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Here Are The Potential Brexit Scenarios — And Their Investing Ramifications

From Invesco: The Brexit process started yesterday, when British Prime Minister Theresa May formally notified the European Union (EU) of the UK’s intention to withdraw from the EU under Article 50 of the Lisbon Treaty.

The invocation of Article 50 kicks off a scheduled two years of formal talks with the European Commission, the EU’s executive branch, on the terms of the UK’s exit. Talks will likely lead to a new UK-EU relationship or — in the event of a failure to strike a new deal in time — to the UK “crashing out” of the EU, with the potential for serious economic disruption to trade, investment and general relations.

The nine months since the June 2016 referendum on EU membership has been full of preliminaries, doubts, soul-searching and posturing on both sides of the English Channel. At Invesco Fixed Income, we expect a good deal of posturing to continue as actual negotiations get underway.

Key elections will shape the future of the UK-EU relationship

We expect the 2017 talks to focus mainly on the terms of exit rather than the substance of the post-exit relationship, given the spate of critical elections in key member states in the coming year: France (presidential elections in April/May and parliamentary elections in June), Germany (federal parliamentary elections in October) and Italy (new general elections due by March 2018, which could be brought forward).

The economic substance of the future UK-EU relationship cannot be properly negotiated until these crucial elections are decided because the underlying political dynamic in each of them is driven by different views about the balance of power among nation-states and EU integration, or even federalization. This leaves a tight time frame — roughly one to one-and-a-half years — to negotiate between the German federal elections and the end of the two-year time frame allowed under Article 50 (unless it is mutually agreed to extend that time frame).

Below, we discuss three possible scenarios and outcomes that could lie ahead.

Scenario 1: Amicable divorce and cooperation

We expect an eventual compromise in 2018-19, which would lead to a special relationship — a “Brespoke” arrangement. We would assign a subjective 65% probability to such a relatively favorable outcome. This, our central scenario, is based on the fact that the EU has almost always found ways to compromise when it is in the rational economic or political interest of all key parties — often at the eleventh hour, sometimes after an extension of “final” deadlines. We are encouraged that, in recent writings, the European Commission has raised the possibility of a looser confederation — a multi-speed Europe with varying degrees of integration.

We believe that once the intensity of this critical year of EU elections is over and the immediate risks to EU secessionism have passed, the political temperature can be lowered. The EU position can shift from a hard-line stance (aimed at discouraging nationalism and the UK’s go-it-alone, cherry-picking approach) to a balanced approach that encourages cooperation and a modus vivendi, or practical compromise, with Europe’s many divergent views on the role of the EU.

Scenario 2: Bad break-up

That said, a terrible failure cannot be ruled out, and we assign a 25% probability to this scenario. We fully acknowledge that the recent posturing and current stance on both sides of the English Channel point to a substantial tail risk of a breakdown in talks that could lead to a “hard Brexit” borne out of a failure to reach any kind of transitional or final deal.

Such a scenario could well precipitate a UK recession and EU slowdown, in our view. A breakdown could also have global repercussions in a world that is already on edge due to trade tensions following the Brexit referendum itself, US President Donald Trump’s protectionist campaign rhetoric, and the recent dilution of the G20 statement’s anti-protection clause. The market effects would likely be most severe in the UK, concentrated in sterling downside and lower gilt yields, but with some tail-risk spillover to risky asset classes in both Europe and worldwide.

Scenario 3: Never say never!

We impute a minimal 10% chance to the improbability that that somehow the UK and EU revert to full membership. This would probably require an initially vituperative negotiation that helps precipitate an even sharper fall in sterling, a surge in inflation and a deep UK recession that causes a reassessment of the decision to exit. Far from a bullish scenario, such an about-face would likely be a response to a supremely bearish turn of events in the UK, EU or wider world economy — the sort of reversal that would be required to overcome current opposition to EU membership.

Invesco Fixed Income’s view

In assessing UK asset prices over the coming Brexit talks, particularly sterling, Invesco Fixed Income takes the following three points into account:

  1. We would expect sterling to strengthen if a hard Brexit can be avoided (as in our central scenario). We believe a hard Brexit has been substantially priced in.
  1. It is difficult to identify all the potential highs and lows at this point. However, the EU summit planned for April 29 could be a more immediate “low” for sterling. Following this gathering, the remaining 27 EU states are likely to set out their negotiating strategies and could take a harder line at the start.
  1. Other factors will likely continue to drive UK markets. The potential inability of President Trump to deliver on his fiscal initiatives in the US or the potential for a European election with an anti-EU outcome are two possible developments that would likely lead to US dollar and euro weakness, which could bolster sterling.

Taking all of the above into account, and our central view of eventual compromise, we have a longer-term bias to be overweight sterling. However, we expect there to be better opportunities to implement this view, for example, after April 29.

The Vanguard FTSE Europe ETF (NYSE:VGK) was unchanged in premarket trading Thursday. Year-to-date, VGK has gained 7.59%, versus a 5.37% rise in the benchmark S&P 500 index during the same period.

VGK currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #2 of 91 ETFs in the European Equities ETFs category.

Important information

The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.

This article is brought to you courtesy of Invesco.

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