#BREXIT A long term fundamental outlook on its impact on #GBP. Part 1 of 2: Political fundamentals

There is one fact that is an axiom in any analysis on the implications of #Brexit:
Britain is pulling out from a vast single market and this will have negative implications on its economy.
This is undeniable.

Before the referendum, the narrative of the populist politicians that supported #Brexit was very different.  It was more or less "we'll be better of when we pull out" and this claim was supported by empty numbers.  Immediately after the referendum it became evident that there was no actual plan and no strategy to follow.

So the UK embarked on the negotiations without any plan but wanting to change the European project... the basic principles on which the EU is based upon. Principles like citizen's rights, freedom of movement, freedom of trade within member states, etc.
This was a naive move.  EU would not and will never negotiate any of these principles.  They form the basis of its existence.  And it simply informed UK that none of these are negotiable and cherry picking is not part of the game.

This was no surprise to anyone but to some of the political elite in the UK.  It forced them to look the exit process from a reality prism setting aside populist beliefs.
Having done that, the first part of the negotiations have started and they will be probably be completed soon. marking the start of the actual trading negotiations.
And during these negotiations Britain had to concede defeat on every issue, some say, make considerable concessions, others call it, or simply agree to the EU terms which is the simplest and the best way to describe it.

Trade negotiations will probably start at the beginning of next year, and during them the UK will continue in its current transitional status with regard to its relation with the EU.
On the two edges of these negotiations there are two models.  On the positive edge there is the Norway model and on the other negative there is the "bad divorce", the "no deal" model.

The Norway model  is the one that would have minimal if any negative consequences for the British economy. The problem is that it makes no political sense.  The UK would have almost full rights as if it was a member state and absolutely no part in the decision making processes.  The referendum would have been a meaningless political act.

The "no deal" modelis a dreaded scenario for the UK and that is clearly understood by the majority of its political elite.  It would have grave consequences for its economy in the long term.  This scenario is almost fictional.  It makes no economic and no political sense.  And it is also ironic because even if it happened, the economic realities would render it as failed in the depth of time and the UK would have to reestablish favorable trade relations with the Union.  Despite all that it cannot be excluded due to political reasons as it will be shown later.

Some have suggested that the Canada-EU trade deal model should be followed initially and then upgrade it to Canada +.  This, and other similar suggestions are oversimplified solutions that cannot be applied.  The Canada model offers no solution in many issues and if it was to be followed important sectors of the UK economy would have taken a direct hit.  Sectors like aviation, energy and most importantly the financial industry.
Moreover, while Canada's percentage of trade with the EU is 10%, the case of the UK is totally different:

The second flaw in this thinking is that vague second step..upgrade to Canada+.  The EU would never negotiate on vague terms and will agree only to a clear and complete deal.

So, reality dictates, that the final trade deal will be somewhere in the middle. The closer it is to the Norway model the better will be for the British economy.  The furthest away from it the harder the blow.

To predict the trade deal is impossible.
To assume that both parties will try to close the deal as close to the Norway model as possible is a rational assumption.  The main player the decisions of whom will define the outcome of the negotiations is the UK.
The Union has very little room to manoeuvre.  Free trade requires the respect of its fundamental principles.
Britain on the other will have to decide on what concessions is willing to make.  And this is a political puzzle, the solution of which will be found by its political elite.
British internal politics will be the decisive factor on the outcome of the negotiations.

The majority of pro-Brexit conservative politicians seem to have understood the realities of #Brexit. The #Brexit bill of 40 billion was accepted and justified with the reasonable political manoeuvring  (if not disguise).  There is a small minority that still believes without any justification whatsoever that they can have their cake and eat it.  For the moment though  they do not seem to have any real political influence.

If the road to reach the start of the trade negotiations was bumpy for the UK, the trade negotiations themselves will be even bumpier.  Great political skill will be needed by the pro-Brexit realist politicians to present any concession made as a victory, as an advantage or as a necessity for the common good, and not as a defeat or as broken promise.
Will the Conservatives succeed in that? They seem to have the will.  They seem that they have understood the harder the# Brexit the harder the blow to the economy.
And this the real incentive that will drive their efforts to make Brexit as soft as possible.  If things start going the wrong way it will have an immediate impact on the economy, and all bleak predictions will bombard the British people every day through the media.  In such case a crushing defeat  in the elections is highly probable. This is the strongest incentive a politician can have.

