Please see article below from Legal & General’s asset allocation team – received 14/09/2020.
Our Asset Allocation team’s key beliefs
The day after the UK voted to leave the EU – more than 1,500 days ago – we wrote in our Key Beliefs that “Brexit will now dominate markets for a while longer and be a market factor for years to come”. This week, we cover the latest developments in that ongoing saga and two other recurring issues for markets.
As with all Key Beliefs emails, this email represents solely the investment views of LGIM’s Asset Allocation team.
Rule Britannia, Britannia waives the rules
The result of last year’s election reduced the probability of a soft Brexit outcome, in our view. Since then there has been no real progress in discussions with the EU, so the chances of a comprehensive deal have dwindled further.
The new Internal Market Bill, and the news that the state-aid regime will not be ready until mid-2021, further lower the likelihood of securing a deal. This means that – barring a Parliamentary block, a policy U-turn, or a significant softening in approach from Brussels – we are probably now looking at a narrow range of outcomes between a hard exit and a slightly less hard exit. The difference in economic impact between the two is relatively small, and is likely to be swamped in the current environment by COVID-19 developments and fiscal and monetary policy.
This news is not particularly shocking, as negotiations with the EU have been going back and forth for a while, but investors have woken up to Brexit risks again in the past few weeks. With the market probability of a no-deal exit reaching approximately 80% in our estimates, sterling fell by around 4% against the euro and US dollar.
Looking forward, the narrowing Brexit outcomes should mean sterling’s range is more limited too, so we wouldn’t expect the wild swings in the currency of recent years. We believe the tail risks are also skewed to the upside from here: a no-deal scenario may see a touch more weakness, but a sniff of a deal could stoke a greater recovery.
Israel: the first domino?
The unsettling news for Israel is that COVID-19 dynamics in the country are deteriorating on all fronts, with the government announcing a second lockdown on Sunday. Many had supposed that the economic pain of shutdowns would deter politicians from re-imposing them, but Israel has demonstrated that we shouldn’t rely on that.
The question we need to ask ourselves is whether Israel is the first domino to fall and if Spain and France are the next ones to topple. There are some idiosyncratic differences between Israel and continental Europe, such as in party politics, demographics and behavioural tendencies, but equally it is possible to draw some parallels.
Spanish and French ICU capacity per person is greater than Israel’s but, at current rates of case-load expansion and growing ICU occupancy rates, Spain looks like it may become stretched by the end of September and France potentially a month or so later. That said, the head of the Spanish health-emergencies department believes Spain has already turned a corner for the better in its latest wave.
We believe further full-country lockdowns in Europe are not part of the consensus thinking in markets, so there is a downside risk, but more lockdowns could mean more stimulus too.
Hopes for any further fiscal stimulus in the US before the elections darkened last week as a deal proposed by the Republicans failed to pass a Senate vote. Negotiations have become increasingly difficult of late and a failure to pass a deal soon puts millions of Americans in jeopardy.
While there is a wide range of outcomes over the next few months, the risk of the economy stalling in the fourth quarter has risen. The consensus probability of a stimulus deal stood as high as 90% a month ago but, with those odds plummeting, economists will need to embark on a series of forecast downgrades if Congress fails to act. This was also a likely driver of weaker equity markets in the past week, hidden somewhat by the headline news of the technical squeeze in tech stocks.
Both sides still seem far apart on reaching agreement on another round of fiscal stimulus. Republicans do not wish to provide state and local government aid to ‘bail out’ Democrat states, while there is disagreement within the party on the type of stimulus and whether another round is even necessary. Democrats meanwhile voted against the proposals as they contained some ‘poison pills’, such as funds for the coal industry and a tax break for private school costs.
Additionally, the Federal Reserve is having problems with its Main Street Lending programme, designed to help small firms, with only $1 billion of loans out of a total capacity of $600 billion made so far. This means the central bank’s ability to offset an underwhelming fiscal stimulus could be reduced.
The drag on the economy is building, but not yet apparent in the data. The blockages in approving further stimulus should not be seen as a cliff, but an increasingly steep downhill ride the longer the standoff continues.
Another useful article from Legal & General covering the latest developments with regards to Brexit and other recurring issues for markets.
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