Increased Brexit uncertainty keeps UK asset classes edgy; keep Sterling exposure hedged

In a moment that marks victory for British Prime Minister Theresa May over her political opponents who wanted a softer approach to leave the European Union (EU), British lawmakers on Wednesday voted in favour of the government's legislative blueprint for Brexit. (Image: Reuters)

UK Parliament has voted down yet another deal on Brexit with 17 days to go for the current deadline. It’s remarkable that over the last two months, Theresa May’s government had to re-negotiate this proposal with the European Union (EU). Earlier this week, May had ensured legal assurances from the EU on the thorny issue of -- Irish backstop -- but this was not enough.

After the March 12 vote, Asian markets are trading negative this morning with Nikkei down a percent. FTSE 100 futures is trading 1.6 percent lower, while the dollar-pound has stabilised after a sharp volatility through March 12. Read: Brexit in limbo

So, what went wrong? The deal has been weighed down by the concerns regarding Irish backstop. Backstop is an agreement over the Irish border, which separates Northern Ireland and the Republic of Ireland and guarantees that the Irish border remains open regardless of the trade negotiation outcome between the EU and UK. It is noteworthy that current deal involves a 21-month transition period before the final exit in 2020, during which trade relationship would be figured out.

The idea is to keep Northern Ireland (part of UK) under the EU customs union to prevent a hard border within the island of Ireland if Brexit happens without an all-encompassing trade deal. This has been necessitated by UK’s commitments made to Northern Ireland in the late 90s (Good Friday agreement).

Those opposing the May’s proposal see this provision as a key concern as it compromises UK’s ability to struck comprehensive trade deals with other countries.

Legal assurance not enough To overcome this concern, on March 11, UK did get legal assurances from the EU that Irish backstop is temporary. However, UK’s Attorney General opined that risk remains that UK would have no lawful means of exiting the backstop once it gets imposed. In other words, this means EU customs laws on Northern Ireland could continue indefinitely.

What next? In the immediate future there are two crucial steps to be followed. On March 13, UK parliament has to vote on a no-deal Brexit. If it is defeated then on the following day (March 14) Parliament has to vote on Article 50, i.e. whether to extend the March 29 deadline.

EU's chief Brexit negotiator Michel Barnier said, “The EU has done everything it can to help get the Withdrawal Agreement over the line” and its 'no-deal' preparations were now 'more important than ever before'. This highlights heightened uncertainty in the coming days.

Revised timetable

Preparedness Chancellor of the Exchequer Philip Hammond had earlier confirmed that 4.2 billion pounds has been made available for Brexit preparations. Bank of England (BoE) also announced that it was increasing its lending facilities for commercial banks over the next few months to tackle financial transactions post-Brexit. Further, frequency of BoE's liquidity operations would switch to weekly from monthly in the days to come as was in the time of the 2016 Brexit referendum.

However, now contingency plans are up in case of a no-deal Brexit scenario. On March 13, UK government would announce detailed plans on how the border with Ireland would be managed in case on no-deal Brexit.

Takeaways There is high likelihood of an amendment to Article 50 and hence extension of the March 29 deadline. The current heightened uncertainty further dampens trade and investment in the UK.

For investors, we continue to suggest that given the political backdrop, it is advisable to keep the sterling exposure hedged. Indian investors should keep a close watch on UK developments as the disorderly Brexit would further drag regional growth outlook and could have a contagion effect. Mark Carney, Governor, BoE, said earlier that no-deal Brexit would raise the probability of 'negative quarters' of growth.

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