Brexit: what we do and what we don't know yet - Nomura

Analysts at Nomura offered a summary of what we do and don't know about Brexit following the weekend's news and subsequent drama in the sterling markets with GBP/USD dropping 200 pips and below 1.2000 before recovering back some ground.

Key Quotes:

What we do know 

1. Brexit means Brexit; the UK is leaving the EU. 

2. Theresa May’s “red lines” mean control over immigration and sovereignty conflict with the EU on any attempt to hold onto single-market access for the UK. 

3. GBP has fallen significantly already and the market has priced in the possibility of a “Hard Brexit” to a strong extent, but confirmation of the speech’s content on Tuesday is likely to give the market more confidence on that view, likely taking GBP lower. 

4. Economic growth in the UK is yet to falter and in some respects is stronger than prior to the vote, bolstering euro sceptics’ arguments and leading to even lower public confidence in economic forecasting. However, this is not good news for GBP on the flow front because the more the UK consumer spends, the wider the goods deficit is likely to be and the current account too. The market looks to have come to terms with this in view of falls in GBP after positive economic data surprises.

5. The flow picture for the UK remains fragile. Even if the market fully prices a “Hard Brexit” the flow picture should continue to drag GBP lower. With a current account deficit in excess of 5% of GDP the UK requires large financial inflows to offset the deficit and therefore the price of UK assets needs to be at attractive levels, requiring higher UK yields and/or a lower currency. We expect a mix of both, especially if the FX to rates relationship move backs to the EM dynamic we saw in October (see more on this in point 5 below). 

What we do not know yet 

1. To have any “Brexit clarity”: We have heard the political rhetoric of a “red, white and blue” Brexit, but have not heard any specifics about what Brexit will look like. Will the UK strive for a grand bargain with the EU in the early rounds of negotiations, such as asking for single-market access and controls over its borders? Or will the UK be clear in its early approach with a workable solution towards a “clean break” from the EU. The widespread newspaper leaks over the weekend suggest the latter, which is the least market-friendly outcome.

2. We don’t know yet the outcome of the Supreme Court hearing on Article 50 and therefore the political fallout from its result. A snap general election remains unlikely, but could become a higher possibility if the parliamentary vote fails to get passed. However, polling as it stands would suggest the conservatives’ majority would increase. Therefore, rather than leading to higher “Soft Brexit” hopes it may be the end of them.

3. Will the UK’s high Inflation cause early Brexit woes? The consensus of economists expects growth to fall from 2% in 2016 to 1.2% in 2017. This would likely be caused by lower investment and reduced consumer spending from the uncertainty and inflationary impact on real earnings. However, after years of poor performance in economic forecasting, with the last six months of UK growth data suggesting the vote never even occurred it is difficult to have high conviction on this consensus view. Or as Andy Haldane put it recently there is “nothing inevitable” about that, it is just a “best guess.” The hardest part about calculating the inflation outlook is whether wage growth in the UK will be sustained because of the economic uncertainty ahead. For the BoE a majority of the MPC seems convinced there is a very skewed risk to the economy on a 2-3yr view that Brexit will hit the economy hard. That means there is a high hurdle to be jumped before the MPC becomes hawkish. In our view, one or two stronger wage data releases are unlikely to cause the market to prepare for hikes. Thus, we see plenty of room for 5s10s to steepen from here. 

4. Who will the UK be negotiating with and can that change the outcome? There are several elections in Europe that could alter the makeup of the EU leadership and are likely to cause delays in Brexit negotiations. There are some outcomes from those elections that would see the UK better off and some unlikely outcomes, where the market would be less focused on Brexit and more focused on pricing in an EU breakup scenario. The best the UK could hope for is for the EU to become more flexible and offer the UK a politically palatable exit (one of our “Grey Swans”). If the definition of freedom of movement of workers is redefined in such a way that the UK government is able to retain singlemarket access the outcome would likely be more market friendly. 

5. Will GBP and other UK assets enter a dynamic akin to what we saw in October? Our Brexit Stress Indicator remains elevated and has slowly been rising again with several UK asset classes underperforming their closest peers. However, it is not as high as the levels in October after the conservative party conference speech by Theresa May. The big question this morning is will UK asset class correlations with GBP move back towards the EM relationship we saw in October? In this period, we saw weaker FX drive higher Gilt yields via front-end breakevens and pricing in rate hikes to defend the currency. There is no way of being sure if and when this correlation will return; we would expect it would become more likely should GBP/USD drop below 1.2000 and keep going, i.e. into fresh territory, but even then we would expect it to again be a temporary phenomenon. That was before the Donald Trump victory when the FX to rates relationship moved back towards a reserve currency status. The cross-market correlation between the Brexit Stress Indicator and risk sentiment proxies, such as US and global equity prices, are shifting from positive (higher stress tends to lead higher equity prices) to more neutral. This correlation still suggests Brexit is not viewed as a global risk event at the moment, but more of a local story. The beta of Brexit stress to FX markets has been declining since November as the market has been focused on the US election. We expect the market to pay more attention to Brexit developments in coming weeks, but at the moment, global risk sentiment seems less likely to be significantly hit by higher Brexit stress."