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October hard Brexit off the table as Boris miscalculates

Johnson plays fast and loose in Westminster while Greece’s government pursues a path of fiscal responsibility. 

Political developments in Europe provided the principal focus for investor attention during the past week.

The Brexit update

In the UK, 22 rebels from the Conservative Party voted against the government, in moves designed to curtail Boris Johnson’s ability to leave the EU on 31 October with no deal.

With the Tories also losing their Westminster majority after Phillip Lee defected to the Liberal Party, a UK general election now seems inevitable.

However, with Jeremy Corbyn having the ability to delay a vote beyond 31 October, events over the past few days seem to suggest that the Prime Minister and his advisors have miscalculated and will be forced into applying for a Brexit extension – unless they are able to do a deal with Brussels, which looks highly unlikely given that no discussions are currently taking place.

Although there is much uncertainty and fluidity in the situation, we are inclined to believe that the Brexit deadline may need to be moved until the end of 2019.

This could see an election in November, fought on the basis of the Tory and Brexit parties campaigning for a hard leave and the rest of the parties in a de facto alliance.
The result could deliver a Labour/Liberal/SNP coalition seeking a second referendum and a potential cancellation of Brexit altogether.

Currently, many assume that the Tories would be the overwhelming favourites to win such a vote. However, we believe that the outcome is too close to call given regional variations, which could see the Conservatives lose seats to the SNP in Scotland and to the Liberals in London, the South East and South West.

Indeed, we could see the rival coalition ahead, as we are sceptical as to how many seats the Tories can win in traditional Labour seats in the north.

Meanwhile, Labour’s election chances could further be enhanced were Jeremy Corbyn to agree to step aside at the upcoming Labour Party conference.

Either way, with Boris Johnson’s Uxbridge majority looking vulnerable, it seems to us quite possible that we will see another UK prime minister in 2019, with Boris at risk of being the only UK leader to never win a single vote in parliament.

UK investment view

These UK developments lead us to be very bearish on Gilts. Compared to other countries, the UK is now rapidly moving to ease fiscal policy and this could make lower interest rates less likely.

Meanwhile, should a Labour government win power, we believe that a very progressive fiscal policy aimed at investment in infrastructure, green technology and nationalisation could materially raise yields.

A reversal on Brexit could also spur growth and make rate hikes more likely in the course of 2020. In this context, we can’t see the UK joining the negative interest rate club and so prospects for 10-year yields at levels below 0.4% look very much skewed to the upside, in our opinion.

Similarly, we believe that the risk /reward ratio also now favours a long position with respect to the pound.

Elsewhere in Europe

Italian political developments continue to favour BTPs, as worries related to break-up risks and confrontation over the upcoming budget continue to recede. We continue to see Italy offering value and expect the spread to tighten further in coming weeks, though moves from this point should be more gradual and progressive as volatility starts to fall.

The rally in BTPs makes Greece stand out as the most attractive market in the eurozone, in our view. We see scope for further Greek credit upgrades as the new government continues to pursue a path of fiscal responsibility.

We have also started seeing value in some selected emerging market assets. For example, Romania traded at a lower yield than Italy a few months ago, but now offers a pick-up of more than 100bps at the long end of the curve.

Non-manufacturing picks up US sector slack

In the US, the ISM manufacturing survey dropped below 50, adding to voices worrying about prospects for slowing growth leading to recession. There is no doubt that Trump’s trade policies have had a material impact on global trade and the manufacturing sector globally has been exposed.

However, we continue to see other sectors in the US picking up the slack, as evidenced by yesterday’s better-than-expected ISM non-manufacturing data.

Consequently, we continue to project US growth at around 2.5% in the absence of a sharp fall in stock prices. Growth prospects would be much stronger, in our view, if Trump would tone down the rhetoric on trade – even if this means more of a ceasefire in the run-up to the presidential election rather than a deal being found.

The Federal Reserve remains on course to cut rates by 25bps this month, but in many respects, it is much more important what comes out of the White House than the FOMC.

Looking ahead

Today’s payrolls report will provide a test of whether other sectors in the US economy are picking up the slack as manufacturing activity stalls.

However, we see the upcoming ECB meeting as potentially the biggest driver of risk in markets. There have been a number of hawks seeing to play down expectations of further monetary accommodation. But we are inclined to believe that Draghi will carry the day at his last meeting and this will mean a package of measures is delivered.

We see a 10bps rate cut with deposit tiering (potentially exempting 90% of excess bank reserves from the negative interest rates). This could benefit European banks by up to EUR10 billion per year and with the LTRO allotment made at the deposit rate, this could reinforce the carry trade to benefit the banking sector at a time when equity valuations are very depressed, on a price-to-book ratio of 0.4 times or less.

Additionally, we expect to see QE, with an additional EUR30 billion of purchases per month until such time that core eurozone inflation exceeds 1.5%. Such a step could effectively lock the new board into delivering ongoing accommodation and mean that Christine Lagarde’s first few meetings should be easier, without the need to deliver further policy initiatives.

Otherwise, our gaze will remain on the events in Westminster – with UK politics witnessing some unprecedented and surreal developments. In many ways it feels like the world’s oldest parliamentary democracy is broken and public trust in its elected officials is at an all-time low. It is possible that a general election may improve this, but there are no guarantees.

With Johnson seemingly happy to play fast and loose in his approach to Westminster, it is also ironic that in an upcoming election being pitched as ‘The Politicians versus The People’, that the ‘people’ are represented by the upper-class Etonian elite who are prone to express a general disdain for the proletariat masses.