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Analysts dust off doomsday scenarios as Brexit hits buffers


According to Market Intelligence, December 2022


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Analysts dust off doomsday scenarios as Brexit hits buffers

Analysts are looking more closely at what a "cliff edge" Brexit would mean for financial markets and the global economy, as negotiations over the terms of the U.K.'s exit from the European Union hit a stalemate.

The EU had hoped to allow talks to move on to a future deal governing trade after Brexit this week, but this has now been pushed to December at the earliest as the two sides have not met the criteria of "sufficient progress" after five rounds of negotiations.

Senior City of London figures told U.K. lawmakers on Wednesday that firms would be forced to begin moving core operations over to the EU early in 2018, if no deal for a 'transition period' to maintain current trading rules beyond the official Brexit date in March 2019 is agreed by the end of 2017.

"European negotiations have a habit of never being done early," said the chief economist of one European investment bank.

"Just think of the series of Greece summits a few years ago — there is a lot of emotion and politics on both sides but then at the 11th hour in a smoke-filled room, common sense tends to prevail. Markets clearly have to react to changes in the situation but we still expect a deal at some stage."

However, the "cliff edge" has clearly moved closer in recent weeks, with the EU's chief negotiator Michel Barnier saying talks were in "deadlock" and Bank of England Governor Mark Carney saying the central bank was now working out contingency plans for a "no deal" Brexit.

Sterling has fallen 3% against the dollar and 1.5% against the euro in the last month. Some analysts have predicted the currency could fall from $1.31 to as low as $1.10 if the talks collapse completely.

Five- and 10-year U.K. government bond yields have been virtually flat over the same period, but the spread between five- and 30-year gilt yields has collapsed from a high of around 150 basis points in February to around 110 basis points now, reflecting fixed-income investors' dim view of the U.K.'s longer-term economic prospects.

"Whatever your probability was of a 'no deal' Brexit a couple of months ago, you have raised it by now," said Jane Foley, head of foreign exchange strategy at Rabobank in London.

"I have a very strong sense that a lot of our customers, in the food and agriculture business for example, are very uncomfortable and will find it hard to invest."

Stakes rising

Rabobank economists have estimated that leaving the EU without a trade deal in place would cost the U.K. 18% of GDP growth until 2030, amounting to some £400 billion, compared to continuing its membership. They see U.K. exports tumbling by 30% and consumer prices rising by the same amount in this scenario.

The stakes have been raised since the country's external accounts were revised materially by the Office for National Statistics at the end of September.

The U.K's net external asset surplus for 2016 had been reported as £469 billion, but the ONS revised this to a £22 billion deficit thanks to a £529 billion reduction in the estimate of overseas long-term debt securities held by U.K. investors. Foreign direct investment also fell markedly.

That £500 billion swing in the country's external position is worth 25% of GDP, according to Bank of America Merrill Lynch rates strategists, who believe the change has made the U.K. economy more vulnerable to the sentiments of foreign investors.

"A current account deficit leaves a country vulnerable to funds drying up, or investors demanding a higher return," they said in an Oct. 18 note to clients.

"The chances of a worse outcome on Brexit talks are not zero, and what is new is that the economic and market risks from that alternative are greater, in our view, than they seemed before the ONS revisions."