Whether or not the UK leaves the European Union (EU) with a deal or not, the impact of Brexit will be profound. December’s Market Voice analyzes the prospects for the UK economy, and equity, fixed income and FX markets.
- According to the OECD, Brexit will have a negative impact on the UK economy, which will be made worse should there be no deal with the European Union.
- Data from Refinitiv Eikon suggests that the financial markets have not priced in the full negative consequences of a no deal Brexit. And so far, fixed income markets are not pricing in very much Brexit risk.
- The FX markets have priced in a large negative move in GBP towards the end of the year, while there is also potential volatility ahead for EUR.
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Big Ben is not just counting down the minutes to the start of 2021, but is also counting down for the UK departure from the European Union, which means time is running out for a trade deal with Europe.
There are still unresolved issues — especially fishing rights and government support for businesses — but if these remaining issues are ironed out, the prospects of quick UK Parliamentary approval is strong because the opposition Labour Party indicated it wants to avoid a no-deal exit.
How likely is a Brexit deal?
Unfortunately, the logistics of European passage are more problematic.
Under EU rules, trade agreements must be approved by the legislatures of the 27 member states based on their local system. In some cases, this requires a national referendum, and it is hard to see how this can be accomplished with end-year looming.
The European Parliament can pass a provisional agreement in lieu of the national approvals but the legality of this for a trade agreement is moot.
The prospects of a no-deal Brexit is becoming more likely with each tick of the countdown to year end.
How will a no-deal Brexit impact UK growth?
The absence of a deal is probably not the cataclysm for the UK economy feared a year ago as companies on both sides of the English Channel have had ample time to prepare for this possibility.
However, the trade disruptions of a no-deal exit will still have a negative impact on activity and, as indicated in Figure 1, the UK economy is not well positioned for adverse winds.
Figure 1 shows the recently released OECD estimates for real GDP growth for 2020, 2021 and 2022 (from left to right). The combination of the negative impact of Brexit and COVID-19 is estimated to have shrunk UK real GDP 11 percent this year — a substantially worse performance than the other G7 economies.
Figure 1: OECD real GDP growth forecasts for G7
The OECD offers some seemingly good news for the UK, with real growth projected to rebound to a positive annual 4 percent plus rate over the next two years.
While not enough to offset this year’s underperformance, leaving the UK still lagging the rest of the G7 for the next two years, it nevertheless still suggests a significant rebound will emerge next year. The bad news is the OECD forecast assumes that a trade deal with the EU is in place at the end-year onset of Brexit.
The maximum forecasts are roughly consistent with the OECD’s year-over-year rate shown in Figure 1, but the more pessimistic (presumably no-deal) forecasts suggest that instead of recovering, the UK economy will shrink further in the first half of next year and then stagnate through to the end of 2022.
This is also roughly in line with the UK Office of Budget Responsibility estimate that a no-deal Brexit would be a 2 percent hit to next year’s real GDP growth.
Figure 2: Reuters polling outlook on UK real GDP growth
Are markets prepped for a no-deal Brexit?
Arguably, UK equity markets are priced for bad news on the Brexit front. The FTSE is down 12.6 percent from levels earlier in the year, badly lagging other G7 markets. Indeed, the SPX, STOXX and TOPIX are all positive.
As was highlighted in November’s Market Voice, the UK incidence of COVID-19 infection is roughly on par with the Euro area, while both look better than the U.S., so the underperformance more likely reflects the pending Brexit than the pandemic.
While there seems to be bad news reflected in the UK market, Figure 3 suggests that things are even worse than is priced into the market.
There has been a longstanding relationship between relative UK vs U.S. GDP trends and the relative performance of stock markets. Based on this link, it appears that as much as the FTSE has underperformed the SPX this year, it has not been adequate to reflect the extreme underperformance of the UK economy.
A no-deal Brexit is almost certainly going to result in further underperformance of the UK economy next year, so despite this year’s poor performance, there is clear risk of yet further declines in 2021.
Figure 3: UK vs U.S. relative GDP and stock market performance in USD terms
If a no-deal Brexit is expected to hurt UK equity performance, then this should also be reflected in declining credit quality.
As shown in Figure 4, the yield on U.S. BBB corporate bonds has declined over the past two years to a record low, but this still leaves U.S. 5Y bond rates roughly a percentage point higher than in the UK. And even with the UK fiscal deficit widening to a stunning 16 percent of GDP this year, the 5Y credit default swap for UK debt has fallen to near record lows versus the U.S. spread.
The government projects that the deficit should moderate, but will be a substantial 5 percent plus of GDP in 2021, with significant deficits extending at least through 2025.
Figure 4: U.S. vs UK 5Y BBB corporate rate and sovereign CDS spreads
No-deal risks in the FX markets
While the GBP is trading near a two-year high against the USD, there is significant Brexit risk priced into the currency markets.
As shown in Figure 5, GBP 1M (i.e., through the onset of Brexit) implied volatility moved sharply higher over the past two weeks and relative to realized volatility is trading at the highest level since last spring’s COVID-19 market breakdown.
The skew for GBP puts versus calls has also surged even relative to the elevated level of implied volatility. While the forward volatility curve implies a downtrend, 1M implied volatility is priced to stay above this year’s averaged realized volatility into the second half of next year.
So while GBP is relatively strong, the market is priced for a sizeable negative move at the end of the year.
Figure 5: GBP 1M implied volatility and skew for puts
The EUR, like GBP, is trading near multi-year highs, but while there is significant risk of GBP weakness in the market, the same is not true for the EUR.
As shown in Figure 6, implied 1M volatility relative to realized volatility is trading in the middle of the recent range, and the same is true for the skew for EUR puts. 1M implied volatility outright is trading only marginally above realized volatility for the past year.
While the implications of a no-deal Brexit are more dire for the UK than for Continental Europe, it will, nevertheless, be a significant source of disruption — especially for trade flows between the two regions — and potential volatility for the EUR.
Figure 6: EUR 1M implied volatility and skew for puts
Watch: Eikon — The ultimate set of tools for analyzing financial market
The bottom line
It is all but certain that the UK will leave the European Union at the end of 2020 and with each tick of the clock, the possibility of this happening with no trade deal is rising. 2020 has not been kind to the UK economy, putting it ill-placed to absorb the disruptions to activity that would come with a no-deal Brexit.
While there is some pricing for this risk in markets, it is far from uniform. The GBP market has clear pricing, with recent sharp elevations of EUR implied volatility and skew for puts. UK equities have been weak, though arguably not weak enough to reflect the economic contraction that will come with a no-deal Brexit.
UK fixed income markets do not seem to be pricing in much risk at all, which seems at odds with the ballooning fiscal deficit and the potential of Brexit to negatively impact corporate profitability. It also seems that the market is ignoring the prospect that Brexit will also adversely affect the European Union, which is particularly apparent in the benign outlook priced into the EUR implied volatility.