Last week it appeared conversations
On Brexit, had built expectations
To broker a deal
That both sides would feel
Was fruitful for all Europe’s nations
Alas, based on headlines today
That good will is slipping away
Concern has now grown
That both sides condone
No deal, to the market’s dismay
Apparently, Brexit talks have reached their denouement, with the weekend efforts of PM Johnson and European Commission President Von der Leyen unable to bridge the final gaps. The key issues regarding fishing in UK waters and state support for UK companies remain outstanding and neither side has yet been willing to budge. There is clearly a great deal of brinksmanship ongoing here, but with the timeline so compressed, the chance for a No-deal outcome is still remarkably high. In fact, as of a bit past 6am in NY, the headlines claim that negotiations might end by this evening in Europe, after one final call between the two leaders.
So, is this the end? Is Brexit upon us, three weeks early? And if so, what can we expect going forward?
The first thing to remember about international negotiations is they are never over, even when they have ended, especially in a situation of this nature. The economic impact in both the UK and throughout Europe will be significant in a no-deal outcome, and this is something that neither side really wants to occur, despite any rhetoric to the contrary. The most recent analyst estimates indicate that the UK’s economy will suffer a long-term reduction of 3.0% in GDP compared to the situation if a deal is completed. Meanwhile, the EU’s impact will be a much smaller 0.5% of GDP, but that impact will be unevenly distributed, with Ireland expected to suffer a 6% decline in economic activity, while various other nations see much smaller effects. Germany, too, will feel the pain, as German auto exports to the UK are one of the most lucrative parts of German industry, and with tariffs imposed, they will certainly decline.
And, ultimately, that is why the best bet remains that a deal will be done. Especially given the economic disruption of the pandemic, the ability for either the UK or EU to blithely sit by and allow a critical trade relationship to crumble is virtually nil. So, even if the talks ostensibly end later today, they will not have ended. Both sides will still be seeking a deal, as both sides desperately need one.
However, investors are clearly worried, as evidenced by this morning’s price action across markets. Perhaps the most obvious outcome is that of the pound, which has fallen 1.3% on the news. Last week I was making the case that the market had not fully priced in a positive deal, and any agreement was likely to see the pound rally. At the same time, a true collapse in talks with a no-deal outcome is likely to see a further decline, with 5%-7% seen as a reasonable result. This morning’s movement is just a down payment on that, if no deal actually is the outcome.
But this news seems to have forced investors across markets to reconsider their current positioning and potential market responses to negative news. Perhaps you are not old enough to remember what negative news actually is, so I will give a brief refresher here. Negative news is a situation where not only is the economic impact indisputably harmful to a (country, company, currency), but that a central bank response of further policy ease will be unable to change the outcome. Thus, Friday’s weaker than expected NFP number was not really negative because it encouraged the view that the Fed will ease further next week, thus offsetting any bad economics. But Brexit changes the structure, not just the data, and no matter what the BOE does, customs checks are still going to slow down trade and commerce.
It is with this in mind that we look at markets this morning and see that risk is broadly being reduced. Asian equity markets started the move as the Nikkei (-0.75%), Hang Seng (-1.25%) and Shanghai (-0.8%) all showed solid declines. And this was despite Chinese data showing that exports from the mainland had increased a much greater than expected 21% and fostered a record large trade surplus. In Europe, the situation is similar with one real exception. The DAX (-0.3%) and CAC (-0.8%) are leading the Continent lower as investors react to the potential crimp in economic activity. However, the FTSE 100 (+0.5%) is higher as most members of the index will benefit greatly from a weaker pound, and so are responding to the pound’s market leading decline.
Speaking of the pound, it has fallen 1.3% from Friday’s closing levels and is the leading decliner across all major currencies. But weakness is evident in the commodity bloc as AUD (-0.5%), NZD (-0.4%) and CAD (-0.2%) are all suffering alongside oil (WTI -0.9%) and gold (-0.4%). EUR (-0.1%) has been a relative outperformer as the market continues to estimate a much smaller impact of a no-deal scenario. Meanwhile, in the EMG bloc, losses are virtually universal, but the magnitude is not that substantial. For example, MXN (-0.7%) is the worst performer today, obviously suffering from oil’s decline, but we have also seen weakness throughout the CE4 (HUF -0.4%, CZK -0.3%, PLN -0.2%) along with ZAR and RUB, both having fallen 0.3%. In fact, the one bloc that has outperformed today is APAC, where only two currencies (MYR -0.2% and SGD -0.15%) are in the red. Given the genesis of the problems is in Europe, this should not be that surprising.
Bond markets are taking the risk-off theme seriously with Treasury yields lower by 2.2 basis points and European govvies seeing substantial demand. Gilts lead the way, with a 5.6bps decline, but Bunds (-3.0bps) and OAT’s (-2.6bps) are also rallying nicely. Remember, too, that the ECB meets Thursday with expectations built in for a €500 billion increase in PEPP as well as a maturity extension of between six and twelve months in addition to an increase in the TLTRO program, with a maturity extension there as well. One other thing to watch from the ECB is whether or not they mention the euro and its recent rally. Madame Lagarde and her colleagues cannot countenance a significant rally from current levels, and I expect they will make that clear.
As to data this week, aside from the ECB, CPI is the biggest thing in the US:
|Tuesday||NFIB Small Business||102.5|
|Unit Labor Costs||-8.9%|
|Wednesday||JOLTs Job Openings||6.325M|
|CPI||0.1% (1.1% Y/Y)|
|-ex food & energy||0.1% (1.6% Y/Y)|
|Friday||PPI||0.1% (0.7% Y/Y)|
|-ex food & energy||0.2% (1.5% Y/Y)|
With the last FOMC meeting of the year next Wednesday, the Fed is in their quiet period so there will be no commentary on that front. With this in mind, the dollar, which continues to trend lower, will likely need some new catalyst to take the next step. At this point, the biggest surprise is likely to be a positive conclusion to the Brexit talks, but given what we have seen over the past eight months, it is pretty clear that investors remain hugely bullish on the idea of the post-pandemic economy and will not be denied in their belief that stocks can only go up. My gut tells me that US equities, where futures are currently lower by 0.3% or so, will finish the day higher, and the dollar will cede much of its overnight gains, even without a deal.
Good luck and stay safe