PGIM Fixed Income 1Q 2021 Outlook
PGIM Fixed Income shares their views on the current economic environment and outlook for fixed income markets.
Seeking Additional Uncertainty? Brexit Brings It
Oct 15, 2020
PGIM Fixed Income’s Katharine Neiss, PhD, Chief European Economist, and Mehill Marku, Senior Investment Strategist, discuss the uncertainty surrounding Brexit and how Brexit will affect the British economy and investors’ allocation decisions for years to come.
In a year of abject uncertainty, there is still some clarity to be found: Brexit is happening and the UK’s relationship with the European Union will never be the same. Beyond that, Brexit remains mired in uncertainty that will affect the British economy and investors’ allocation decisions for years to come. The UK’s recently tabled Internal Market Bill, which would unilaterally override provisions in the Withdrawal Agreement, has once again raised the prospect of a no-deal Brexit and severing decades-old economic ties between the UK and the EU. Yet, the introduction of the Bill has not totally extinguished the potential for a deal, as skinny as one might be, which could still help cushion some of the Brexit-related impact on the UK economy. Given the deterioration in the economic outlook1 amidst the Covid crisis and the need for both sides to remain engaged in many areas of common interest, our base case is that a so-called “skinny deal” will likely be reached by the end of October or early November and in time to be ratified by the respective parliaments. However, the somewhat acrimonious split raises longer-term implications. Perhaps the most important result of the current negotiations is its effect on the mutual trust between the UK and the EU going forward. Furthermore, the Bill undermines the UK’s reputation as a negotiating partner and hurts its prospects for future trade agreements with other countries, including the U.S., in its post-Brexit existence. It has also been cited as a risk to the Northern Ireland peace process and giving new impetus to the Scottish drive for independence, where the voting majority is now in favour of a break from the UK.
A Closing Window of Options
Unlike the period following the 2016 Brexit referendum, which allowed for a broad spectrum of possible outcomes, far fewer options are now left on the table. The so-called “skinny Canada deal”2 under discussion would allow for tariff-free goods trade, but that’s pretty much it. For a services-based economy, such as the UK’s—which is vastly different than Canada’s commodity-heavy exports—such a deal would leave the bulk of UK trade subject to a new set of still unestablished rules. The bottom line is that, deal or no deal, the UK’s new trading relationship will be very different to the one it had as a member of the EU, and that in turn means the economic consequences of Brexit are largely baked in.
Businesses More Prepared, But Few Will be Left Unscathed
The good news is that businesses appear more prepared for the potential extra requirements of trading with the EU once the transition period concludes. For example, in September, 61% said that they were either fully prepared or as ready as they could be, which was up from 54% when the survey first asked the question in February 2020 (Figure 1).
Figure 1: Post-Brexit Trade Preparedness (% of UK Businesses that Trade with the EU, Survey Responses*)
Despite the signs of preparation, the gravity of the situation remains palpable, particularly given the additional challenges from the Covid pandemic. A recent study found that the industries most affected by the Covid shock may be the least affected by Brexit, suggesting that no corner of the UK economy will be spared between the two (Figure 2). Furthermore, a survey taken over the summer by the Descartes Business Group found that two-thirds of large firms are very or extremely concerned about delays in their supply chain impacting their business post-Brexit and noted that their Brexit preparations have been disrupted by Covid-19. Indeed, the UK government has outlined a plausible worst-case scenario of significant congestion between the Dover-Calais crossing, a major hub for goods trade in the UK. So, another key takeaway is that, deal or no deal, the UK will experience a degree of economic disruption in the early part of next year.
Figure 2: Industries Ranked by Performance During Economic Shocks*
It May Not be 2016 for the Markets, But…
The anticipated market reaction to the current trade negotiations could follow the patterns forged throughout the Brexit process. In a hard break, no-deal scenario, sterling may weaken further—possibly along with a slight weakening in the euro—while UK gilt yields may decline, and spreads on UK-centric and deal-sensitive credits could widen. However, a decent amount of that anxiety may already be priced into the market, so the reaction could be more subdued than the one following the referendum. On the other side, a friendlier break with a trade deal may have a fairly strong, positive impact on sterling, a slightly positive boost for the euro, a mild lift for gilt yields, and a positive tailwind for UK / Brexit-centric credits. To that end, we remain solidly overweight UK credits in our European investment grade and high yield strategies.
Brexit is a Process, Not an Event, and Its Uncertainty Will Remain for Years to Come
Beyond needing to negotiate a new trade agreement, the UK and EU will need to agree to arrangements covering a whole host of issues, such as transport, data protection and financial services, to name a few. The task and the uncertainty that it creates adds another item to the “unprecedented” list of recent developments as the separation unwinds more than 40 years of economic integration. Furthermore, the Vote Leave campaign was primarily about taking back control; so, what will the UK do with its new-found sovereignty? Whether the vision is for a “Singapore-on-Thames” or “State Aid for Winners,” there has been surprisingly little public debate on the desired future state of the UK. The ambiguous vision coupled with a new trading arrangement, which will be anything but comprehensive, sets the UK on a course for regulatory competition as it diverges from the EU. As the UK looks to define its future, there is little doubt that its historic task could be made even more uncertain by a deep freeze in its relationship with the EU, rather than the current, mild chill.
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This material reflects the views of the authors as of October 8, 2020 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income.
1 Our forecast for real GDP growth in the UK is -10% in 2020 and 7.0% in 2021.
2 Modelled on the Comprehensive Economic and Trade Agreement between Canada and the EU.
All investments involve risk, including the possible loss of capital. Past performance is not a guarantee or reliable indicator of future results. Source: PGIM Fixed Income. The information represents the views and opinions of the author, is for information purposes only, and is subject to change. The information does not constitute investment advice and should not be used as the basis for an investment decision.
Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy. Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely representative of a broad range of possible outcomes. Projections or forecasts are estimated, based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
Fixed income instruments are subject to credit, market, and interest rate. Emerging market investments are subject to greater volatility and price declines.
Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information, nor do we make any express or implied warranties or representations as to the completeness or accuracy. Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely representative of a broad range of possible outcomes. Projections or forecasts are estimated, based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation. Clients seeking information regarding their particular investment needs should contact their financial professional.
PGIM Investments LLC is an SEC-registered investment adviser and a Prudential Financial, Inc. company. PGIM Fixed Income is a business unit of PGIM, a registered investment adviser. PGIM is a PFI company.
© 2020 Prudential Financial, Inc. (‘PFI’). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom, or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. PGIM and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.
1041358-00001-00 Ed: 10/2020
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