Which is harder CFA or FRM

A hard Brexit would eliminate uncertainty for the markets

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We have long argued that the best possible Brexit scenario would be an agreement between the UK and the European Union (EU) on post-exit trade relations. We are still convinced of that. However, following today's vote in the UK Parliament, given the tight time left, this seems almost impossible.

MEPs in the UK Parliament voted overwhelmingly against the exit agreement proposed by Prime Minister Theresa May. The EU, on the other hand, has said it is unwilling to make any further concessions.

In the meantime, the time until the exit scheduled for March 29 is becoming increasingly scarce.

In our view, there are only three ways for the UK government out of this impasse:

  • She revokes Article 50, effectively canceling Brexit
  • She tries to extend the negotiation period
  • She accepts a hard Brexit without an exit agreement

Cancellation of Brexit

Even if a number of opinion polls have recently indicated that British voters are now in favor of remaining in the EU, there does not seem to be a majority in the British House of Commons in favor of moving away from Brexit.

Should Article 50 be repealed, we would expect an extremely positive response from the financial markets, both in the UK and in the rest of Europe. The bond markets would likely sell off, sterling would rally and UK stocks should see gains. However, this seems to us to be the least likely option.

Extension of the negotiations

The second option, an extension of the negotiations, appears to be the most likely from our point of view. However, it harbors further uncertainty.

Any extension must be unanimously approved by the remaining EU members. We assume that some of them are likely to ask for certain concessions before giving their consent. In addition, we would question whether there will be enough time until March 29 to get approval from 27 different parliaments.

Rumors circulating in Brussels suggest that any extension will be quite limited, possibly only until the summer. The two sides have been negotiating for two years without reaching an agreement. From our point of view, it is therefore questionable whether an extension by two months would bring about significant changes.

We also recognize that markets abhor uncertainty. An extension of Article 50 also increases uncertainty.

Hard Brexit

We currently estimate the probability of a Brexit without a prior agreement to be around 30% to 35%.

The impact of such an outcome would be significant. However, we do not believe that a hard Brexit will necessarily mean the end of the world. In many ways, it could be the quickest route to the assurance that markets so crave.

A no-deal Brexit would in all likelihood mean heightened uncertainty over a period of three to six months while the details are worked out. The EU has declared that the Status quo ante wanting to maintain it over the coming year as the two sides adjust to the new environment.

The initial reaction would arguably be negative: we would expect a significant rally in bond markets and gilts should return to their all-time lows. In our view, however, things could only get better afterwards once a hard Brexit was confirmed.

Can Theresa May hold onto power?

In the course of the Brexit saga, British Prime Minister Theresa May has repeatedly reiterated her intention to stick to her current course.

At the end of last year, she survived a challenge to her leadership by members of her own party and insisted that even if she lost this week's vote on her proposals to leave the EU, she would not step down.

The opposition Labor Party has now requested a vote of no confidence in its government.

In practical terms, we do not believe that a change at the top of the UK government would significantly change the situation. Unless the talks are extended, we do not assume that there will be enough time for a successor to May to negotiate a new agreement with Brussels.

A new prime minister could unilaterally revoke Article 50, ultimately canceling Brexit. However, we do not see any interest in such a move among the leading candidates for this position.

Should May resign, market nervousness could increase significantly for a while as investors wait for information about their successor's identity, the possibility of new general elections, and one last attempt at reaching an agreement.

According to our final analysis, however, a change in leadership is unlikely to have a noticeable impact on the direction of development.

Weaker pound sterling becomes more attractive

Many investors we speak to already believe sterling is undervalued. However, given the uncertainty surrounding Brexit, they are still reluctant to buy.

A hard Brexit would certainly lead to a devaluation of the pound sterling. However, we assume that as a result, numerous investors would take hold to get involved at even cheaper prices.

The trade regulations of the WTO apply

In the event of a no-deal Brexit, the United Kingdom would be subject to the trade rules of the World Trade Organization (WTO). These include, among other things, the WTO trade tariffs, which are usually higher than the rates negotiated within the framework of individual trade agreements.

For the UK, however, there is an option not to impose these tariffs on imported goods. The country has a high trade deficit with other countries. Hence, in the wake of Brexit, it will be important to maintain the flow of goods to avoid the bottlenecks that some commentators are concerned about.

There is no guarantee that the elimination of trade tariffs would be reciprocal with other trading partners. However, it should be possible to maintain the flow of goods to Great Britain as a result. In addition, any successful UK trade talks would improve trading conditions.

For companies, the confirmation of a hard Brexit would bring security with it. Exporting companies would have some degree of security about the tariffs that would be imposed on their goods. However, we would expect the pound sterling to be devalued, making their goods cheaper for overseas buyers. This should provide some level of support.

The immediate reaction to the confirmation of a hard Brexit would in all likelihood be extremely negative: the Bank of England's Monetary Policy Committee could intervene.

We would assume that the central bank tends to be more relaxed than too restrictive. She might even consider resuming her quantitative easing program.

The impact on Europe

One area that has so far been neglected is the likely impact of Brexit on Europe.

Of course, the consequences of Brexit will be felt most strongly in the UK. However, we assume that a hard Brexit could reduce EU growth by around 0.2% to 0.3%. Overall, this may not seem particularly high, but if you take into account that the EU is only growing by 1.5% to 2%, this is a considerable bite.

We are therefore of the opinion that there is likely to be a high level of motivation within the EU to normalize trade relations as quickly as possible.

Limiting uncertainty

Two and a half years ago, when all options for a negotiated Brexit were still on the table, a hard Brexit appeared to be the worst possible scenario.

In the meantime, however, the markets may have come to the conclusion that acceptance is preferable to short-term exposure if this ultimately means the end of uncertainty.

The comments, opinions, and analysis in this document are for informational purposes only and should not be construed as personal investment advice or recommendations for any particular security or investment strategy. As markets and economic conditions are subject to rapid changes, comments, opinions and analyzes are as of the date of publication and are subject to change without notice. This document is not intended to be a complete analysis of all material facts relating to any country, region, market, investment, or strategy.

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What are the risks?

All investments involve risk, including the potential for loss of capital. The value of investments can go down as well as up and investors may not get back the full amount invested. Bond prices generally move against interest rates. So if bond prices in an investment portfolio adjust to rising interest rates, the value of the portfolio can fall. Investments in foreign securities involve special risks, including currency fluctuations and uncertain economic and political developments.

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