Author: Alastair George
If the objective of the EU was to demonstrate just how hard it is to leave the Union under Article 50, it would have surely succeeded. The UK has been put into a position where Parliament has rejected a government-negotiated Withdrawal Agreement three times. Now, under a new PM the UK has finally put forward detailed alternative arrangements for Northern Ireland. Despite initially positive indications, the EU presently appears to have baulked at these proposals, aiming perhaps at forcing the UK to extend Article 50 and conduct another general election to break the Parliamentary deadlock. We believe no-deal at the end of October remains a low probability. In the circumstances, in our view investors should keep sight of the relatively discounted valuations of sterling and UK equities for the medium-term.
The escape route mapped out by the UK’s Benn Act unfortunately provided a very good reason for the EU not to make any serious concessions at this stage and therefore is likely to prolong the harmful uncertainty. Not only have PM Johnson’s government attempts to establish the credibility of the threat of no-deal been seriously compromised by the Benn Act but also by last week’s court disclosures which indicated that the UK government would in any case seek to extend Article 50 in the absence of a deal.
If Article 50 is further extended, then an election is likely to follow which raises the prospect of revocation. To date, the opposition Labour party has been reluctant to come off the fence in favour of remain. Current policy appears to call for negotiating a deal followed by a second referendum, should it come to power. This policy would give the EU every incentive to play to keep the UK in the EU in any referendum, for example by sticking close to the terms of the unpopular Withdrawal Agreement. The result of such a policy therefore seems quite likely to be no-Brexit, as with a straight Article 50 revocation, but only after another long period of uncertainty.
On the other hand, if Labour were to switch tack and follow the UK’s Liberal Democrat party on a platform of Article 50 revocation it may appeal both to those who wished to remain in the EU and a further significant proportion of the population who wished to secure the end of the uncertainty at the earliest possible opportunity.
The prospect of no-Brexit may also have appeal among European leaders including the Irish premier Leo Varadkar who recently and somewhat controversially stated that the British political system was standing in the way of the UK people. With this apparent prize of no-Brexit hanging in the air, it is hardly a surprise that EU negotiators are being resistant in the face of the UK’s recent proposals. However, in terms of a Labour administration becoming a reality a missing piece of the jigsaw is perhaps a more centrist Labour manifesto which would have broader appeal to the UK electorate.
The recent disclosure, if it is accurate, of a call between German chancellor Merkel and PM Johnson in which Merkel stated a permanent customs union in Northern Ireland was an EU redline is disconcerting. If true, this would make any deal hard to achieve and at the same time put the original Withdrawal Agreement in a quite new light. Unless this is later denied, the prospect of a deal by the end of October has now become slim.
For election purposes, PM Johnson should be expected escalate the rhetoric as a “forced” deferral of Article 50 will provide the UK PM ammunition to fight a general election on a platform of getting Brexit done. If successful, investors should also be prepared for a hardening of the UK position on Brexit as no-deal is held out as a politically viable alternative. However, even if no-deal becomes politically viable it still does not mean it will happen. It remains the case in our view that agreement will benefit both sides.
With both sterling and UK equities trading at discounted valuation levels compared to long-term trends, investors are clearly placing a risk premium on UK assets. This is due to Brexit risk combined with the possibility the issue will open the door to a left-leaning Labour administration.
However, investors may be best served by seeing through this fog of war for public opinion. A no-deal outcome in October remains a low probability in our view and an agreed deal at this late stage is also increasingly unlikely, especially as EU leaders appear to be spurning PM Johnson’s invitation to engage.
As a result, the base case is shifting towards an Article 50 extension and general election. For as long as Labour sit on the fence on Brexit, current voting intentions which suggest another Conservative administration remain relevant. However, a successful “get Brexit done” campaign still does not imply no-deal outcome. In our view no-deal remains a scenario, useful for achieving convergence in any discussions between the EU and UK.
We believe that as risk has a name (i.e. “Brexit”) in the UK, investors are quick to shun the market. Yet discounted valuations can be the prelude to a significant period of outperformance, provided the worst-case scenario does not occur. Furthermore, trade and political risk is not a UK-only phenomenon as investors in Germany and the US have discovered in 2019. Valuations in UK equities suggest a selective approach may pay dividends for the medium-term, provided investors genuinely have a time horizon sufficiently long for the Brexit question to be resolved.