How a Brexit deal, or no deal, will affect markets

The writer is chief market strategist for Europe, Middle East and Africa at JPMorgan Asset Management

The midnight hour in the Brexit negotiations is fast approaching. The outcome will be far-reaching for markets, and not just for sterling and UK assets.

The sticking point is the same issue that has weighed heavily on negotiations for the past four and half years. The UK wants to maintain access to the single market but, in a bid to regain “sovereignty”, it does not wish to adhere to EU regulations. In this context it seems impossible to see a deal being reached.

But there is still scope for compromise and for a narrow trade deal to be agreed. In key sectors, the UK could choose to align with EU regulations for a set period. There could then be joint oversight committees to oversee the arrangements.  

For those sectors not covered by the trade deal, I expect transition arrangements to reduce the initial impact, given the current weakness of economies on both sides of the channel.

While this would still result in a much narrower trade deal than that which the UK currently has in place with the EU, both sides could potentially claim victory. It is still possible, however, that both sides choose to walk away.

Deal or no deal, the two scenarios have very different implications for sterling. In the event of a deal, we would expect to see sterling appreciate by about 5 per cent in trade-weighted terms because it would take the risk of an economic shock from a no deal off the table. By contrast, an acrimonious no deal could see sterling fall by 10 per cent.

It is far harder to say what the different outcomes will mean for the FTSE 100 index. It is often assumed that there is a negative relationship between the currency and the UK benchmark. This seems intuitive given that 77 per cent of FTSE 100 revenues come from abroad. It is often assumed that weaker sterling raises the repatriated value of overseas earnings and, in turn, the benchmark index.

Unfortunately, it is not that simple. The relationship between sterling and the FTSE 100 is far from stable. Sometimes there is a negative correlation. Other times, there have been long periods in which the relationship has been positive.

Over the past 10 years, the average correlation between daily FTSE returns and trade-weighted sterling has been fairly close to zero. The period immediately after the 2016 EU referendum result demonstrates this point. The FTSE 100 fell, then rallied, then fell. Two weeks after the referendum trade-weighted sterling was down 12 per cent. The FTSE was up 2 per cent.

This is because many moving parts are at play. We need to consider not just what is happening in the UK and to sterling, but also how such developments affect events elsewhere in the world.

While the majority of the impact would be expected to be felt at home, we would expect any failure in negotiations to have a broader effect on European activity. UK and European revenues constitute about 40 per cent of the total revenues of FTSE 100 companies.

Revenues from elsewhere in the world might also be disrupted, such as the 27 per cent of revenues that come from North America, or the 30 per cent of revenues that come from developed Asia and the emerging markets.

Confidence is fragile given the Covid-19 crisis. A disruptive souring in discussions between the UK and EU could weigh on global risk sentiment and asset prices. This could, in turn, hit corporate and consumer sentiment, prolong the global period of economic weakness caused by the virus and further depress global commodities prices and interest rates.

The FTSE might be especially exposed given its sectoral composition. Relative to other benchmarks, the FTSE 100 is disproportionately weighted towards financials and energy and materials companies. Financials at present account for 16 per cent of the market cap of the FTSE, compared with 12 per cent in MSCI World. Energy and materials make up 21 per cent of the FTSE versus just 7 per cent of the MSCI world.

I can say with some degree of confidence that a no-deal Brexit outcome would lead to lower sterling. And that the FTSE 250, which is more domestically focused, would underperform the FTSE 100. But I do not think it is a given that the FTSE 100 would rise in absolute terms.

If negotiations do not look like they are proceeding to a fruitful conclusion, UK investors should seek alternative options to hedge the value of their portfolio. By contrast, if our base case looks correct and a deal can be agreed — that might actually be the time to buy UK stocks.