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Does the sound of music in Salzburg change the outlook for Brexit?

21 September 2018

Theresa May has been in Salzburg this week trying to sell her Chequers proposal directly to European leaders. In recent weeks, Michel Barnier had said that there were some good elements in it but rejected the overall proposal. There have been many headlines recently relating to the possibility of an "unprecedented deal" being possible, but a consensus on decisions around certain issues like the Irish border remain sticking points. Each time there is a positive statement, the pound rallies. However, the message from Salzburg was far from encouraging, with a clear rejection of the Chequers proposal. It appears that the October deadline is slipping to November and possibly beyond. French President Emmanuel Macron in particular seems to be taking a hard line, to discourage others from doing the same. Despite the tough talking I expect a deal of some sort will be agreed between now and the 29th of March. This may just postpone many of the difficult negotiations to be agreed upon in the transition period.  Even if this happens it is unlikely all the requirements of any faction will be met and it will be hard to sell to the UK parliament. Theresa May has adamantly refused to countenance a second referendum but it may still be the only way to break a parliamentary deadlock. 

The Prime Minister has said we should be prepared for a Brexit with no deal. This may be a negotiating position but we have to consider the potential impact on portfolios. With supply chains crisscrossing Europe in and out of the UK, a hard Brexit is not good for manufacturing here or on the continent. In this event, we would expect sterling to fall, which would be positive for UK companies with overseas earnings. There could be a negative impact on European equity markets, but this could be offset in sterling denominated portfolios by the currency move. There would be little impact on equities elsewhere in the world and all other things being equal, these would rise in sterling terms. The picture for interest rates is more difficult. Post the Brexit vote, the Bank of England cut rates but has since raised rates again. At present they are expected to raise rates again next year. While the Bank of England could be expected to cut rates to boost the economy on a hard Brexit, if the currency falls too much, interest rates may have to move higher.  Overall, a hard Brexit would not necessarily be bad for sterling based investors.

The counter to this is the possibility of a deal being done that will be seen as a good Brexit with continued free trade.  In this scenario, the pound would strengthen and UK equities with overseas earnings that make up the majority of the London market, would be adversely effected.  The initial reaction would not be good for the majority of portfolios but investors have shied away from investing in the UK and could return boosting prices. With these complex factors at play, we can look at some basic valuation measures for the UK equity market. The prospective price earnings ratio for the FTSE 100 index is just 12.5x (an earnings yield of 8%) and the dividend yield is 4.3%.  With the ten year gilt yield at just 1.6% the equity market is already pricing in a lot of bad news. 

The Salzburg summit changed nothing, this is not good news for the UK economy and uncertainty remains high. For UK investors however, there are more positive signs.  So as we say "so long, farewell, auf wiedersehen, goodnight" to the EU leaders in Salzburg; it is not all bad news for UK investors.




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