A New Level for Cable
Prime Minister Boris Johnson’s December 12, 2019 triumph sent Cable through the roof, from a 1.29$ handle to over 1.35$ in one day, the highest level since the spring of 2018.
Part of that astonishing rise was due to markets anticipating the end of the deadlock that had been paralyzing the British Parliament for a year, and part to the conviction that – thanks to a substantial majority of 80+ – Johnson would have pivoted away from a harder form of Brexit, and embraced a closer relationship with the EU in the upcoming negotiations on future trade relations.
We argued in favor of both on November 25 – well before the election:
“On that note, we believe there is opportunity in long sterling positions, and we anticipate risks will subside as we get closer to the election date, as polls increasingly pointing out to a Conservative victory are likely trigger more risk-on…We, however, continue to be skeptical that the Bank of England could pursue any form of monetary tightening for now, while all the other major central banks seem on course to keep their highly accommodative stance well into 2020…”
“…From what we understand, the Prime Minister is instead likely to drop some of the hardest demands put forward by the more extreme pro-Brexit factions in his party, and if anything pursue a softer Brexit than what most analysts are forecasting at this time.” (November 25, 2019, Eyes-Only Macro)
But on day one after the vote, a public intervention by the Prime Minister put a dent into traders’ convictions. More specifically, Johnson reiterated his commitment to a hard Brexit, and sent Cable back to 1.31/1.32 – where it has pretty much been trading to this day.
That level is on balance higher than the average GBP value during the four months that went from Johnson’s selection as the Tories’ standard bearer until election day, but still lower than it would be if it was not pricing in a tremendous amount of volatility for 2020, plus a further discount in the form of tail risk – that the UK could end the Transition period without a deal in place on December 31.
The Elections Aftermath
Johnson campaigned heavily on a “get Brexit done” message – so heavily indeed that even members of his team were surprised by his discipline and ruthlessness.
After the election, he appeared confident that the UK and the EU could negotiate a “comprehensive” trade agreement by December 31, but markets have already identified the main flaw in his reasoning – that if the British Prime Minister insists on regulatory “divergence,” a deal would indeed be more complicated than he anticipates.
Analysts have also correctly argued that the EU could simply run the clock (after all, many believe, the Irish issue has been sorted), then agree on a “de minimis” trade deal closer to the deadline – something that would include goods (which the UK imports) but not services (which the UK exports) and most importantly exclude financial services. At that point, the massive UK financial industry would have to rely on piecemeal agreements and “equivalence” decisions made by the European Commission on specific pieces of legislation.
We anticipated that before the election:
“…Markets are, however, understandably uncomfortable … with Prime Minister Boris Johnson’s post-Brexit strategy, which they consider simplistic and too dismissive of the EU’s current negotiating position. Johnson, they claim, could still rock the boat by insisting on a de minimis trade agreement with the EU that could damage supply chains and hurt the financial services industry – currently UK’s main export to the continent. (November 25, 2019, Eyes-Only Macro)
Specifically, Johnson and his cabinet repeatedly manifested the willingness to achieve “regulatory divergence” with the EU, which is likely to make negotiations complex and – on balance – more contentious. On her part, European Commission’s President Ursula Von Der Leyen made it clear that regulatory divergence will be met with restricted access to the EU Single Market for UK services.
The issue of regulatory divergence – it is still to be seen to what extent the UK will choose to diverge – is a complex one in trade negotiations. It is vastly more relevant than tariffs or duties in a modern-day trade agreement, and it is central to the future of the EU-UK trade relationship.
A Concise Timeline (What Lies Ahead)
But before getting to the issue of regulatory divergence – and the complicated business of having to negotiate a deal that would loosen, rather than tighten, a relationship between two state-like entities – it’s fair to draw a timeline that gives us some background, and helps traders make sense of the upcoming signals.
1) End of February – Beginning of March
– The European Council finalizes the negotiating mandate – to be given to the European Commission. The mandate – we have been told – will include goods but not services, as the limited time available makes it impossible to focus on the so-called “areas of mixed EU/National competence” – which would require ratification from the EU, as well as all 27 Member States. A mandate to negotiate only a minimal trade agreement is likely be seen as bearish news by investors, but keep in mind this doesn’t mean services can’t be discussed in 2021, once a basic FTA is done and dusted.
2) By July 31
– Per the “Withdrawal and Transition Agreement,” the UK could, in theory, request an extension of the Dec. 31 deadline up until July 31 – though Prime Minister Johnson ruled it out (yet the EU still does not buy it). After that, the December 31 negotiating deadline can’t be changed – amendments to the WTA are no longer be possible since the current negotiating process is no longer covered by article 50.
3) December 31
– The UK leaves the EU, most likely after ratifying a deal that includes goods (but unclear to what level will it protect current supply chains) but NOT services (nor, of course, financial services, one of their subsets).
– Specifically, on the financial services industry, we have been told that the so-called “equivalence” regime is likely to allow British firms to provide services within the EU. But granting “equivalence” is a unilateral – and temporary – decision by the European Commission, and does not grant long-term relief in the event of future regulatory divergence.
– To that extent, the EU will conduct an initial assessment of the current legislation by the summer of this year – of which the outcome seems a no brainer because the UK and EU will still have the same legislative framework in the financial services industry.
In other words, UK firms will still be able to provide financial services in the near future regardless of the presence of a free trade agreement with the EU.
But this should not give investors – or fund managers for that matter – false confidence. The equivalence assessment can change if there is “regulatory divergence” and in any case it is also likely to be influenced by political dynamics.
More specifically, on this: the rules that govern – among others – British-based financial entities are the result of a compromise among EU countries. But the UK had an overwhelming influence in writing those rules, given the legal and policy expertise its officials have, and the fact that London was – and still is – the biggest source of capital for EU firms – to the extent that a European Commission official once said the so-called “Capital Markets Union” (the new EU plan to increase cross-border capital flows) without the UK would be just a “Union.”
What might happen is that even if Britain maintains the current standards, the EU might change the rules once Britain has left, and that would force London to follow on the same path – a politically unpopular choice – or else face being declared “non-equivalent” and being excluded from the Single Market.
And the UK might trigger politically motivated actions in the years to come if it pushes too hard on deregulation – for instance, as UK cabinet officials publicly declared, on rules governing artificial intelligence. Johnson’s plan is indeed to push for a leaner regulatory framework to facilitate the development of a British own IT industry in the poorest regions of the country – the ones that gave him an overwhelming political victory in December.
All this seems to point out to a complex and long negotiation, one which has the potential to damage the UK economy, while being unable to lift Cable over the 1.31-1.32 level.
Investors should also consider staying underweight domestic UK stocks – volatility will impact them as well as the Pound. With British consumer spending growth slowing down to 1% in November (excluding fuel purchases, retail sales growth was the weakest since October 2017), and growth in unsecured consumer lending slowing down to 5.7% y/y, there is enough to argue that the resiliency of the UK consumer might be on the turn, which points to UK growth being unlikely to surprise on the upside in 2020.
To be clear, we are not advocating against opportunistic, tactical positioning ahead of crucial deadlines – we believe in a deal by December 31 and do think left tail risks are exaggerated.
But we would thread carefully when it comes to short-term trades, given what is probably going to be a very wide, obsessive, but mostly inaccurate coverage by financial – as well as non-financial – news wires.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.