Since the Conservative Party Conference earlier this month, UK asset markets have become increasingly sensitive to the UK’s prospective trading arrangements post Brexit. Prime Minister Theresa May has made it clear that the government is unwilling to provide a running commentary on the plan, although much of the rhetoric has been geared toward the worst-case scenario of no transitional deal, or a so-called hard Brexit.
To some degree, this rigidity is understandable – after all, the likely separation date from the EU is still at least two years away, so why indicate any willingness to compromise at this stage? (EU leadership hasn’t shown much inclination to bend, either.)
Volatility in currency, sovereign markets
However, the tone of the domestic debate has certainly taken markets by surprise: Since the beginning of October, the British pound is down around 5% while 10-year gilt yields are up more than 30 basis points (source: Bloomberg). So have market participants overreacted, or is there more volatility to come?
We think there is every likelihood that volatility remains high, not least because markets are unlikely to get much clarity on the prospective negotiations and, judging by recent polling, the government’s rhetoric sits well with voters. An October Ipsos MORI poll showed the Conservatives with an 18% lead versus a 6% lead in September. Does that mean both the pound and the price of gilts have further to fall?
We believe that the pound will remain vulnerable to further weakness, as this is the primary route by which political risk has been reflected in financial markets.
The outlook for gilts is a little more nuanced. As the chart shows, 10-year yields are returning to levels last seen in the run-up to the Brexit vote on 23 June.
On the one hand, yields are approaching levels that many investors find offer sufficient compensation for the uncertainties in the UK outlook. However, absolute levels are still low, and there remains much speculation as to what Chancellor of the Exchequer Philip Hammond will announce at the Autumn Statement on 23 November. There is scope to slow the currently planned fiscal austerity, although markets will still want reassurance that bringing the deficit down to a more manageable number remains a key policy objective. Our expectation is that the Chancellor will recognise these constraints on fiscal policy, although clearly, political risks remain.
In short, what plays well with the electorate tends to get a more mixed market response. Let’s hope neither the polls nor the markets become the sole determinant of government policy.
Mike Amey is PIMCO’s head of sterling portfolio management and a regular contributor to the PIMCO Blog.