How worried should investors be about Brexit?

Last week, Prime Minister Theresa May suffered the worst defeat by a UK government in modern history.

Parliament voted 432 to 202 to reject May's Withdrawal Agreement, triggering the opposition Labour Party to table a vote of no confidence.

The government survived – by the same narrow 52% to 48% margin by which the country voted to leave the EU. After the events of the last week, the pound rallied, with currency markets pricing in a lower likelihood of a hard Brexit. But it remains uncertain whether the UK will face a no-deal Brexit, hard Brexit, soft Brexit, delay, or no Brexit at all.

The impact of a worst-case no-deal Brexit on the UK economy would be negative.

• Last November the Bank of England spelled out its estimates of the negative fallout from the worst-case scenario of a no-deal Brexit at the end of March. Under its “disruptive scenario” the Bank forecasts that UK GDP could fall by as much as 3% from its 1Q19 levels.
• In our view, in the worst case sterling would depreciate sharply, with GBPUSD potentially falling to 1.15 and EURGBP rising to parity. We recommend a cautious approach to the pound, protecting against near-term downside, but we expect it to appreciate over the longer term (our 12-month forecasts are 1.40 GBPUSD and 0.86 EURGBP).

And the Eurozone would not escape unscathed.

• In its latest Global Economic Prospects report, the World Bank noted that a no-deal exit "is a risk to the UK and to Europe and any region that trades heavily with them." Of the UK's top ten trading partners, seven are from the EU (Germany, France, Netherlands, Spain, Belgium, Italy, and Ireland), and their exports tend to be high value-added items. Growth in the Eurozone is slowing – it was just 0.2% in the third quarter, and Germany, its largest economy, is flirting with recession. A loss of export revenues could push the Eurozone economy further toward recession. Wider contagion is also a risk.
• Jerome Powell, chairman of the US Federal Reserve, recently warned that a disorderly Brexit could have a negative knock-on effect on the US economy through US banks' exposure to the European banking system. With this in mind, investors with high exposure to the UK or Eurozone assets should carefully consider their global diversification strategy.

But on a global scale the UK economy is relatively insignificant.

• In terms of contribution to global GDP, the UK represents just 2.5% while the US and China together account for 40%. Clearly, the political risk from US-China trade tensions is more globally significant than the risk from the Brexit process.

And a disorderly no-deal Brexit is not set in stone.

• The UK parliament wants to avoid a no-deal scenario, either by finding a compromise agreement or potentially delaying the UK's exit beyond the end of March. After surviving the no confidence motion last week, May appeared to shift toward a softer Brexit stance, with plans to consult with senior parliamentarians and leaders of all parties. The EU confirmed that it would actively engage with a softer Brexit approach on the future relationship with the UK. Press reports also suggested both that the EU is ready to make further concessions on the Irish backstop if the initiative were to come from Ireland and that they would consider a delay to the withdrawal until 2020.

For investors outside of the UK and the Eurozone, now is probably not the time to look for bargains. But in most scenarios, diversified global portfolios should be relatively well insulated from Brexit risks. The impact of Fed policy, the global growth outlook, and the outcome of US-China trade negotiations remain the most critical factors for global investors.

Bottom line

Last week, Prime Minister Theresa May suffered the worst defeat by a UK government in modern history, but survived the no confidence vote prompted by the result. The eventual Brexit outcome remains highly uncertain, but the most damaging no deal exit, which would hit the UK economy and have spill-over effects into Europe and elsewhere is not set in stone. Investors with high UK or Eurozone exposure should consider diversifying to mitigate the risk.

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