What Investors Should Watch as Brexit Talks Heat Up

As we enter another period of accelerated Brexit negotiations, how can investors best navigate the next few weeks and months? Our assessment is that a number of U.K. assets have already priced in a significant chance of a disruptive Brexit, but there is scope for further moves in either direction, depending on the path the negotiations take.

Base case: Cooperative outcome to Brexit talks

Our base assumption is for a cooperative outcome to the current negotiations, such that both the U.K. and European Union (EU) can sign the transition deal extending the negotiations out to December 2020. We see incentives for both sides to agree to the transition: For the EU, it would ensure that the U.K. contributes to the EU budget until the end of the current fiscal period in December 2020; for the U.K., it would assuage the risk of a disruptive separation in just five months’ time, an event for which the economy would unlikely be fully prepared. Indeed, we see a greater risk for a disruptive Brexit at the December 2020 deadline than the current March 2019 deadline. That said, we consider it prudent risk management to think through all eventualities.

Near-term Brexit risks

We see a number of U.K. assets pricing in a relatively high chance of a disruptive Brexit, given current levels.

When we look at the bond market, U.K. yields have tracked euro yields very closely, despite the U.K. having already started its interest rate hiking cycle. We believe this is because some market participants expect the U.K. monetary cycle to pause (or even reverse) in the event of a disruptive Brexit. So rather than tracking moves across both the U.S. and European markets, U.K. yields have tracked those in areas where the tightening cycle has yet to begin.

Meanwhile, we view the British pound as between 5% and 10% below its long-term fair value, which we attribute predominantly to Brexit risk. And when we look at the sterling corporate bond market, while most U.K. industrials trade in line with their peers, U.K. banks still trade at a yield premium, which again we would assign to Brexit risk. U.K. banks operate in one of the world’s most regulated financial systems and have some of the highest capital ratios in the industry.