What are the risks of a no-deal Brexit?

by Kara Ng, Russell Investments

On the latest edition of Market Week in Review, Quantitative Investment Strategist Dr. Kara Ng and Research Analyst Brian Yadao discussed the latest Brexit developments, optimism in the China-U.S. trade war and downside risks to markets in the months ahead.

Johnson to suspend Parliament for 5 weeks, increasing odds of no-deal Brexit

With the UK set to leave the European Union (EU) on Oct. 31 without a divorce agreement, Prime Minister Boris Johnson obtained permission from Queen Elizabeth II to suspend Parliament for five weeks, beginning in mid-September. Johnson’s move means that Parliament will not reconvene until Oct. 14, Ng said. “This essentially reduces the amount of time that members of Parliament will have to work out a divorce deal with the EU ahead of the Brexit deadline,” she stated, emphasizing that this increases the chances of a no-deal Brexit.

So, what could transpire if the UK does crash out of the EU? Ng and the team of Russell Investments strategists expect British pound sterling to plummet against the euro, with the pound-to-euro exchange rate potentially falling to parity. Such a risk is already being priced into markets, Ng noted, as both the exchange rate and the yield on UK gilts continue to drop.

“The ultimate problem with a no-deal Brexit is that it would disrupt trade between the UK and the EU, further damaging both economies,” Ng stated, noting that Europe has already suffered a fair amount of collateral damage from the China-U.S. trade war and the global economic slowdown. The European Central Bank’s plans for fiscal stimulus and European equity valuations that look fair are a few bright spots, she noted.

Markets rally on China-U.S. trade war optimism

Global markets rallied the week of Aug. 26 in response to a slightly more optimistic tone from U.S. and Chinese leaders on the trade-war front, Ng noted. In particular, a statement from China on Aug. 29 that it would rather engage in discussions with the U.S. versus further escalation served as incrementally good news, she said.

“The statement from China’s Ministry of Commerce represents an opportunity for both sides to reset and potentially de-escalate things,” Ng remarked. That said, the U.S. will still raise tariffs on roughly $100 billion worth of Chinese imports on Sept. 1, she said, with all Chinese imports facing tariffs of 15% to 30% by mid-December. “The big picture here is that the trade war has sharply escalated over the past month,” Ng concluded.

Downside risks to markets remain high as global economy slows

Based on developments, the rally in markets the week of Aug. 26 was probably not justified, Ng said. Why? “The recent uptick in markets was based on hope, not action,” she stated.

“At Russell Investments, our investment belief is that while markets are efficient, they occasionally overshoot due to human biases such as extreme cycles of fear and greed,” Ng said. As evidence, she pointed to the fact that the S&P 500® Index remains high, despite the fact that the U.S. Treasury yield curve has been inverted for nearly 100 days and the country is on the brink of both a manufacturing and earnings recession, with the trade war continuing to crimp business confidence and capital expenditures. “There is an upside for markets if trade issues get completely resolved, but the downside risks remain disproportionately large,” she concluded.

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