Europe – (When) does the slowdown end?

In a nutshell

• Current Eurozone economic weakness is largely externally-driven, with domestic consumption so far supported by solid labour market trends. 
• However, its persistence is worrisome – especially as there seems little more that monetary policy can do at this point.
• While fiscal stimulus would be a more effective response, it is unlikely to materialise judging by recent history. An improvement in global trade, and no new accidents, seem a prerequisite for a pick-up in growth.

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Brexit – a messy path – with some light at the end of the tunnel

Deadlines have come and gone, but the Brexit saga is still with us – and has become increasingly complicated. To the surprise of many, the first part of the story – negotiations between the UK and the EU27 – went rather smoothly. The resultant Withdrawal Agreement, however, then failed to be ratified by the UK Parliament, being voted down twice, by wide margins. This impasse led to a request for a deadline extension by the UK government in order to avoid the risk of “no deal” Brexit on March 29. While the EU assented, it only provided an extension until mid-April – as the UK would have to decide to hold European elections for a longer one.

Since the beginning of the process, our base case has been that Brexit occurs in a rather orderly fashion, with a Withdrawal Agreement in place and a transition period that lasts a number of years. This is a critical point as a “no deal” scenario would be far more disruptive, in large part because of the lack of such a period that allows all economic agents to adjust to the new status quo. Although the path has narrowed, a smooth Brexit remains our central scenario and we think the UK Parliament’s clear opposition to leaving without a deal provides support to this view. Consequently, our forecasts envisage sterling upside on a medium-term perspective, with GBPUSD appreciating towards the 1.35-1.40 range and EURGBP falling towards 0.82 (or below). This is because UK parliamentary approval of a Withdrawal Agreement would lead to the pricing out of (whatever is left of) the “no deal” Brexit premium and potentially the pricing in of tighter monetary policy by the Bank of England.

That said, Theresa May’s inability to gather sufficient support for her deal, despite having reached such a late stage of the process, is a worrisome sign. More recently, PM May has shown willingness to pursue a softer Brexit path, such as staying in a customs union with the EU, by forming cross-party consensus around this objective. This shift may provide the impetus needed to avoid “no deal”, although it is not yet clear that it will be successful.

In the meantime, markets have shown little concern about the worst-case outcomes. As illustrated by chart 8, both the UK equity market and the value of the GBP suggest that a smooth resolution is almost taken for granted by most investors. Since the European Court of Justice (ECJ) ruled last December that the UK can unilaterally revoke the Article 50 notification and remain in the EU, the domestic-focused FTSE250 equity index has gained 8%, while the GBP has strengthened by more than 5% in trade-weighted terms.

Markets have clearly taken comfort from this court decision – but a more cautious approach seems warranted. The fact that the UK government has the right to revoke the notification doesn’t mean it will, especially given how little support there is for this among members of the ruling Conservative Party, and how divisive it could prove.

It is not certain that a smooth, “soft” Brexit scenario will prevail, and even less so that a “no Brexit” scenario may materialise. Which means that the possibility of “no deal” should not be dismissed. Given the potentially large impact of such an outcome and the favourable market conditions, hedging GBP downside (via short-term GBPUSD puts) makes sense: if the tail risk materialises, the downside to sterling would be substantial. In the aftermath of the referendum result, GBPUSD fell towards 1.20, undershooting our (then) fair value estimate (1.57) by 23%. With our models now suggesting that the new GBPUSD fair value is around 1.40, a similar divergence to the downside could take GBPUSD between 1.15 and 1.10, i.e. a near 15% drop from current levels.