Johnson's tough Brexit vow fueling uncertainty

Britain's newly minted prime minister, Boris Johnson, is counting on brinksmanship to lead his bitterly divided country out of the European Union by an Oct. 31 deadline, a strategy promising short-term pain and uncertainties but opportunities as well for long-term investors, analysts say.

Mr. Johnson's threat to push through a "no-deal Brexit" that would disrupt supply chains on both sides of the English channel if the EU denies him the concessions he needs to win parliamentary support for a more orderly exit has added to the critical mass of uncertainty facing investors in U.K. assets now.

The pound sterling — which traded Aug. 1 at a 12-month low of $1.2075, down from its $1.2657 close on May 23 when Theresa May resigned as prime minister and $1.2476 on July 22, the day before Brexit hardliner Mr. Johnson won the contest to succeed her — has been the key barometer of market concerns about a messy breakup. (With more than half of major U.K. company earnings coming from overseas, a fall- ing pound provides a boost for the FTSE 100 stock index, making that closely watched benchmark a less perfect proxy for market fears.)

With his coalition government clinging to a slender majority in Parliament, a number of his fellow conservatives opposed to a no-deal Brexit, restive chunks of the United Kingdom such as Scotland hinting at Brexits of their own and fair odds of a no-confidence vote or a general election in the months to come, there is no clear path forward for now.

For investors, that "elevated uncertainty" makes it more difficult than usual to arrive at a base case scenario for the rest of the year, said Ken Dickson, an Edinburgh-based investment director on Aberdeen Standard Investments' global strategy team.

A typical "decision tree" analysis doesn't seem equal to the task now, agreed Colin Harte, London-based head of research, multiasset quantitative solutions, with BNP Paribas Asset Management. "This is more like a decision forest," he said.

Most observers agree on one thing: Mr. Johnson's coming to power has made a departure from the EU that could prove highly disruptive for the U.K. economy much likelier.

With Mr. Johnson's ascension to the prime minister's office, the probability of a no-deal Brexit "has increased significantly" — a challenge U.K. investors appear to be taking into consideration much more than asset owners in Europe are at this point, said David Zahn, head of European fixed income with Franklin Templeton Investments.

The odds of a no-deal Brexit "have certainly gone up, probably to around 70%" from 20% earlier in the year when Ms. May was struggling to win parliamentary approval for the Brexit arrangements she had hammered out with Brussels, said Paul Jackson, Invesco Ltd.'s London-based global head of asset allocation.

Others are less sure.

At face value, it looks like things have changed dramatically but it may be too soon to draw that conclusion, said Karen Ward, J.P. Morgan Asset Management's London-based managing director and chief market strategist, Europe, Middle East and Africa.

Mr. Johnson still has to get parliamentary approval and that body has time and again opposed a no-deal exit, noted Ms. Ward. "If he truly wants to deliver," he has to change the configuration of Parliament, hold an election and increase his majority — and if current polls are to be believed, that prospect "is not looking like a slam dunk," she said.

A by-election defeat Aug. 1 for Mr. Johnson's party in the Welsh election district of Brecon and Radnorshire highlighted the risks the prime minister would face if he calls a general election in search of a mandate, while affirming yet again the knife's-edge split between U.K. citizens eager to leave the EU and those in favor of remaining.

With Mr. Johnson apparently taking an ahead-at-all-costs approach to the obstacles facing him, market players predict the uncertainties facing investors now will get worse before they get better — and that, in turn, could raise the likelihood of short-term market movements that asset owners with the luxury of taking a five-year view on investments will be able to take advantage of.

While it's difficult to be precise, it's clear a no-deal Brexit will have a "severely negative impact on the economy," and the decline of sterling in currency markets is the most visible manifestation of those concerns, said Rupert Watson, London-based head of asset allocation with Mercer Investments.

The FTSE 100 U.K. stock index, meanwhile, has proven more resilient, reflecting the benefits its component companies enjoy from garnering a majority of their earnings overseas.

Seventy percent of FTSE 100 earnings come from overseas so sterling going down boosts their profits, noted Invesco's Mr. Jackson. The same isn't true of the FTSE 250 index of small- and midcap companies, which are far more domestically oriented, he noted.

Over the week following Mr. Johnson's victory, the FTSE 100 climbed 2.3% to 7,686.61 as sterling was weakening by just more than 2%. Over the past week however, broader market concerns have come to the fore, including the potential fallout globally from U.S. President Donald Trump's threat to impose additional tariffs on hundreds of billions of Chinese exports, and the FTSE has followed U.S. stocks sharply lower in recent days.

Market veterans said while at sterling's current level, much of the economic risks facing the U.K. now have been discounted, Brexit-related uncertainties are likely to worsen in coming months. As a consequence, the likelihood of the U.K. currency overshooting on the downside is high.

In terms of fundamentals, sterling at $1.15 to $1.20 would have pretty well discounted the impact of a hard Brexit but it could probably fall further, temporarily, to between $1.10 and $1.15, said BNP Paribas' Mr. Harte.

At that lower level, "I think that we would probably, as a house, get close to starting to tilt to go overweight for sterling-based accounts," and gradually build that position, he said.

Pension funds, meanwhile, will look at some point after October to position themselves for an eventual rebound of sterling in currency markets. Part of that adjustment would include taking profits on FTSE 100 holdings and shifting money into the mid- and small-cap stocks in the FTSE 250, market veterans said.