15 January 2019
GBP: Brexit and the bumpy ride to its eventual recovery

The undervalued pound still has a bumpy ride before its eventual recovery. We look at various Brexit scenarios and sterling's possible reaction. Reasons behind an Article 50 extension matter dearly for GBP

A bumpy week for sterling

We believe there's more than a 60% chance Article 50, the treaty which began the UK's withdrawal process from the European Union will be extended. But be careful... not every scenario there will be positive for the pound, for instance, it could fall if a general election is called. 

The most positive outcome for GBP is a second referendum, likely bringing EUR/GBP to or below 0.85. We still expect a market-friendly resolution by the end of the year which could see sterling stronger (GBP/USD at 1.40). While GBP is ultra-cheap (the cheapest currency in the G10 FX space), the valuation gap is unlikely to close fully as the damage to the economy has already been done.

For now, the lack of short-term risk premium priced into GBP and the potential disappointment if  Article 50 isn't extended immediately may translate into weaker GBP this week

UK economy stalling as Brexit concerns mount

The service-sector kept the UK economy crawling along in November, but recent surveys point to a further slowdown in growth both in December and the early stages of 2019, as Brexit uncertainty weighs more heavily on activity

According to the latest set of monthly UK data, the economy fared slightly better than feared in November. The economy grew by 0.2% on the month, driven primarily by another better month for the service sector. Dig a little deeper though, and the picture still looks fairly grim.

Firstly, the manufacturing sector contracted for the fifth month in a row and on a year-on-year basis, is now shrinking at the fastest rate since before the 2016 referendum. We don't expect conditions to get any easier given the recent slowdown in Europe (and elsewhere), while we also don't expect pre-Brexit stockpiling to significantly drive up production given the lack of storage capacity for inventories. The slowdown in global demand also appears to be taking its toll on the trade balance, which widened further in November.

Secondly, the most recent survey readings from the service sector suggest there was a pronounced slowdown in December, which looks set to persist into the new year. The service-sector PMI indicated that new orders growth has stalled amid Brexit uncertainty, while the recent decline in consumer confidence appears to have hit the high street hard over Christmas. The latest British Retail Consortium figures suggest it was one of the worst Christmas trading periods since the financial crisis.

The upshot is that growth looks set to be noticeably slower in the fourth quarter than the third, when activity was boosted by warm weather. We expect GDP growth in the 0.2/0.3% region in the final quarter of 2018, and something similar for the first three months of 2019.

Why a Brexit delay is becoming more likely

As Parliament looks set to vote down Theresa May’s Brexit deal, time is fast running out to find and implement an option that lawmakers can rally around. One way or another, it’s looking more likely that the UK will be left with no choice but to apply for an extension to the Article 50 period

On Tuesday 15 January, Theresa May's Brexit deal will finally be put to members of Parliament (MPs) to vote upon, and as things stand it looks set to be defeated by a fairly heavy margin. If that happens, the Prime Minister will have three days to bring forward a new plan, and at this point, MPs will get a say on what direction to take. The Labour Party has also suggested it will put forward a vote of no confidence in the government, in the hope of triggering an election.

Nobody really knows exactly where the next couple of weeks will take us, but time is running out – not only for MPs to find an option that commands a majority in Parliament, but also to pass a raft of legislation in time for Brexit day.

While the UK government has so far ruled it out, it looks increasingly likely that the 29 March Brexit date will need to be pushed back. The most likely way of doing this would be for the UK to apply for an extension to the two-year Article 50 negotiating period. This would require all EU member states to unanimously agree, which isn’t necessarily a given, although assuming there is a legitimate reason for doing so, we suspect they would cautiously back an extension.

In this article, we take a closer look at why most Brexit scenarios now point to a delay of some kind.

Reading time around 4 minutes

Our guide to today’s crunch Brexit vote

With Theresa May's Brexit deal set to be voted down by Parliament today, our team explains what it could all mean for the pound, and why an extension to the Article 50 period is getting more likely

In this bundle