UK: When will it be time to be wary of British assets? – Natixis

René Defossez, Research Analyst at Natixis, notes that the fourth negotiating round over Britain’s exit produced very meagre results and the impression given sometimes by Michel Barnier and David Davis is that they are the new stars of the moonwalk: the more negotiations progress, the more disappointing the results.

Key Quotes

“On the occasion of the press conference that concluded the fourth round, Michel Barnier dashed the hopes of many by saying that it could be weeks or months before there is sufficient progress and it become possible to move to the next stage of talks about a trade agreement, this when the British camp would like these talks to start as soon as possible. Admittedly, Michel Barnier conceded that Theresa May’s Florence speech had created a new dynamic, while as always David Davis claimed there has been decisive steps forward, however no obstacles have been removed to permit negotiations to move to the next phase. The most optimistic observers will point out that the EU is now agreeable to holding talks over a transition period, on the condition there is sufficient progress on the issues of the divorce bill, the status of expatriates and the Irish border.”

“In short, negotiations over a trade agreement will not get under way any time soon. The EU27 is not prepared to make any concessions over prerequisites for moving to the second stage, while the British camp is perplexed by the EU’s lack of flexibility. Even the Labour Party has urged the EU to show greater flexibility. Hilary Benn said yesterday he understood the government stance on the Brexit bill, being that the government will not commit at this stage until it knows what the EU is prepared to offer on the hugely important question of trade and market access.”

“The problem in all this is that the UK is not negotiating from a position of strength and if talks collapse and a cliff edge scenario unfolds, investors will punish not the EU27 markets but the British markets.”

“As regards the Eurozone, the growth outlook is relatively good and uniform (GDP growth for EU Member States once again displays low dispersion), the fiscal situation is tending to improve and monetary policy is fairly decipherable. By contrast, when it comes to the UK, GDP growth is tending to slow because consumption is running into headwinds (erosion in earnings year-on-year, low household savings rate, tighter lending conditions and, possibly in a few weeks, a hike in the bank rate, along with less favourable wealth effects) and firms are less inclined to invest (1pp contribution to Q2 GDP growth), while exports have made a very disappointing contribution despite sterling’s weakness. Furthermore, the quality of the British debt is deteriorating and the Bank of England is a source of uncertainty (not of its doing, but because it faces a conflict of objectives), it being very likely it will pursue a pro-cyclical policy if it raises its rates over the next two months.”

“The decline in the quality of the British debt could have weighed on Gilts. This has not happened because, even after the one-notch downgrade, the quality of this debt remains good. Admittedly, the 10-year Gilt-Bund spread has widened, but this has been due nearly entirely to the change in expectations concerning monetary policies. In the first part of the year, Gilt in fact tended to outperform Bund, even though risks for the UK’s long-term issuer rating were already patent.”

“For credit quality to have a decisive bearing on the Gilt-Bund spread, the situation would have to deteriorate considerably at all levels (economy, Brexit negotiations, doubts over the UK’s capacity to fund its current account deficit, etc.). This point has not yet been reached. Having said that, the monetary tightening by the Bank of England can be expected to see Gilts continue to underperform.”

“The prospect of weaker growth, the many and varied Brexit-related risks and a possible hike in the bank rate notwithstanding the adverse economic environment could weigh on British equities. In fact this is already so: the FTSE 100 has underperformed significantly the EuroStoxx 50 since the start of the year (whether the two indices are expressed in the same currency or not). A number of funds have already modified their asset allocation at the expense of British equities.”

“Real estate, especially in London, could also be affected by Brexit-related uncertainties. The rise in house prices has already slowed considerably since last year, which is of some concern, as the property cycle is often closely correlated to the business cycle.”

“All in all, the Brexit risk has already a negative impact on some UK assets.”