Labor on the other hand could go either way on the #Brexit negotiations.  No analyst can figure out what their real stance or even if there is a solid stance.
Their influence on the issue will become primary if they win the next elections.  Election results cannot be predicted but a real possibility exists for Labor winning them.  What would happen in such case is a matter of debate.  The most realistic scenario depends on the status of the #Brexit talks at the time of the elections and it is as follows:
If the talks have gone relatively smoothly, a good trade deal is a realistic possibility visible in the near future, then it is more likely for Labor to achieve a victory than a crushing victory (that is if the elections happen before the closing of the final deal).  This would not allow for the radical or populist party segment to impose its conditions and force its policies.  The moderate, pro-European pro-liberal segment would prevail.
If on the other hand, #Brexit is at a dead end when the elections take place and the economy and the economic climate is at a downturn, it is more likely for Labor to achieve a crashing victory giving them a big majority.
In such case it is very likely that, the negotiations turn sour and the country is steered away from the EU and a trade deal.  In this scenario, before and after the elections, the economy and #GBP would be under pressure.  Inflation would be on the rise.  The Bank of England would suggest a rate increase to control inflation and protect #GBP as well as austerity policies to be implemented so that the economy will withstand the shock.  Would a newly elected Labor with a clear and fresh mandate, a huge majority, and with a prior to the elections populist rhetoric, allow the central bank to increase the rates and take into account its suggestions?  Probably not.  Will it impose its policies to the Bank of England and print money instead?  Based on its current rhetoric yes.  Therefore this is a real probability.

A question one has to ask when trying to analyze the political fundamentals of #Brexit is the following:
Does the UK hold any cards during these negotiations?  There have been two suggestions especially right after the referendum and until  the beginning of the initial talks 9 months ago.
One was that it could break the bloc of 27 and get the support of some countries.  This is simply not happening.  The Union came out of Brexit stronger.  One of the populist movements that plagued the Union during and after the #EUR crisis, won its case and this country exited the Union.  And this country was one of its largest in all respects but most importantly economically.  The luck of purpose, the vanity, the damaging in so many levels effects of such a move became evident to the people of Europe.  Defeats and contraction of such movements in Holland, France, Italy followed.  And the rhetoric of these movements has radically changed.  The word EXIT has vanished and they now focus on the immigration issues.
Add to that the fact that the EU economy is on the beginning of an uptrend cycle.
Lastly and most importantly, the Union will base these negotiations on its founding principles that dictate who takes part on free trade.  This is non negotiable.
So the 27 will follow the lead of France and Germany and the bloc will remain united.
 
The second and strongest card was security.  This translates to military spending and sharing of intelligence.
The latter is an issue that concerns both parties and the consensus is that resolving it and overcoming any legislative obstacles is a one way street.  This is not a trading card for neither the EU nor the UK.
The second is an issue of strategic importance.  UK was the biggest defense spender from all the Union countries and one of its loudest voices in the international diplomatic arena although not always in line with EU foreign policies.
However, the Union is turning towards the line of a deeper unification in foreign/defense policy.  Germany that does not spend almost nothing in defense is likely to change that.  The popular opinion within German citizens that was traditionally against an increase in spending has changed and now it does not oppose it.  On top of that, the introvert swing in the US foreign policy and the NATO demands for an increase in its spending, are likely to accelerate this process.  It is calculated that it would take Germany about ten years to reach an acceptable defense capability and this would not cause any economic strain to its economy.
And of course there is also France which will be the only nuclear power of the Union.

None of the above is anymore considered to be a valuable negotiating card. The UK and the EU no matter what the outcome of the trading negotiations will be, will remain allied an closely related countries.  So intelligence will be shared.
As for the defense spending and its strategic importance, it is an issue that the EU will have to resolve even in the best trade deal scenario.

Another factor that has to be considered is the role of the US in the process.
The timing of the Trump election and of #Brexit happening could not have been worse.  With just about any other administration, the role of the US president would be to bridge the differences between the two parties and help to achieve the best possible outcome which translates to the softer possible divorce.  With the Trump administration this is not possible.  President Trump is an outspoken supporter of #Brexit.  During these first months of his administration the US-UK relationships have deteriorated and he is seen with reservation both by UK and by EU politicians.  Moreover, the US under his administration seems to be entering in an introvert cycle.
As a result, it is highly unlikely that the US will have any constructive and synthesizing role in the process.

A question that both parties have asked since day 1 of the negotiations is: Which one of the two has more to loose from a hard #Brexit?
The answer is obvious not only to the UK and the EU but to the rest of the world.  They will both loose but the UK will loose vastly more than the EU.
The EU will loose one of its biggest countries and economies but it will remain a huge united economic market itself.  It will not have to change or adapt any of its regulations and laws, it will not have to form any new trade agreements, and it will remain the priority choice in Europe for any other country or bloc of countries as far as trading is concerned.  On top of that all the benefits of the EU that have been forgotten because of the #EUR crisis and also because of the rise of populism, are on the front-line again:  The boost of EU GDP since its inception, the absence of customs and consequent  decrease in bureaucracy and reducing of costs, attraction of inward investment, the free movement of capital and people, harmony and peace within the Union, legal and human rights for all its citizens, commitment to rule of law and market economy, harmonizing standards,  elimination of anti-competitive practices, the buying power of its citizens, etc
UK was a part of all these but to what extent it will be part of them in the future will depend on its final trade deal with the EU. A very notable example is that the UK as a Union member was the 5th largest source of inward investment in the world especially for Japanese firms.
In case of hard #Brexit, it will not be part of any of the above and this will have a devastating effect on its trading relations with other nations.  Supporters of hard #Brexit have been saying that new trade deals would be formed with and they would have been far more beneficial for the UK than the existing ones within the EU umbrella simply because they would have been focused on the UK and the EU bureaucracy would have been avoided.
Nothing could be further from the truth.  The EU simply because of its size and economic power will remain the number one priority when it comes to trading.
Furthermore, the forming of  trade deals is a very lengthy and complicated process by itself.  But the UK would have to do more than that before starting negotiations for new trade deals.  It would have to adjust its laws and regulations concerning trade, since at the moment these are EU laws.  This process would take years to complete.

