Brexit: The Heavy Lifting Begins

Around the Curve

Brexit: The Heavy Lifting Begins

Brexit has already affected the UK economy. The Conservative Party victory will only make matters more urgent.

A victory for the ages. Records broken. Boris Johnson, UK Prime Minister, was swept to a huge victory. His Conservative Party won a majority of 80 seats, with all Tory candidates vowing to support Johnson's renegotiated Brexit transition deal. It only took 3 years to get here and the transition plan was thought to be the easy part. Now starts the hard work as Johnson's freshly minted government needs a trade deal with the EU.
 

The Tale of the Tape

The risk coming into the election was always a hung Parliament and that raised the spectre of a Labour-led government. Yet, the Conservative mantra ("Get Brexit Done") largely won over a Brexit-weary public. Johnson's Conservative Party made sizeable gains in traditional Labour strongholds, especially in the North and the Midlands. These were constituencies that had voted Leave on June 23, 2016. Overall, Johnson's majority was the largest Tory win since Margaret Thatcher's due to those Labour switchers. As the press noted, even former Labour Prime Minister Tony Blair's Sedgefield seat fell to the Tories. So sweeping was Johnson's victory that pundits openly speculated whether or not he has forged a new voting coalition a la Donald Trump in the US. This remains to be determined.

Financial markets had been "forecasting" a Tory victory, as investors increasingly gained confidence of a Johnson victory and with it the prospect of reduced economic uncertainty. The sterling-sensitive FTSE 100 is 17% higher from its late summer low, in spite of an appreciating pound. Likewise, the FTSE 250, an index compromised of domestic companies, posted a 17% gain in local currency with many of these companies benefitting from the rejection of the Labour Party's nationalization agenda. Utility stocks, for example, surged, as did water companies, each Labour Party targets. Not surprisingly gilt yields are moving higher, as risk aversion ebbs. Traders have been covering pound short positions, giving sterling a boost. Positive election day exit polls briefly pushed sterling to $1.35. Some period of price consolidation should be expected in these markets, as investors ponder what's next.

 

Source: Bloomberg. Past performance is no guarantee of future results. See Definitions section for addiotional information.  "GBPUSD" is the exchange rate of the British pound vs. the US dollar. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Pound Sterling and Trader Positioning

  1. What's next? The Queen's speech will open the Parliament this week. Members will vote on the Prime Minister's withdrawal bill, which is expected to take place by January 31, 2020. That gives the government 1 year to negotiate the UK's future trading relationship with the European Union (EU). The agreement allows for a 1-or 2-year extension of the deadline, something that Boris Johnson campaigned against. The PM is said to be striving for a Canada-type trade deal, achieved by the end of 2020. Conveniently overlooked is the Canada trade deal took 7 years! Negotiations with the EU should begin late in the first quarter of 2020;
  2. The sweeping victory could also produce some political headaches. The Scottish National Party (SNP) was also a big election day winner. The SNP picked up 13 seats, giving it a total of 48 seats. This win will raise the volume of SNP party head and First Minister of Scotland Nicola Sturgeon's call for a new Scottish independence referendum. Another referendum, however, will need Parliamentary approval, an unlikely outcome. Additionally, the nationalist parties in Northern Ireland gained seats. These parties support uniting Northern Ireland with the Republic of Ireland. Both Scotland and Northern Ireland voted to remain in the EU in the Brexit referendum; and,
  3. What about the economy? Clearly, after 3 years, the elections have reduced, but not eliminated, risk and uncertainty. Nonetheless, the Tory election and the expected approval of the withdrawal bill should allow businesses and consumers to breath a sign of relief. As part of the Conservative Party manifesto some additional government spending has been proposed, following years of Tory-driven fiscal restraint to reduce a bulging budget deficit following the Great Financial Crisis (GFC). This spending will focus on healthcare, education, taxes, and a higher minimum wage, marking a shift away from Margaret Thatcher's brand of conservatism.

 

Sources: Office of National Statistics, Haver Analytics (Chart 2), Confederation of British Industry, Haver Analytics (Chart 3). Please see Definitions section below for additional details, Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

The economy is showing signs of the wear and tear over Brexit. Business investment has plunged, as businesses have been unwilling to implement long-term plans. Likewise, according to the Confederation of British Industry, both total and export orders plunged, but could be showing a slower deterioration. Both the lack of movement on Brexit and the generalized global economic slowdown have affected these trends. The prospect of moving forward on Brexit and eventually establishing the future trading relationship with the EU should improve business confidence. Whether or not that releases a torrent of investment remains to be seen, given the many still moving parts in Brexit. The economy should recover slowly, with fiscal policy adding to domestic demand and the Bank of England standing ready to ease policy, if necessary. The strength of sterling should dampen inflation and pave the way for a cut in the policy rate.


Conclusions

Investors breathed a collective sigh of relief with the UK's election outcome, at least by the market and currency reaction. The magnitude of PM Johnson's victory essentially gives him carte blanche to pursue his vision of the UK's future. Still questions remain, like whether or not Johnson and the Tories have re-drawn the UK electoral map or will the Labour switchers be a brief marriage of convenience on Brexit. Further, strong gains by nationalists in Scotland and Northern Ireland could complicate the political process in the UK. Nonetheless, the heavy lifting does start now. The expectation of a UK/EU trade deal by the end of 2020 is unrealistic and an extension request seems to be the likely course. But the close trading relationship between the UK and EU argues establishing the new rules of the trade game will benefit both. The enormity of the task means more time will be needed, since areas like agriculture, manufacturing, security, and services must be resolved. Yet, Brexit is now a certainty and even that will be a relief for businesses. This saga though is not over yet.


Definitions:

Tory refers to a member of the Conservative Party (a center-right political party) in the United Kingdom.

The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency.

The Conservative Party, officially the Conservative and Unionist Party; also known colloquially as the Tories or simply the Conservatives, is a center-right political party in the United Kingdom.

Gilts are bonds that are issued by the British government.

A basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).

"Brexit" is a shorthand term referring to the UK vote to exit the European Union.

The European Union (EU) is an economic and political union established in 1993 by members of the European Community. The EU now comprises 28 countries after its expansion to include numerous Central and Eastern European nations. 

The FTSE 100 Index comprises the 100 most highly capitalized blue-chip companies, representing approximately 81% of the U.K. market. It is used extensively as a basis for investment products, such as derivatives and exchange-traded funds.

The FTSE 250 is a capitalization-weighted index of the 250 most highly capitalized companies, outside of the FTSE 100, traded on the London Stock Exchange. 

The British pound (GBP, also pound sterling, or sterling) is the currency of United Kingdom.

The Scottish National Party (SNP) is a Scottish nationalist, social-democratic political party in Scotland. The SNP supports and campaigns for Scottish independence within the European Union.

The Bank of England (BoE) is the central bank of the United Kingdom.

The Bloomberg CFTC Sterling Net Non-Commercial Futures Positions represent open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the Commodities Futures Trading Commission (CFTC). All traders' reported futures positions in a commodity are classified as commercial if the trader uses futures contracts in that particular commodity for hedging. 

The Confederation of British Industry (CBI) produces a monthly survey (and a more detailed quarterly report) analyzing the performance of UK manufacturing industry. Questions relate to domestic and export order books, total order books, stocks, price and output expectations with the main market focus being the domestic orders balance. The survey is seen as a loose leading indicator of the official industrial production data.

Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People's Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC's commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC's commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia and New Zealand:

This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827).  The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.