Brexit back on list of issues managers worry about

While the coronavirus pandemic and the economic impact of measures to halt the spread of the virus have dominated the attention of markets and money management executives, Brexit is creeping back onto the agenda.

The U.K.'s departure from the European Union — which officially took place Jan. 31, but is subject to a transition period until Dec. 31 — is back on investors' minds. On June 12, the U.K. government formally notified the EU that it would not be requesting an extension to the existing transition period. Sources had viewed the potential for an extension application as unlikely, so the government's notification will not have come as a surprise.

Sources said managers have largely come to terms with the fact that a no-deal Brexit will mean losing their ability to access the EU market under so-called passporting, with a temporary regime in place while equivalence and other rules are thrashed out. But they are still facing the risk of a no-deal Brexit, which executives fear would further exacerbate the coronavirus-induced damage to markets and the pound sterling.

"The current Brexit situation adds to the high uncertainty around the impact of the coronavirus disease, both for the U.K. and for the EU," said Nichola James, managing director, lead analyst on the U.K. and co-head of sovereign ratings at DBRS Ratings GmbH — known as DBRS Morningstar — in Frankfurt. "Therefore, it is important that both sides reach agreement to avoid the risk of a stalled recovery, especially in the U.K."

Brexit has resurfaced, "having been out of the spotlight for a few months," said Tristan Perrier, Paris-based senior economist at Amundi. "It has come with the other big theme of 2019 — U.S.-China tensions are also coming back."

Amundi executives think these themes will continue to grow in the second half of the year "and be seen as major risk factors by investors if indeed the major worries related to the pandemic relieve in developed markets, which is our scenario," Mr. Perrier said.

And managers refused to rule out a no-deal Brexit, even though "it would be extremely damaging politically and economically," said Stuart Thomson, senior strategist at Manulife Investment Management Holdings in London. The economic challenges can be countered through a "steep drop in sterling, negative interest rates and (an) even bigger fiscal package," Mr. Thomson said. While it is unlikely, Manulife executives "cannot entirely rule it out."

Amundi executives "consider a no-deal (Brexit as) a very clear material risk, with a significant probability," although a deal is still slightly more likely late in the process, Mr. Perrier said.

But the stakes are high, particularly given the economic damage from the coronavirus-related lockdowns and shutdowns of parts of the U.K. and European economies. So far in 2020, the FTSE All-Share index lost 19.85% through June 11, having dropped 35% at its lowest point, on March 23, before rebounding a bit. The MSCI Europe index lost 15.75% for the year through June 11.

"I think the economic damage from a hard Brexit is not seen as so high now as (the damage) from COVID was so high," Mr. Perrier said.But there are signs of an economic improvement. The FTSE All-Share gained 23.31% from that low-point in March, and is flat this month through June 11.

And that is why managers' attention has been refocused on Brexit.

"The relative proportion between (the damage caused by the coronavirus and Brexit) may seem quite different by the end of this year. If you are already in free-fall, it does not matter to add another negative thing. Once you are climbing the ladder painfully, you do not want something to ruin your efforts," Mr. Perrier said.

The coronavirus pandemic coupled with the threat of failed Brexit negotiations is already impacting the U.K. when it comes to its status and outlook.

Last month ratings agency DBRS Morningstar introduced a "negative trend" on the U.K.'s AAA sovereign ratings, "on the view that the coronavirus disease will materially negatively impact the U.K.'s economy and public finances in the context of an already slowing economy and expansionary fiscal policy related to Brexit," Ms. James said.

DBRS Morningstar analysts warned that the U.K.'s public debt ratio could come close to 100% of GDP and that, despite low funding costs, "this high debt ratio will limit the government's fiscal flexibility should the current shock become prolonged" if, for example, the EU exit causes material economic and fiscal dislocations, Ms. James added. A sustainable and robust recovery phase for the U.K. "could be supported by an agreement with the EU," and the negative trend could return to stable, she said.

The main impact of prolonged negotiations and uncertainty around Brexit will be felt in the pound sterling, sources said.

"The main takeaway for investors and asset managers is we think there is room for the pound to fall further," said Constantine Fraser, London-based analyst, European research at global research firm TS Lombard. "Ultimately, we don't have no-deal as a base case. But the road (to an agreement) could be bumpy and … we think sterling has room to fall further before probably then recovering."

The pound sterling was hovering around $1.26 on June 12, having recovered from a drop to $1.15 on March 18 amid the coronavirus crisis. On the day the outcome of the Brexit vote was revealed — June 24, 2016 — the pound fell to its lowest point in decades against the dollar to $1.32.

In the coming months, Mr. Fraser expects "Brexit continuing to weigh on sterling more than it appears to be currently, before clarity (on the negotiations) arrives in September or October when we discover whether we are on course for a deal."

And Neil Williams, senior economic adviser to the international business of Federated Hermes Inc. in London, warned there is little room to maneuver for the U.K.'s central bank to help alleviate any Brexit-related problems heaped on the economy.

"Our analysis suggests a U.K. bank rate now as low as -6% when you explicitly take into account (quantitative easing) and the other emergency measures during this (COVID-19) crisis. It confirms we are thus running the loosest overall monetary and fiscal stance in three decades of data, and probably post-(World War II), with little correction expected for 2021. This loose U.K. policy mix offers little sustained upside for sterling when virus effects finally dissipate and Brexit's cloud lifts," he said.

While the Bank of England's monetary policy committee "may now be wary of squandering what limited ammunition it has left, ideally preferring to use QE rather than more visibly taking (the) bank rate into negative territory," a troublesome Brexit process means that last resort cannot be ruled out, Mr. Williams added.

And Manulife's Mr. Thomson agreed that a combined negative impact on supply and demand within the U.K. economy from the coronavirus and Brexit "could be the trigger for negative interest rates."

But on the positive side, if the U.K.'s Brexit negotiations do reach an agreement then "we would expect to see sterling appreciate. Not to the level where we were prior to the referendum — we're looking at closer to $1.40 to $1.45," Mr. Thomson said. The pound sterling spot rate vs. the dollar was $1.49 on June 23, 2016.

"One thing we can be sure of is that we are not going back to austerity. There will be a tax increase (in the event of a no-deal Brexit), but that is only a token to show we are 'in this together.' It is going to be the borrowing that finances" most of the U.K.'s needs, Mr. Thomson said.