UK markets were surprisingly resilient in the months leading up to the original March 29 Brexit separation date, as parliamentary developments dampening the outlook for a deal were seemingly offset by signals that an extension would forestall a no-deal “crash-out.” The pound, though about 12% weaker than its pre-referendum level, has appreciated modestly against both the US dollar and the euro since the end of 2018, by roughly 5%. UK stocks (as represented by the FTSE 100) also have rebounded from the global equity declines observed in December 2018, though to a lesser degree than US and European indexes. The yield on 10-year gilts has bounced around a bit, though mostly in line with other sovereigns.2
While a Brexit deal’s impact on equities is not straightforward, some generalizations can be made. For example, export-focused companies that produce significant revenue outside the UK—which includes much of the large-cap FTSE 100—have benefited significantly from the pound’s post-referendum weakness. These names would enjoy unchanged trading rules during the Brexit transition period,3 but their foreign earnings may take a bit of a hit from a stronger pound due both to currency translation effects as well as some loss of relative price competitiveness in international markets. In contrast, more domestically focused companies—which tend to populate the FTSE 250 and FTSE SmallCap indexes—may find that a less-downbeat near-term economic outlook encourages more spending by their customers, though now cheaper imported goods may compete for those incremental pounds.
Should a deal before the April 12 deadline remain elusive and the UK be forced to request an extended Brexit delay, the market implications are harder to gauge; while it raises the probability of no Brexit at all, it does so at the cost of a protracted period of uncertainty. In the less likely but worst-case scenario of a no-deal/crash-out Brexit, the potential market impact seems unambiguously negative. We would expect risk aversion to take hold worldwide, as a crash-out would disrupt not only what previously was intra-EU trade but also other trade agreements the UK was party to as a member of the EU, including its trade with the US.4 The reaction of markets to the results of the Brexit referendum may provide a good framework for what to expect. After the surprising victory of “Leave” in June 2016, the exchange rate on the British pound plunged 11% against the dollar almost overnight, global equity markets fell sharply, and investors flocked to historical safe havens like US Treasuries, German Bunds, Swiss francs, Japanese yen and gold.
A Brexit deal or an extended delay would appear preferable to a crash out from an investment perspective, but they do little to provide long term certainty to businesses or investors. The UK and EU will need to return to the negotiating table to establish terms of their future relationship. It’s likely that headline risk around the progress of these negotiations could combine with other fears facing the global economy slowing global growth, trade battles, growing isolationism/protectionism —to create higher levels of volatility across currencies, sovereign yields, credit and equities, accompanied by bouts of risk-off investor sentiment.
Though such pronounced market gyrations can be disconcerting, we believe companies with strong balance sheets, sustainable earnings and conservative managements are more likely to weather the impact of Brexit no matter the outcome, to the potential benefit of their current investors. In fact, near-term market volatility may provide opportunities to build on or to acquire positions in such companies at attractive valuations, especially for patient investors with cash on hand. Currency risk hedges, meanwhile, may help mitigate return volatility during periods of tumult, as may other traditional hedges like gold.
2. All data Bloomberg as of March 29, 2019. 3. To bridge the gap between the UK’s formal exit from the EU and the establishment of a new UK/EU trade partnership, the PM May/EU Brexit agreement included a transition period during which EU law, including the current trade and regulatory relationship and the free movement of people, would continue to apply in the UK as if it were still a member state. The transition was intended to run until December 2020, with the possibility of extension for up to two years (to be triggered by July 1, 2020). We expect a similar transition plan likely would be part of any Brexit deal. 4. The UK has signed continuity agreements with some of these markets that will take effect in the event of a no-deal Brexit, though negotiations are ongoing with some of its larger partners, including Canada and South Korea. A mutual recognition deal signed with the US in February 2019 is not a free-trade deal, but rather an agreement to accept technical standards for certain “telecom equipment, communications, pharmaceutical products and marine equipment.”
