So if we’re all being honest with ourselves, Brexit is a bad idea from a stability perspective, right?
Of course it is.
Now I realize that the populist storm clouds appear to be receding, but even as the world seems to be coming to its senses (as evidenced by Geert Wilders relatively poor performance in the Dutch elections and the seemingly imminent ouster of Steve Bannon from the Trump administration), some decisions have already been made.
Brexit is one of those decisions. There’s no turning back now. Which, as I never tire of reminding readers, is a damn shame because a quick Google trends check is all the evidence you need to support the contention that a whole lot of folks in the UK had no idea what they were voting to “exit” last summer. That is, they didn’t know what the EU was – literally…
Needless to say, there’s considerable debate about what the (long) path to Brexit presages for GBPUSD and for UK assets in general. Relatedly, forecasts for the impact on the UK economy can be very nicely described as “divergent.”
For those who missed it, here is Goldman’s visual guide to the two-year Brexit negotiation process:
See? Simple [sarcasm].
Well, one person who is skeptical about the extent to which this process will approximate a smooth ride is Citi’s Matt King, one the best sellside strategists there is.
Below, find excerpts from King’s latest in which he reminds you that “there’s no such thing as a happy divorce.”
The “seven-year itch” is a real phenomenon: the probability of a marriage ending in divorce rises until around the 7-8 year mark, before falling steadily thereafter. By the time a marriage has survived 44 years, the probability of it ending in divorce is supposed to be well under 1%. But Britain’s cohabitation with its 27 EU partners never did fit the pattern of a traditional relationship, so perhaps its defiance of normal statistical trends should come as less of a surprise.
Markets, in particular, have once again proved utterly unflustered in the face of potentially tumultuous events. £ and gilts rallied; credit spreads basically yawned.
But is such imperturbability to be taken as a sign of resilience, or of complacency? As in previous weeks, we think it owes less to the continuing strength of economic data and more to a palliative of central bank liquidity and global credit creation ; as in previous weeks, we think the market reaction is less strong than it seems on the surface; as in previous weeks, we think this support will in time be eroded by the gradual exit of the central banks and by disappointment on the fundamental outlook ; as in previous weeks, we think there are trades to be done offering pleasingly asymmetric returns as a result.
“We only want the best for the children”
Like many a divorce, this one seems to have started out with the best of intentions, and all sides declaring their primary interest to be the long-term welfare of the children. The conciliatory tone of Theresa May’s letter to the EU, with its references to “Europe remaining strong and prosperous”, to “the interests of all our citizens”, to the need for “implementation periods to adjust in a smooth and orderly way”, and to “shared European values” was matched only by Donald Tusk’s response that “We miss you already”. And indeed, our economists’ overall expectation and hope is that “reason will prevail”, with an ultimately hard Brexit being preceded by a long transition period.
“But we must secure the best deal”
But parents’ good intentions seldom survive their first encounters with their lawyers. There is something about sitting across the other side of the negotiating table – rather than around the same table in a process facilitated by mediators – which almost inevitably poisons the atmosphere.
Worse, as [we] noted a few months ago, the game of chicken is much less likely to end in disaster when the default outcome from a failure to agree is maintenance of the status quo. The cliff-edge created by Article 50 is designed expressly to achieve the opposite, at least for the party leaving. And while such an outcome would have negative consequences also for the EU, the imbalance in trade exposure inevitably stacks the negotiating cards heavily in the EU’s favour (Figure 1).
An unpleasant Nash equilibrium
As such, while there is undoubtedly a positive outcome in which both sides make concessions and negotiations go well, at a minimum we struggle to see progress in that direction until much closer to the ultimate deadlines. The UK has so few negotiating chips that it seems unlikely to give way on citizens’ rights until it can see the promise of something in return. For the EU, the prospect of a hard cliff-edge gives them such a strong advantage that it would be poor negotiating strategy to provide the early agreement of a transition period that the UK now acknowledges it needs. While progress may be slow, the likelihood of increasing anxiety among UK business in the absence of such an agreement means the coming months seem likely to bear a more negative tinge than has been visible to date.
How to make your own trade arrangements
But while the oncoming trade negotiations seem likely to be both drawn-out and fiendishly complex, thankfully we think the trading implications for investors are at this point relatively clear.
While the overall timing and magnitude is uncertain, Brexit represents a significant potential negative for firms with heavy UK exposure. Unlike in some other markets, credit seems thus far to be pricing nothing in.
In equities, for example, Citi’s “Brexit basket” of UK-exposed, mostly mid- and small-cap names has clearly underperformed since the referendum. This is visible not only against the more internationally oriented companies of the FTSE 100 (which have benefited from the depreciation of £), but also against the Euro Stoxx (Figure 3).
In credit there is no such effect. While we cannot replicate performance of the “Brexit basket” precisely – since many of the companies are too small to trade freely in credit – a division of £ iBoxx by issuer nationality shows that all spreads are close to their tights, and that after some initial underperformance around the referendum itself, if anything UK issuers have outperformed (Figure 4).
Nor can this effect be the direct consequence of BoE QE being focused on UKdomiciled issuers: the same pattern holds in both € credit and in CDS (Figure 5, Figure 6). It also holds both among financials and non-financials. If anything, the outperformance of UK names is slightly stronger in € credit than in £.
We therefore see every reason for investors to make beta-neutral switches out of UK names into non-UK ones. With nothing in the price and QE not the culprit, it is hard to see what would cause UK names to outperform further.
Fog in trading channels commonsense pricing cut off
More broadly, this failure of spreads to price in widely agreed fundamental risks are part of a broader pattern we perceive in which – particularly in credit, but even elsewhere – normal market movements have been dampened or failed to materialize altogether. In credit, this stems fairly obviously from the direct interventions of central banks. But even in rates, we have been surprised not to see the front end of yield curves react to a series of hawkish speeches by Fed and ECB officials.
The fear is inevitably that such distortions will continue, and that markets’ widely acknowledged expensiveness to fundamentals will if anything become worse. “We have to put the money somewhere!” is a common refrain, which we heard again from investors this week.
In the near term, such willful blindness has the potential to continue, and is potentially self-reinforcing. If the market doesn’t price the risk, why should investors worry about it?
But such a philosophy is inevitably vulnerable sooner or later to a collision with reality. As central banks back away, and negotiators move beyond the benign initial platitudes to confront the thorny realities of individual self-interest, we think markets look uncomfortably exposed. Even in the most amicable of separations, the children seem invariably to get hurt. Especially when no one realizes just how lucky was the position they were starting from.