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Out of the Box: Great Britain — Deal or No Deal

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A no-deal Brexit could send both the UK and the European Union into recession, the International Monetary Fund (IMF) has warned. An abrupt exit from the European Union will see the UK’s Gross Domestic Product (GDP) shrink by 3.50% within three years, the IMF said in its twice-yearly World Economic Outlook. The report warned that Europe is also likely to be impacted by a disorderly exit, with the EU’s GDP decreasing 0.50% by 2021. Setting out its forecast, the IMF said: “More generally, a no-deal Brexit that severely disrupts supply chains and raises trade costs could potentially have large and long-lasting negative impacts on the economies of the United Kingdom and the European Union.”

We are right at the wire now, right at the edge. There is talk of extending Article 50 until year end but no one knows and it is all in the hands of the EU now where any of the 27 member nations could veto the deal, regardless of the consensus opinion. The desires of Germany or France could be overturned by Poland or Hungary or Italy.

The EU goes into special session today and the whole determination could turn on the spin of a wine bottle. Even Macron has stated that he was open to alternative plans including an election, or another referendum, on Britain’s relationship with the E.U., if May was able to get them approved in Parliament by Wednesday. However, this has not happened.

The UK is set to automatically leave the EU without a deal at 11pm on Friday unless an extension is agreed with the European Union or by revoking Article 50. The Prime Minister has been meeting leaders in Germany and France seeking to delay Brexit until 30 June as the government works with the opposition to get Theresa May’s withdrawal agreement passed through Parliament. The IMF added that Brexit remains a risk to the wider world economy, warning that a no-deal outcome was one of the unpredictable factors that could trigger a “sharp deterioration” across the world.

For the markets, especially the European markets, a “Hard Brexit,” or no deal, would cause a rout, in my estimation. Even an extension could put severe pressure on the European markets as everything, and anything, will continue to be unresolved. Then there are the EU elections, which are rapidly approaching on May 23.

Britain’s negotiations with Brussels may be with a whole different crowd, after the elections are finalized.

For investors my gravest concern is the European banks and the European bonds currently governed under British law and British bonds currently governed under EU laws. Both could be in serious trouble. Both could take serious hits, if things go badly.

European banks are poised to underperform in 2019, thanks to their inherent issues that not even the ECB, with their zero-cost money, can cover up. The region’s lenders have been rocked by record-low interest rates and sovereign debt crises, such as in Italy. The initial negative reaction of their stocks to a new round of loans from the European Central Bank, which are expected to have less favorable terms than in the past, attests to just how much some of these institutions are troubled.

If it is to be a “Hard Brexit” then none of us has any idea of just how bad it could get. We just have no idea of what types of interbank relationships/obligations are on the books. Moreover, we have no idea if British law or European law will be applied if push comes to shove. If the British no longer recognize EU law and/or if the EU no longer recognized British law then we are in a very desolate no-man’s land that could shove the banks, of both entities, into a major crisis. I am not saying that it “will” happen but I am sure saying that it “could” happen. We are all just about to find out.

The British government has said that if Britain leaves the bloc, with no transition deal, the EU would automatically become a “third country.” This means that the “zero risk weight” rule would no longer apply to the branches of the EU banks in Britain. Therefore, this will be removed for the preferential treatment for EU exposures, and possibly impair the balance sheets of the parent companies of the EU banks. The same, by the way, could be said for the British banks.

This also brings “Counterparty Risk” into the equation. If you are a money manager it would be judicious to check and see what kinds of “Counterparty Risks” you now have and whether they are prudent. If things begin to fall apart then you will be very glad that you considered this issue, before it is too late. I issue my “Warning.”

Another major issue is the rising threat of a no-deal Brexit for more than $115bn of European bank debt issued under English law.  This debt would no longer comply with either British or EU laws and it “could” be a legal disaster. This would also apply to the Tier I and Tier II debt, CoCo bonds, issued in the same fashion, which would also become largely unregulated by anyone. It is estimated that approximately $140bn of these CoCo bonds, issued from European non-UK banks, are governed by English law. In a “Hard Brexit” the European Union might not recognize the British laws and so they might revert to national laws which would decrease the value of these bonds substantially, in my opinion. I advise you all to check your exposure here!

I also point out the Germany’s two largest banks are in merger discussions. One, or both, could be stricken by a “Hard Brexit” and the resulting possible disturbances to their balance sheets making some kind of merger or buy-out next to impossible. Plenty of “Risk” in this situation as well, in my view.

I also point out that American banks may not be spared the contagion here. We have no idea about their interbank relationships/obligations with the British banks or the European banks either. Further, we have no real idea about their “Counterparty Risks.” It is because we just do not know, that makes this situation so full of danger.

Eyes wide open today. The spectacle is going to get underway. Pay attention!

Mark J. Grant
Chief Global Strategist, Fixed Income
Managing Director
B. Riley FBR Inc.
U.S. 954-468-2366

Information herein is for general use; is not unbiased/impartial; is current at publication date, subject to change; may be from third parties; and may not be accurate or complete. Opinions are the Author’s, not B. Riley FBR, Inc., or their respective affiliates or subsidiaries. This is not a research report or solicitation or recommendation to buy/sell the subject securities. Investment factors are not fully addressed herein. B. Riley FBR Inc. and their affiliates may have a proprietary position in the subject securities.

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