A European Union (EU) flies alongside a British Union flag, also known as a Union Jack in London.
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Sterling is getting a further boost after British and EU leaders agreed to extend Brexit trade talks beyond Sunday’s deadline, temporarily staving off the threat of a no-deal scenario.
Analysts broadly expect the pound to continue to rally if the U.K. and the EU can hash out a deal in the coming weeks. Barclays projected on Monday that an accord before the end of the year could see sterling break through the $1.35 barrier and continue to “grind higher” from there.
“On the contrast, it seems there is potentially more room to the downside if we don’t necessarily see that deal come through, and that is a bit of a change from what we saw last week where things felt very asymmetrical in a positive sense,” Barclays Co-Head of Global FX Sales Mimi Rushton told CNBC on Monday.
But while the pound is expected to take a substantial hit in the event of the U.K. leaving the EU orbit on World Trade Organization (WTO) terms, analysts are not anticipating a global contagion for other financial assets.
Peter Chatwell, head of multi-asset strategy at Mizuho told investors in an email bulletin Friday that the threat of a no-deal departure is only a “big deal” for sterling in the foreign exchange markets and said he didn’t buy the narrative around a global ripple effect.
“It should mean gilts (U.K. sovereign bonds) continue to rally strongly, U.K. breakevens rise materially, and ultimately that the BoE (Bank of England) will probably cut to 0% and increase QE (quantitative easing) before the February meeting. The door to negative UK rates is well and truly open,” Chatwell said.
The Bank of England has been conducting academic research on the impact negative interest rates could have on markets and the economy, having cut rates from 0.75% to 0.1% since the beginning of the coronavirus pandemic and expanded its target stock of U.K. government bond purchases to £895 billion ($1.2 trillion).
The slices of the equity market most sensitive to Brexit developments are U.K. banks, U.K. housebuilders and U.K. domestic stocks, followed by the FTSE 250, according to Goldman Sachs Chief Global Equity Strategist Peter Oppenheimer.
Domestic firms will be hit by lower GDP growth owing to frictions in output and trade, higher costs in GBP terms as sterling falls against other currencies, and lower real incomes for consumers as the basket of goods they buy becomes more expensive in sterling terms, Oppenheimer highlighted in a research note Sunday.
“In contrast, the large U.K. internationally exposed stocks do little trade back-and-forth with the EU — they are in many cases not exporters but rather own foreign-based businesses where earnings are oftentimes in dollars,” he said.
“FTSE 100 has a beta close to zero to GBP (a measure of relative volatility of an asset compared to the wider market) and, while volatility may rise, we would not expect much change over a few weeks. It is worth noting that in the two trading days after the 2016 Referendum FTSE 100 fell an accumulative 5½%, but within four trading days of the result the index was above the pre-result levels, and within a week of the result it was up almost 3%.”
Oppenheimer noted that a week after the referendum result, the FTSE 250 and Euro Stoxx 50 were both down 6%, though both had rebounded strongly from an initial sell-off.
‘Cooperative’ no-deal more manageable
Given the progress of talks and the previous ratification of the Brexit Withdrawal Agreement with solutions on many key issues, the current “no-deal” scenario may not be as economically damaging as many previously feared, according to Capital Economics Chief Economist Paul Dales.
The Withdrawal Agreement clinched last year featured agreements on citizens’ rights, a financial settlement and Northern Ireland, and progress has been made on financial services equivalence and the rollover of many of the U.K.’s third-party trade deals, Dales highlighted in a research note, though he suggested the economy would not get off scot free.
“The imposition of tariffs and customs checks at the borders (the latter will happen if there’s a deal too) will surely cause some economic disruption as trade moves more slowly across borders,” he said.
“And we suspect that a fall in the pound from $1.32 (€1.09) now to around $1.15 (€0.96) would temporarily raise CPI (consumer prices index) inflation to around 3.5% next year, thereby reducing real household incomes.”
Dales also foresees further monetary policy easing from the Bank of England in this instance, along with potential fiscal loosening from Finance Minister Rishi Sunak, in the form of VAT (value-added tax) cuts or financial support for businesses exporting goods to the EU which would become subject to tariffs.
“As such, we suspect that in a ‘cooperative’ no deal GDP growth would be around 1% lower in 2021 as a whole than it would be if there were a deal,” Dales said.
“Put into context, the Covid-19 crisis has meant that GDP this year will be about 11.5% lower than last year and at one point earlier this year it was 25% lower.”
