"All Brexit scenarios remain in place", says BlueBay AM's Mark Dowding

Eugenia Jiménez
"All Brexit scenarios remain in place", says BlueBay AM's Mark Dowding

While Spain could use Brexit turmoil as election leverage, the outlook for sterling turns complex as all Brexit scenarios remain in play.

Government bond yields were little changed during the past week, with robust US consumer and investment data offset by a benign picture with respect to CPI inflation. 

Last week's payrolls report suggests some modest acceleration in wages, yet with growth robust and margins strong, there is little evidence of this feeding through into broader price pressure at this point - even if we should observe inflation starting to move a little higher in coming months, as negative base effects from the Q4 fall in commodity prices are erased. 

Risk assets continued to rally on receding growth slowdown fears and prospects for accommodative policy. 

Dot plot path likely to lower

At the Federal Reserve (Fed) meeting next week, it is anticipated that the FOMC will lower their dot plot to signal a more benign path for rates going forward, as well as pre-announcing an end to quantitative tightening, with balance sheet reduction anticipated to cease later in 2019. 

Notwithstanding this, we continue to look for rates to move higher in the second half of this year, with domestic growth remaining strong, global risks receding and tightness in the labour market continuing to push wages a little higher. 

We continue to disagree with market pricing, which discounts the next move in US rates to be down, not up, and we see no reason to expect the economy to slow materially as we look further ahead into 2020, noting that policymakers won't want to deliver a material tightening in fiscal policy, which could slow growth in an election year.

European politics: Vox in focus

In Europe, sovereign spreads were mostly stable during the week, with Greece the outperformer, following supply-induced softness the week before. Meanwhile, Spanish Bonos lagged, relatively speaking, as opinion polls in the run-up to the April election showed further gains for the extreme nationalist party, Vox. With Vox polling as high as 14%, there is a risk it becomes the second-largest party in a right-wing coalition and this could prove unsettling to investors. 

The centre-left PSOE party continues to lead the polls, but a coalition government seems inevitable, with politics in Spain much more fragmented than it used to be. PSOE gains have come mainly at the expense of the left-wing populist party Podemos. 

However, on the right, it has been noticeable how the Partido Popular and Ciudadanos are being pushed in a more Nationalist direction to counter the rise of Vox - something which means that there is little room for reconciliation with Catalonia any time soon, should they win power. 

Notwithstanding this, we remain confident that whoever wins the Spanish elections will stand behind the debts of the regions and so, although we expect Catalan to continue to be a divisive issue in Spanish politics for years to come, we continue to see value in Gencat debt, trading 200bps cheap relative to the sovereign.

Brexit election leverage?

The Spanish election could yet be a factor that creates an issue for the UK as it applies for a Brexit extension. This will require unanimity from all EU member states and we remain concerned that this isn't a foregone conclusion. 

More specifically, we suspect that the EU - holding all the cards and realising that there isn't any appetite in the UK for a ‘no deal' outcome - will demand certain conditions in exchange for granting an extension request. 

Pointedly, we sense from policymakers in Brussels that there is little logic to granting the UK a three-month extension just so that Theresa May can spend more time trying to negotiate herself improvements to the existing deal. 

Consequently, there may be a desire for the UK to be wedded to achieving a more definitive outcome, which could see the government commit to a series of votes within Westminster - or even a public referendum - to ratify a result. Alternatively, the EU may push for a longer, 21-month extension as previously discussed here. 

Either way, it is yet possible that the conditions which the EU demands could make Tories yet inclined to get behind Theresa May's withdrawal agreement in a ‘meaningful vote 3', if this starts to seem the least bad outcome in the run-up to 29 March. 

Certainly, it strikes us that there is some complacency with respect to extension within Westminster and the broader market. 

Political complacency

Many UK policymakers we meet continue to be surprisingly uninformed when it comes to their understanding of the Brexit process and politics in Brussels, and we continue to witness a disappointing naivete in some quarters from those who continue to assume that Europe needs the UK more than the UK needs the EU.

Meanwhile, revocation of Article 50 seems highly unlikely and would almost certainly trigger a general election. Indeed, an election is now a rising possibility, and although both the Conservative and Labour parties may be disinclined to go to the polls with both parties in disarray, it may yet be deemed necessary to break the deadlock and this is certainly something that would be more easily implemented than another referendum, at this particular juncture. 

All still to play for

Consequently, we find ourselves very much in the final countdown, with pretty much all of the possible Brexit possibilities very much still in play. A ‘no deal' leave on 29 March remains the least likely outcome - though we would currently ascribe similar 30% probabilities to either ‘no deal' or ‘no Brexit' as the eventual outcome by the end of next year.

Furthermore, we would also note that the current negotiations on an agreement, which is leading into a transition period in which nothing really changes, was actually meant to be one of the most straightforward pieces of the whole Brexit fiasco. Even if the UK leaves the EU with a deal, the truly hard work still lies ahead in the context of trying to negotiate a future trading relationship.

In looking at UK assets, we retain strong conviction that under pretty much every scenario Gilt yields are set to rise. 

Although a ‘no deal' outcome would create a flight to quality, we doubt Gilts would be a safe-haven for very long, with the pound likely plunging and the country in disarray. 

Moreover, this outcome would trigger the need for massive fiscal easing. In fact, we think that fiscal policy is likely to be loosened in any Brexit scenario and were a general election to lead to a Labour government, the magnitude of moves could be very significant, with Gilts likely to reprice materially.  

The outlook for the pound is more complex. The strongest rally would come from Brexit being cancelled - but if the route to this is via an election, it is not clear that the pound could benefit much in the near term.

With the UK economy likely to underperform following Brexit, it may not gain materially even if an agreement is passed and so risks could remain asymmetrically on the downside should the ‘no deal' scenario come to pass.

Looking ahead

Brexit will be the focus of the EU leaders summit next week and this seems sure to deliver some volatility, as the Brexit clocks ticks down relentlessly as everyone waits for something, or someone, to give.

Away from the UK, most global investors will be more focused on the Fed meeting. It seems likely that Powell may deliver a dovish message and we see this continuing to support risk assets. 

However, we think it will be hard for Treasury yields to rally from current levels unless risk assets sell off, and with financial conditions continuing to ease, the prospect of the Fed cutting rates in a forecastable time horizon remains extremely remote. 

With the S&P hitting new highs for the year, we continue to view the combination of robust US growth, declining global downside risks and accommodative policy as sustaining and further supporting the rally in risk for now - even if there may be a temptation to book gains into the quarter end.

In this context, what is happening in the US is what is key to global markets. By way of contrast, what is occurring in the UK looks like a very localised side show. Current newsflow coming out of Westminster seems about as relevant and content rich as an average episode of the Kardashians. 

That said, if we are not yet at the beginning of the end of the Brexit process, at least we are nearing the end of the beginning. Things could go badly wrong, but at least it is always good to know that we can rely on our Queen, if it comes to that…