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No deal or no Brexit?

The reality of Brexit will undoubtedly be in focus in the next few days...what will happen next?

US Treasury yields rallied strongly during the past week in the wake of a dovish FOMC meeting. Powell announced an end to quantitative tightening (QT) in September and a broadly flat outlook on interest rates over the coming year, with only one rate hike suggested in the dots in 2020, consistent with downwardly revised growth projections.

With this messaging as dovish as markets could have hoped for, it was a little surprising that the initial reaction from risk assets was not stronger – this seems to highlight that it will be growth that matters as we head into the second quarter, more than policy.

Spring optimism could lift the mood

In this regard, we retain a more upbeat view than many and as we pass the date in the calendar when the days are now longer than the nights, it seems that we may be set to move away from a dark patch in data over the course of the winter months and look for signs of improving activity in the weeks ahead.

With respect to the US, we believe that the consumer will be key to the outlook. With strong growth in disposable income, thanks to growth in employment and wages and declining taxes, it seems to us that the US consumer is in very good health.

In addition, we have seen more than half of the 2018 tightening in financial conditions erased in the course of the past 10 weeks, and with headwinds coming from the rest of the global economy set to abate, we believe there are reasons to be optimistic.

We would also note that during the past five years, US GDP growth has expanded at an average annualised pace of just 1.5% in the first quarter of each year, compared to an average growth rate of 3.6% in the second quarter. It strikes us that we may be set for a similar trajectory in 2019.

Consequently, we believe that those extrapolating a continued slowing in growth may well end up being too bearish in their thinking.

US inflation likely to creep up

We retain a short view with respect to US rates, noting that the pricing of the Eurodollar curve calls for one and a half Federal Reserve (Fed) rate cuts by the end of next year. We expect lower rates today and an end to QT will ensure that this economic expansion continues through the course of 2020, as well as this year. With wages likely to continue to track high, we remain confident that inflation will also edge upwards over the year ahead.

As such, we would expect two-to-three Fed hikes before the end of 2020 and for the FOMC to return to a rate hiking path later in the course of 2019, as it becomes clear that the recent slowing of growth was more of a temporary phenomenon. In this regard, the Fed, derided for being too hawkish just five months ago, could easily end up being criticised for being too dovish in five months’ time.

Data lift for eurozone

In the eurozone, we are similarly hopeful for an improving growth picture in the next few months. Nowcast surveys are showing some signs of improvement and we look for this to be confirmed in PMI and other data.

This optimism seemed shared in research meetings with policymakers in Frankfurt this week, though clearly Europe is coming from a much lower base of activity than is the case in the US.

The recent TLTRO from the ECB is seen as an incrementally helpful step and we are also persuaded to think that the ECB could move towards deposit tiering as a next policy step, in order to help support the Continent’s banking sector.

Eurozone banks effectively pay EUR8 billion per annum on excess reserves held at the central bank, as a result of being charged rates at -0.40%.

By contrast, US banks earn USD40 billion on the excess reserves they maintain with the Fed. With no early move upwards in interest rates on the horizon, it appears that the ECB may be mulling a tiering approach, as per the Bank of Japan, so as to end this tax on the banking sector.

We would assess that this would be positively received, as it continues to support confidence and lend to the notion that the central bank is not out of policy tools and initiatives, in contrast to those who believe that the ECB is powerless to act at this point.

Brexit: end of the beginning?

Meanwhile, the landscape in the UK continues to be overshadowed by the impending prospect of Brexit, with the original March 29th deadline only a week away.

For a long time, it feels that we have been following the Brexit debate and very little has been happening.

In football terms, it seems to have been a pretty tedious 0-0 draw, yet as the final whistle approaches, we know that a definitive outcome must be reached – bearing in mind that any move into a transitional period would only mark the ‘end of the beginning’ of the Brexit story, not ‘the beginning of the end’, with negotiations on a future trading relationship likely to be even more problematic than the discussions to date. With respect to the latest news flow, the EU offer to extend to April 12th, pushing this match into injury time, would appear to kill any hope of May’s deal passing, as this only seemed likely if there was an immediate threat of a ‘No Deal’ outcome.

It appears that a long extension is now the highest probability, though we would also observe that the Prime Minister’s days are numbered and any Tory replacement is likely to be a more ardent Brexiteer.

In this context the likelihood of any Deal being done now seems to be a declining probability and this would seem to infer that the UK will ultimately need to choose between a hard Brexit or no Brexit. At the same time, a general election is also a rising possibility.

Harnessing value in rising Gilt yields

In assessing what these UK risks mean to global assets, we continue to view what is happening in the UK as more localised than globally significant.

In the next couple of days, we may expect to see the pound come under a little pressure as complacency is challenged. However, we believe that a more substantial opportunity exists with respect to the pricing of UK Gilts.

10-year yields at 1.1% appear unsustainably low, as do long-dated real yields, where investors suffer -2.2% real yields in assets that are guaranteed to destroy as much as two-thirds of their value in real terms, if held to maturity.

If the Theresa May withdrawal agreement passes, we will look for yields to rise by 10-20bps from current low levels. An outcome in which there is a longer extension, and an elevated chance of either an election or a second referendum, could see yields substantially higher.

By contrast, it seems yields will only rally as a flight-to-quality trade under a ‘no deal’ shock. In this event, we would look for the pound to drop sharply and so we don’t think that Gilts would stay a safe haven for long as markets embrace a ‘sell the UK’ trade.

Furthermore, in this eventuality, it seems certain to us that there will be need for massive fiscal stimulus and this would also be negative for Gilts.

In this context, it seems that Gilt yields offer an interesting asymmetry and markets seem far too complacent of the risks, which could see yields more than double from where they stand today.

Looking ahead

We continue to back a view which is constructive on the global growth outlook. It is fair to say that both top-down and bottom-up evidence paints a relatively mixed picture at this time, but we believe we saw a change in the tide a couple of months ago and look for this to be captured in data releases in the weeks and months ahead.

Equity markets have certainly adopted a ‘glass half full’ mentality since the start of the year and with policymakers seemingly wanting to encourage markets to rally, it seems that the conditions are in place for this bull market to run further – if only economic data and earnings can support this.

From a technical perspective, it feels that we continue to climb a wall of worry, with many investors underexposed to the move up in prices. Although data is key, we would also highlight that an expansion in multiples is very possible – even in an environment where earnings growth is only relatively moderate.

Otherwise, the reality of Brexit will undoubtedly be our focus in the next few days. Should the prime minister’s vote fail next week, we find ourselves getting many questions regarding what will happen next.

First, we would note that Parliament can only vote legislation brought by a Minister of the Crown – so unless one of May’s government minister rebels and tables their own motion, there is little that other MPs can deliver.

Second, we are interested to note that the Speaker in the House, John Bercow, is in an unusually important position. He decides what is voted and when. He can even wave through votes based on his own aural assessment, if he believes that the number of those shouting ‘yes’ outnumber those shouting ‘no’, without even a formal division and counting of members.

Arguably it seems that Parliament is currently broken and we might only hope that someone can help put it back together again. However, it is hard to hold out too much optimism just yet…………