro-Brexit European Research Group (ERG). (Nigel Farage called the deal “the worst in history” before it had been published – or he’d seen it.) The ERG was upset by two major concessions: the Irish backstop, as the UK couldn’t unilaterally withdraw from the Customs Union; and “level playing field” requirements, whereby the UK would observe EU rules for several areas (during transition), not least in regard of the single market. A no-confidence vote in the prime minister could yet be held, although parliament’s vote on the deal may be more dangerous for the prime minister.
All of this added weight to the impression of a nation watching the latest act in a long-standing Tory argument, one that has claimed the past three Conservative prime ministers and looks ominously close to claiming a fourth. At the least, last week appears to have significantly broadened the range of possible Brexit outcomes. It is still just about conceivable that, with some exceptionally deft politicking, the prime minister’s deal might pass through the UK parliament but, at time of writing, few are betting on it – and that includes the bookies.
The alternatives involve some kind of political crisis or turnaround. Theresa May would have to go if she lost a no-confidence vote and could surely not survive the constitutional crisis – with executive and legislature at odds – that would be created by parliament rejecting her deal. But choosing a new leader does little to reconcile a polarised party that lacks a majority or to precipitate a new Brexit deal that can satisfy the pledges made. (As for the Labour leader, he has studiously avoided suggesting any kind of solution at all – although will reportedly spell out a plan this week.)
If parliament then refuses to vote through a no-deal exit from the EU, a general election or second referendum becomes more likely. Neither is likely to be pleasant, given the tone of Brexit rhetoric. Yet either side might fear that such an impasse would only boost their opponents – the prime minister is hoping that such calculus will help persuade them to vote through her deal. Besides, many MPs may prefer what they see as a bad deal to a no-deal exit.
“The UK’s negotiating power has been overestimated by many – the EU has dictated the terms of Brexit from the beginning,” said Azad Zangana, Senior European Economist and Strategist at Schroders. “The deal is largely as we expected, but this is only the beginning … we believe the risk of a no-deal Brexit will focus minds and lead to cross-party support for May’s deal.”
Brexit developments have implications that stretch far beyond the purview of markets, but investors cannot ignore them. As has been the case ever since the referendum was called, these developments have been mediated to assets through sterling. A weaker sterling is often good for the FTSE 100, since three quarters of the revenues of companies listed on the FTSE 100 are derived from outside the UK – for such companies, their revenues therefore go up in sterling terms when the pound declines. However, a quarter of the revenues are still derived from the UK and, just because a company derives most of its profits abroad, it does not follow that it will be immune to UK developments, and particularly to short-term sentiment – indeed, the FTSE 100 declined last week, due in part to slippage among financial, property and retail stocks.
These variables only serve to highlight the value of diversification, not merely across different stocks and different market capitalisations, but also across geographies. After all, a decline in sterling against the dollar automatically makes any dollar-denominated holdings more valuable in sterling terms. Viewed in these terms, the greatest danger for investors is not short-term politics, but a failure to diversify.
Amid last week’s chaos, events beyond the UK’s shores could all too easily lose their resonance. Yet there were unnerving economic signs last week, as third-quarter growth (annualised) for both Japan and Germany came in negative. Japan’s dip appeared to reflect immediate unforeseen events – the recent earthquake and round of severe floods. In Germany’s case, it reflected both pressure on export volumes and tighter automobile emissions rules – Mercedes-Benz has reported that emissions testing is now taking twice as long as previously. Japanese and European stocks both declined over the week; European stocks suffered due to both Brexit worries and to Italy refusing to amend its budget ahead of the EU’s deadline. This means it is now in contravention of the Stability and Growth Pact, laying it open to punitive measures. (Would that be the same pact that Germany and France contravened in 2004 without sanction…?)
On Wednesday, meanwhile, the S&P 500 clocked a fourth consecutive day of losses. The oil price continued to decline – down to $66 from $80 a month ago – hitting energy stocks. Meanwhile, technology stocks slipped on profitability fears, hinging on concerns over Apple’s iPhone business hitting a peak. Stocks partially recovered later in the week.
Schroders is a fund manager for St. James’s Place.
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