Investors are baffled by range of possible Brexits as difficult divorce talks continue

Investor appetite for U.K. assets has diverged in recent months, with government infighting adding to widespread uncertainty over the range of possible Brexit outcomes.

The four days of second round Brussels talks are led by the U.K.’s Brexit secretary David Davis and the European Union’s chief negotiator Michel Barnier, and will focus on citizens’ rights, the U.K.’s mooted €60 billion ‘divorce bill’ and the border in Northern Ireland.

The first round of detailed negotiations comes as cracks appear in the U.K. government’s strategy for its exit in March 2019, with doubts beginning to become visible in investors’ asset allocations. They are struggling to calibrate the different likelihoods of the relatively “hard” Brexit officially pursued by the U.K. government, which would entail leaving both the EU’s single market and its full customs union, and the spectrum of softer options preferred by increasingly rebellious parliamentarians within both the governing Conservative and the opposition Labour Party.

While the share of institutional investors planning to reduce their exposure to U.K. financial assets in the next six months rose by two percentage points to 20 per cent, according to a quarterly investor sentiment survey from State Street published July 13, the proportion expecting to add to their holdings in the country also increased, gaining three percentage points to 16 per cent.

“Neither the U.K. election nor the beginning of Brexit negotiations have narrowed down what is likely to happen,” Michael Metcalfe, head of global macro strategy at State Street Global Markets, said by email. “If anything the possible outcomes have widened not narrowed.”

 

Sterling protection

Debt investors have even received a boost from Brexit, as more foreign investors have been lured into sterling bonds printed by U.K. companies thanks to the depreciation of the pound sterling, which has given up 10 per cent against the dollar and 11 per cent against the euro since the referendum on leaving the bloc in June last year. This has made the bonds look cheap to investors funded in other currencies, said one head of debt capital markets at a U.K. bank.

 

“Investment-grade U.K. credits have sold around three times more sterling bonds this year than at the same point in 2016, and the allocations to foreign investors have risen significantly as sterling looks attractive,” he said.

 

“There may have been a shift from U.K. equities towards fixed income, but there has been no lack of appetite for bonds because of Brexit.”

 

Importantly, said State Street’s Metcalfe, the balance for now is still positive – more investors still plan to increase their holdings of U.K. assets in the next six months.

“There is still no evidence of capital flight from UK assets,” he said.

“But it is testimony to the continued level of uncertainty over Brexit that the opinion among these respondents is getting more divided not less as the deadline nears.”

 

Questions not answers

 Theresa May’s Conservative government was weakened by the inconclusive result of the June 8 general election, and the prime minister’s diminished authority has led to senior members of her government airing opposing visions for Brexit.

Finance minister Philip Hammond has emerged as the champion of a ‘soft’ Brexit that would favour preserving the current trading relationships with the EU over curbing immigration. He was the subject of a series of cabinet leaks over the weekend that sought to undermine him.

Divisions within the Labour Party, whose leader Jeremy Corbyn reportedly favours a hard Brexit, unlike many of his parliamentarians, further add to a confusing political backdrop which has led European officials to ponder whether the U.K. may struggle to reach any deal at all.

“Talking to politicians on each sides of the fence in recent weeks, we get the strong impression that the politics of Brexit continues only to raise more questions than answers,” said Robert Condon, managing director for public and corporate affairs U.K. at consultancy firm Hume Brophy.

“This is set to continue until time runs out. Whitehall officials will search desperately for the ‘opportunities’ Brexit poses. However, Theresa May’s foes will attempt to derail progress at every turn to try and ensure the continued misfortunes of her party until the next inevitable electoral judgement day.”

Many in Westminster believe May cannot last much longer as prime minister, having lost the Conservative majority at the June election.

Hammond, Davis and foreign secretary Boris Johnson are said to be front runners to replace her, with their posturing ahead of a potential leadership election making a united strategy on Brexit more difficult.

“Within the minority Conservative Government there is an understanding – as admitted by David Davis – that a comprehensive free trade agreement with the EU will take longer than the two-year Article 50 negotiation period,” said Condon, referring to the period set out under EU rules leading up to the U.K.’s exit from the bloc in March 2019.

There is also disagreement within the government over any ‘transitional deal’ to ensure trading arrangements are not suddenly disrupted once exit takes place.

“As we leave the bloc, an arrangement for the interim must be in place. What this arrangement will look like and the period it will be in effect are both undetermined, adding to market instability. The length of such an arrangement is currently the focus of turf wars among Cabinet beasts, Boris Johnson being a nuisance as usual.”

Emboldened by the election result, which appeared to show voters rejecting May’s hard version of Brexit, MPs from both big parties have been calling for a referendum on the terms of the final Brexit deal. Some recent polls in the U.K. suggest public support for this is growing.

Led by former Conservative minister Anna Soubry and Labour MP Chuka Umunna, both high-profile ‘Remain’ campaigners in the June 2016 referendum, a cross-party working group will fight the passage of the government’s key Brexit legislation through parliament over the next two years, in an attempt to secure the softest Brexit possible.

This effort will “only add to the calamity,” Condon said.

Tom Porter is part of S&P Global Market Intelligence’s news platform