We caution investors on sterling and UK gilts as Brexit negotiations commence and the likelihood of a “hard Brexit” remains high.

As widely expected, Theresa May, the UK prime minister, has formally triggered the country’s departure from the European Union – a process beginning today with the presentation of a letter of resignation to Donald Tusk, President of the European Council.

The UK’s position

The letter sets out a proposed process similar to the one May presented in her Lancaster House speech of 17 January, in which she expressed a desire for the UK to remain a close friend and ally of the EU, whilst restoring “our national self-determination”. Practically speaking, this is expected to involve departure from the single market and the jurisdiction of the European Court of Justice. However, the UK also envisions a new partnership that would be agreed during the two-year negotiating window and implemented thereafter.

Given the complexity of the negotiations, the UK expects to work out any new trading arrangements concurrent with negotiations over its exit bill (the amount it needs to pay the EU to settle outstanding liabilities, including pensions and budget commitments). If this is not possible, today’s letter makes clear that the UK remains willing to walk away and revert to WTO trade arrangements, although the prime minister makes the rather strong statement that this could adversely affect security co-operation. To date there is no indication that the EU will soften its stance, which remains settling the exit bill before moving on to discuss future trading arrangements.

Importance of today’s news

Recognising that these are still just initial negotiating stances, there is important information in today’s news. In particular, neither side appears willing to offer early room for compromise, and time is already short. Whilst the full negotiating period is two years, we believe the real period is more like one year: If there is no clarity after one year, businesses will be forced to assume that there will be no transition deal and will start to enact plans based on future trading under WTO rules.

Given the French and German electoral cycle will take up the first six months, the crucial period for the negotiations will be late 2017 and early 2018. This limited time frame and the lack of any early room for compromise suggests that the likelihood of a so called “hard Brexit” remains high.

Investment implications

The initial market response to today’s news has been a weakening in the pound, a modest rise in gilts and little change in equity markets. These look like logical moves – sterling should remain the most sensitive UK asset price to the Brexit negotiations, whilst 10-year gilt yields of 1.16% already encapsulate a multi-year period of at- or below-trend growth. The outlook for equities and UK corporates under the various potential outcomes remains more nuanced. As such, we believe a modest underweight to sterling together with an underweight to UK gilts remains a good risk combination.

Mike Amey is PIMCO’s head of sterling portfolio management and a regular contributor to the PIMCO Blog.

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