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The End of the Beginning

While the election result reduces Brexit uncertainty significantly, it doesn’t eliminate it. Will there be an extension of the transition period? How will any deal affect the economy? In the meantime, UK banks and sterling, especially wounded since the 2016 referendum, still offer value, while low-yielding gilts look unattractive relative to other government debt, such as U.S. Treasuries.

Boris Johnson’s sound victory in Thursday’s election will lead his Conservative Party to its largest parliamentary majority since 1987. Unlike his predecessors Theresa May and David Cameron, Mr Johnson now has a platform to govern as a strong prime minister, without having to pander excessively to the right wing of the Conservative Party or Northern Ireland’s Democratic Unionist Party (DUP).

It is now certain that the UK will formally leave the European Union (EU) at the end of January. But what is not clear is how Mr Johnson will conduct the negotiations on the future relationship with Europe – he may now pursue a more cooperative approach. There are also questions on whether he will be more bold on fiscal policy than the safety-first Conservative manifesto implied.

If he chooses to, the prime minister has the majority to pivot to the centre, occupying the centre ground of the political landscape that the Labour party has moved away from under Jeremy Corbyn’s leadership. With sovereign bond yields at historical lows, the former mayor of London may be tempted to borrow and invest in infrastructure and other projects that will benefit the new northern Conservative constituencies. The Conservative manifesto pledged a fiscal expansion of just below 1 per cent of Gross Domestic Product (GDP), but he may be bolder.

What’s next?

Johnson’s Brexit Withdrawal Deal will be presented next week after Parliament returns on Tuesday 17th December with the final reading likely to be early in the New Year. The passage of the deal means the UK will leave the EU on 31st January and enter into a transition period until 31st December 2020. Once the deal is ratified, the UK and the EU will start negotiating the precise nature of the future trading relationship. We see two, roughly equal, probability outcomes:

  • A limited free trade agreement. Negotiating a comprehensive free trade agreement in less than a year will likely prove too challenging, as similar deals in the past have typically taken several years. The EU and UK are more likely to reach a limited agreement, covering only the most important industries, leaving for example trade in smaller services sectors for future discussions.
  • An extension of the transition period. While the Conservatives have pledged not to extend the transition period in their election manifesto, their large majority may embolden Johnson to renege on this promise and to pivot towards a softer approach in the EU-UK trade negotiations. The key point is that he has the flexibility to choose his path.

Importantly, we see the risk of the UK ending the transition period with no deal as low. If the trade negotiations fail, we expect the two sides to extend the transition period -- possibly by amending the Withdrawal Treaty at the end of 2020 -- or by implementing temporary side-deals, smoothing the transition into WTO trading terms.

What’s next for financial markets?

After a post-election repricing, markets will turn their attention to the government’s policy in future EU-UK trade negotiations, to the prospect of Johnson extending the transition period, and whether the weak macro environment improves on the back of the Brexit deal. As we wrote in our election preview, we foresee limited upside for UK growth in the very near term, as uncertainty about the precise nature of the EU-UK trading relationship will likely continue to weigh on demand. But the key difference is that we now have a government with greater flexibility to act.

Brexit updates will continue to make headlines in the coming year, creating volatility in financial markets. But for those looking through the noise, there will be relative value opportunities in UK risk assets: we still see sterling as trading cheap to the U.S. dollar and UK banks continue to offer value versus similarly rated European financial institutions, despite recent spread compression. The rally in sterling will also have a dampening effect on UK breakeven inflation rates, as a strong currency makes imports cheaper. We also see UK government bonds trading at a significantly lower yield than U.S. Treasuries, making them rich on a relative value basis.

Circumstances, fundamentals and prices will of course change as details about the future UK-EU relationship emerge. The Brexit story is far from over – Thursday’s election is barely the end of the first act.

The Author

Ketish Pothalingam

Portfolio Manager, U.K. Credit

Peder Beck-Friis

Portfolio Manager, Global Macro

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The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.

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