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The results of the June 2016 referendum, and the process of establishing the terms of the separation from the EU, revealed deep running divisions in British politics and society at large. It is undeniable that, since joining the European Union in 1973, the UK has always had the lowest levels of enthusiasm towards the common project, amongst the members of the union. Regardless, the vote to leave the EU in June 2016 shocked most observers, as such a result wasn’t expected; or prepared for, in the case of the British politicians who since had to handle the negotiations to leave the European Union.
How the process initiated with the referendum will end is still unclear. By all accounts it is extraordinary that roughly 8 weeks away from the deadline, having had over 2 and half years to make arrangements, there is still no clarity on what will be the shape of the relationship between the UK and the EU, after March 29th. The latest chapter saw the agreement negotiated between the EU and the British government being rejected by the UK parliament, and now Mrs May will try to convince her European counterparts to negotiate a new agreement with an alternative to the controversial ‘Back Stop’ arrangement at the Northern Irish border.
So, as it stands, there are several possible scenarios still on the table; no deal (hard Brexit), negotiated exit (soft Brexit) or a new referendum which may lead to the United Kingdom remaining in the European Union. If there is no agreement between the 2 parts the default outcome will be a hard Brexit with a loss of all sorts of rights, in trade, services, cooperation, capital and people circulation, etc. This is widely seen as very damaging to the British and European economies and likely to have long lasting repercussions. Another possibility is that the UK and the EU will negotiate an agreement dictating the terms of the future relationship. There are various potential deals on the table, ranging from an enhanced Norway type arrangement to something along the lines of the Canada deal with the EU. However, cross-party divisions in the British parliament are proving difficult to overcome and, ultimately the impasse may lead to a postponement of article 50; perhaps ultimately to a new referendum, or a hard Brexit.
Each potential scenario is likely to have a different impact on the markets, particularly over the most exposed instruments; the Pound and the FTSE. This is perfectly illustrated by what happened after the results of the June 2016 referendum became known; the Pound, which at the time traded at $1.44, suffered considerable losses dropping to $1.20 by October 2016, losing approximately 15% of its total value. In the same period, the FTSE 100 Index gained almost 17%, roughly 1000 points. What we can take from this observation is that the prospect of leaving the EU represents downside risks for the British economy and therefore for the Pound. On the other hand, a weaker Pound supports the UK 100 index, mainly made up by companies with an international reach, with most business accounted for in Dollars; so, a weaker Pound translates into better results for these companies (priced in US Dollars), which explains why the Index gained in value.
This gives us clues on what is likely to be the reaction of the markets to each potential scenario. The more diluted the future relation with the EU is, the higher the downside risk for the Pound and, at least in the short term, the FTSE 100 is likely to go in the opposite direction and record gains; in an inverted correlation with Sterling.
Currently the Pound trades just above $1.31 (at the time of writing this article), close to what has been the average price since the referendum of 2016. What does this mean? Essentially that everything is yet to be decided and all options are on the table. However, it appears that the no-deal option is seen by the markets as less likely than any other, with many observers believing there will be an extension of article 50. This explains why Sterling shrugged away the political noise and didn’t drop below $1.28, during and after the meaningful vote on Theresa May’s exit plan and other important recent decisions by Westminster lawmakers. We can therefore interpret the current value of the Pound, approximately $1.30, as a reflection of a certain optimism (some observers think complacency, considering the latest developments), regarding the outcome of the Brexit process; a no deal scenario would probably be priced in the region of $1.10, or less. Should the process lead to a very soft Brexit, or none at all, we can expect Sterling to trade above $1.40, potentially reaching $1.50 and beyond.