This post originally appeared on the website of BlackRock Blog.

We identified geopolitical risk as the key market driver in the second half of 2019 in our midyear investment outlook. The UK is the latest example, where deep divisions over a potential Brexit have unsettled the political landscape, paving the way for a broader set of potential outcomes. This could over time become a bigger worry for investors and businesses, in our view. We provide our take on the implications.

The UK parliament returned from recess early last week to upheaval, as lawmakers sought to force UK Prime Minister Boris Johnson to back down from his pledge to take the UK out of the European Union (EU) if no deal is reached by the October 31 deadline. That kicked off perhaps the most eventful week in British politics since the UK voted to leave the EU in 2016. Recent UK political upheavals have been reflected in a volatile pound, with the currency nearing multi-decade lows early last week before rebounding sharply. See the chart above. We see further volatility ahead as UK political turmoil is likely to persist, with potential for fundamental realignments in the UK’s political landscape. Other markets have been taking their cues from sterling, with the prospect of a weak currency leading investors to price in sustained higher inflation in the UK.

A wider array of outcomes

The political situation in the UK remains very much in flux, yet recent developments have already changed the distribution of likely Brexit outcomes, in our view. We now see a wider array of potential outcomes, following a high likelihood of a UK general election in the near term. Six months ago, a negotiated deal looked most likely; now, the then-extreme outcomes – no-deal or a new referendum – look to have become more plausible. An election could boil down to a vote that is effectively split on Brexit lines – between leave (under the Conservative and Brexit Parties) or another referendum (under a Labour Party-led coalition).

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A lot of contingency planning – including by the financial service sector – has been put in place and could potentially mitigate the impact of any no-deal Brexit. Yet the exit of an EU member would be unprecedented, making it a significant risk with uncertain outcomes. This scenario would also involve tough negotiations. Among other challenges, the UK would need to fashion a new trade agreement with a group it has left on bad terms. Importantly, we believe the main issue is no longer about a deal or no-deal, but about the possibility of new political equilibrium altogether that could stave off a Brexit outcome or bring about a return of a hard Brexit. It could entail fundamental changes to economic policy. Our conclusion: An unsettled UK political and economic landscape could be with us for some time.

The UK political turmoil is happening at a time when heightened market and business concerns about trade disputes and other geopolitical risks are already slowing global growth. The combination of domestic and international uncertainty has led to a near-collapse in UK business confidence, with data pointing to a possible contraction in economic activity. A deeply unsettled political backdrop in the UK could prolong such uncertainties, weighing on domestic business and investor sentiment.

Bottom line

Against this backdrop, we do not see the Bank of England raising rates as it has guided. This underpins our positive view on UK gilts. We hold a neutral view on UK equities but see opportunities if Brexit-related fears lead to indiscriminate selloffs, particularly in UK companies that derive most of their earnings from global markets. 

Scott Thiel is BlackRock’s chief fixed income strategist, and a member of the BlackRock Investment Institute. He is a regular contributor to The Blog.

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