No-deal Brexit: How markets could react

REUTERS/Lucas Jackson

• A no-deal Brexit is rising in likelihood as the UK’s
  March 2019 deadline approaches.
• No deal would be hugely disruptive for financial
  markets.
• It would likely send the British pound plummeting, UK
  stocks surging, and force the Bank of England into drastic
  action.

As the day of Brexit draws ever nearer, the prospect of Britain
leaving the European Union without a deal continues to grow. What
started out as an almost unimaginable scenario is now,
in the minds of the British public at least, the most likely
Brexit outcome.

Earlier this week,
the government released a series of papers detailing what
might happen in the event of no deal. They varied from shortages
of medicines, to
rising credit-card fees, to
a shortage of sperm. What the government didn’t discuss is
what might happen in financial markets if such a situation were
to play out.

Thankfully, research house Pantheon Macroeconomics has modeled
what no deal might mean for key British market assets in the
aftermath of it happening next March. Although it would not be as
seismic a shock as
the initial vote to leave the European Union in June 2016,
markets would see large moves across currencies, equities, and
bonds.

More pain for the pound

First up, the British pound would inevitably suffer. Since the
referendum, the pound’s movements have been almost entirely
linked to Brexit developments. Any news that suggests Britain is
heading for a softer Brexit, and it rises; any news to the
contrary, and it falls.

That relationship is reflected in
the pound’s recent slump to less than 1.28 against the
dollar, which has coincided with the rising probability of no
deal. If no deal does materialise, Samuel Tombs, Pantheon’s chief
UK economist, says the pound would drop more than 10% from
current levels in the immediate aftermath, falling to a low of
$1.15 by the end of March.

Other analysts are inclined to agree with Tombs’ prognosis.
Back in July, Neil Jones, Mizuho Bank’s head of hedge
fund sales, told Bloomberg that in the event of a no deal Brexit,
the pound would drop sharply and “hit new post-referendum
lows.”

Commerzbank strategist Thu Lan Nguyen mirrored that
viewing, saying she would “anticipate at least a reaction
to the extent we saw after the referendum.” On the day after the
referendum, the pound dropped more than 8%.

A rampant stock market

The FTSE’s performance
since the Brexit vote has been very strong.
Markets Insider

While the pound would plummet, the FTSE 100
— which enjoys an inverse relationship with the currency — would
likely surge to record highs. 

A
weak pound tends to mean a strong UK stock market. That is
because it is heavily skewed towards companies that don’t
actually make their money in the UK. The FTSE 100, for example,
contains miners, oil firms, and pharmaceutical giants, with
around two-thirds of all revenues for companies in the index
derived from abroad. This has helped the index
hit record high after record high following the vote.

Pantheon’s forecast is that the FTSE 100 breaks above 8,000 in
the event of a no-deal Brexit, a rise of around 5.5% from
Friday’s closing price.

Bond yields fall

Turning to the UK’s bond market, Pantheon forecasts the yield on
the 2-year gilt would fall to 0%. It may seem counterintuitive
that yields would fall, given that lower yields tend to reflect
investors perceiving a bond as being safer — something unlikely
in the event of a no-deal Brexit.

Pantheon’s argument, however, is that a no-deal Brexit would
force the Bank of England to immediately reverse
the normalisation of monetary policy it has embarked on in over
last year.

The bank has raised interest rates twice since November 2017,
hitting 0.75%, but would need to cut rates to 0%, as well as
launch £100 billion ($129 billion) of new quantitative easing,
which in turn would suppress gilt yields, according to Tombs.
That cut would be the first time the UK’s bank rate had dropped
to 0%.

If these scenarios seem extreme, Tombs and his colleagues have
some reassuring news, they put the prospect of a no-deal outcome
at just 10%, citing their belief that Prime Minister Theresa May
will capitulate to the EU’s demands, eventually leading to the
softest possible Brexit.