Three Years of Uncertainty: Charting How Brexit Has Shaped U.K. Financial Markets

With two Brexit deadlines already passed and a third expected to be extended, the uncertainty that has weighed on the economy and financial markets for three years looks set to drag on.

Source: WSJ | Published on October 24, 2019

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Lawmakers backed Prime Minister Boris Johnson’s Brexit deal this week, but didn’t approve his accelerated timetable, making a departure from the European Union by Oct. 31 unlikely and extending a political deadlock that has eroded economic growth and business investment.

“I can’t think of another sovereign in our rated universe that has withdrawn from such an integrated trading relationship,” said Colin Ellis, U.K. managing director at credit-ratings company Moody’s Investors Service. “There are a few places—like business investment, like the exchange rate—where we can look at the behavior of some of those variables to have a sense of the effect.”

A Subdued Pound

Since the Brexit referendum in 2016, the pound has lost about 13% of its value against the U.S. dollar and briefly touched multidecade lows in recent months. On Wednesday evening, one pound bought $1.2914. Sterling has also depreciated against the currencies of its major trading partners, including the EU and China.

That is good news for some of the U.K.’s biggest companies, which generate a substantial portion of their revenue overseas, because their foreign income is worth more in pounds.

For manufacturers whose exports become more competitive because of the cheaper pound, the benefits have been largely muted by the higher costs of imported parts and other costs.

Despite the sharp drop in the value of the pound immediately after the referendum result, some foreign-exchange strategists and traders say the currency has been largely rangebound in recent years.

“There has been no trend in the pound after the Brexit vote, the only trend has been sideways,” said Jordan Rochester, currency strategist at Nomura Bank. “It’s a big range for people who zoom in on the screen like traders, but if you take a longer view, like the 1970s, it’s gone nowhere.”

Lawmakers’ support for a Brexit deal for the first time on Tuesday has further pared expectations of sterling-dollar volatility over the next month because it signaled that the U.K. may be able to avoid leaving the bloc without an agreement.

Banks’ Borrowing Costs

Borrowing costs for U.K. banks such as Lloyds Banking Group PLC climbed steeply at times when a disorderly exit from the EU seemed most likely. Those spikes were partly triggered by large investors offloading the lenders’ bonds.

The credit outlook for the U.K.-focused banks was also clouded for a time by their perceived exposure to the domestic economy, as growth slowed because the Brexit uncertainty led businesses to defer investment decisions or move operations elsewhere.

The so-called “Brexit premium”—whereby increased uncertainty led to higher borrowing costs for U.K. banks than it did for European lenders such as Société Générale SA—has diminished in recent weeks as investors bet that a no-deal Brexit may be avoided.

Economic Growth Stalls

By the fourth quarter of 2017, just over a year after the referendum, economic growth in the U.K. had fallen behind that of the lethargic eurozone. This was partly explained by a reluctance among businesses to invest in operations amid the prolonged political uncertainty.

“There is an incentive for anyone spending money to delay that decision, whether that is spending money as a consumer or making an investment in a business,” Mr. Ellis said. More recently, both economies have felt the pressure of a global slowdown and trade tensions between the U.S. and its partners.

Stocks in a Slump

The U.K.’s main benchmark stock index, the FTSE 100, has failed to match the bullish rally in U.S. or even European equities as investors remain wary of the outlook for British businesses.

Analysts say smaller companies in the FTSE 350 are even more vulnerable to the vagaries of Brexit because of the impact of currency fluctuations on their operations and the perceived risk of future trade friction with the EU.

There is a 20-25% gap in the valuations of companies that rely on the U.K. for the majority of their revenue compared with those with bigger international operations, said Simon French, chief economist at merchant bank Panmure Gordon.

Only the finer details of a future trading relationship with the EU will allow for a proper assessment of the outlook for the U.K. and better pricing of its assets, according to economists and analysts.

The range of possible outcomes has been narrowed as both the best- and the worst-case scenarios have been avoided, according to Kallum Pickering, senior economist at Berenberg Bank. In other words, the chances of either leaving the EU without a deal or remaining in the bloc have both fallen.

“If Brexit was a book, at the start it was impossible to guess what the ending was,” said Mr. Pickering. “Now the worst-case scenario is ruled out, markets are less likely to be spooked by the rest of the book. It’s less likely to be a horror story.”