Weekly Update - Brexit Day – What Happens Now?

The Summary
After almost 42 months of uncertainty with repeated speculation about a second Brexit referendum, the Conservative party’s resounding election victory on December 12 finally resolved the debate, paving the way for formal departure from the European Union tonight, January 31st. The result was met with relief by UK businesses, with a rally back into expansion territory in this month’s confidence surveys of purchasing managers in manufacturing and services. What happens next? And what is the likely impact on business and markets?
On Wednesday January 29, the European Parliament voted overwhelmingly in favour of the Withdrawal Agreement (WA) negotiated late last year, removing the last remaining obstacle to tonight’s departure. The WA covers three main areas: it confirms that the UK will pay a €39bn divorce bill, some of which has already been settled; it protects the rights of UK expatriates in the EU and EU workers in the UK; and it removes the need for physical border checks between  Northern Ireland and the Republic of Ireland.
During the transition period – which commences tomorrow February 1 and is due to run until year-end – the UK will retain many of the advantages of EU membership but much will begin to change. In the “Deep Dive” section of this report, we cover areas such as travel and residency, legal status and representation, trade, the regulatory context and the forthcoming negotiations.
Business confidence has bounced in the wake of the December election and mortgage approvals jumped in January, leading the Bank of England (BoE) to keep interest rates on hold yesterday. Nonetheless, the market still assigns a 48% probability to a 25bp rate cut in May. This reflects the slowdown in the UK economy in 2019, with GDP growth slipping below 1% on slow business investment and sluggish productivity growth.
However, the job market has been robust – unemployment currently stands at its lowest point since the 1970s – and wage growth has been strong. Moreover, the election was won on a platform of fiscal stimulus, in addition to the promise to deliver Brexit. This additional spending should combine with improving business confidence to foster a pick-up in activity this year, suggesting that the BoE may not need to cut rates after all. All in all, the consensus expects 2020 GDP growth at 1.1%.

Bottom line. With no change in key rates this year, we expect 10-year UK sovereign yields to rise and suggest focusing on short-maturity bonds which are much less sensitive to moves in rates. Corporate bonds should continue to outperform UK sovereigns. Sterling remains sharply undervalued against the US dollar, as illustrated on the chart below. As negotiations advance throughout the year, we expect the pound to strengthen somewhat, reaching $1.35 to $1.40. Sterling strength tends to act as a brake on large UK companies’ profits which are mostly earned overseas, meaning that mid-sized, more domestic stocks should outperform.

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