Therefore, it is evident to all that a hard #Brexit would have a controlled negative impact on the Union, and a vastly greater negative impact on UK.
#Brexit was a bad decision  for Britain and there is no way the it can make a success out of it as the narrative of Mrs May is at the moment.  The only success would be to minimize its effects.

Interpreting these political fundamentals and their effect on the #GBP

Uncertainty and price swings. 
Until the end of talks this will be major characteristic of #GBP. The causes will depend on the focus of the market at the time and on the characteristics of the event.   Earlier in the #Brexit negotiations a minister would sneeze and #GBP would wobble.  Then the focus moved on the rate policy of the BoE and comments from politicians were completely disregarded by the markets.  And so on..
This pattern will continue until the final deal is known.

Heaven scenario
The negotiations will be smooth and the outcome will be a model similar to Norway's.  #GBP will be in a steady recovery path.
This will not happen.   As simple as that.

Hell scenario.
No deal and a hard #Brexit.  #GBP crushes in a rather short period of time.
This is an improbable scenario but in no case it should be excluded. It is an existing possibility, and the probabilities of happening are real.

Most probable scenario.
A deal will be reached after complex and bumpy negotiations with lots of highs and lows.  The deal will be much closer to the Norway than to the no deal model.  Everything will be phased, with adequate transition periods giving time to investors to adjust their policies.

This scenario is based on the following assumptions:

• Pro #Brexit Tory politicians have realized that they are not evenly matched against the world's largest trade bloc. The EU is not the pitiful giant they envisaged prior to the referendum and it has vastly less to loose in comparison with the UK in any kind of final deal. Instead of demanding the moon on a stick as they did at the very start of the initial talks, they will continue on the route of concessions that they are currently.
• Pro #Brexit Tory politicians will be able to "save face" and present their concessions as an advantage or as a necessity for the common good, and not as a defeat or as broken promise.
• In the likely scenario, in which Labor is the next government, it will continue on the current political line of a soft #Brexit that the Conservatives are trying to follow despite their internal divisions and contradictions.
• Rogue populists within the conservatives that continue to regard exit without a deal something to contemplate lightly, will have minimal influence.

These are reasonable assumptions since:

• It is evident to the majority of  pro-Brexit politicians that there is no such thing as a "success #Brexit".  #Brexit will have negative implications for the UK.  The closer to the current status the trade deal is the lesser their effect in the short, medium and long term. 
• Their political survival depends largely on the handling and outcome of #Brexit negotiations.  A bad deal will have immediate negative economical consequences that will be felt sharply by the electorate.  A bad deal will also mean with certainty that the Labor will be in government.  Finally, there is swing against #Brexit in the electorate, since it has realized the political vanity that was behind it and the negative consequences that it will have.  In case of a bad deal, the electorate will punish those who supported it.

In politics though, nothing is certain.  There is always the possibility that the unlikely scenario will prevail.

What could make this scenario fail, are two factors:

The Tories under Mrs May push for a soft #Brexit but fail because of the denial of pro #Brexit hardliners who are driven by illusions and personal ambition.

In such case the negotiations would stall, elections would be called  and the door will open for Labor 

Labor is the second and highly unpredictable factor.  In case of a landslide, there is a high probability that Corbynism in the economic policy will prevail.  The fact that such policies are against the EU's clear and solid commitment to market economy combined with the opinion of Mr Corbyn towards the Union, signal a hard #Brexit.  If the Labor victory is not that wide, this scenario become less likely and more moderate and EU friendly policies are more likely.

The time factor

This is very important and it has a heavy influence on the economy and on #GBP.

The notion as supported by some analysts that the start of the trade negotiations would mean that the worst of #Brexit fears have subsided, is totally wrong.  Even when the trade negotiations are given the green light, these are going to be highly complex and lengthy. The internal political dynamics, and the government's resilience to withstand the shocks of these negotiations, will remain a question mark as there is still no agreement within the Tories as to how the future relationship should look.  Will there be such agreement any time soon?  No it will not.  It will be a step by step process with Mrs May trying to push towards a soft #Brexit, while testing the limits of her pro #Brexit hardliners.

Will the 2019 deadline be met?  Probably not but this is not necessarily a difficult issue as long as by that time the path is clearly towards a reasonably soft #Brexit.

The phasing of the negotiations and the time distance from the deadline have been priced in by the markets and that is one of the main reasons for the relative stability and uptrend of the #GBP during the last months.

Based on the above, the outlook og #GBP is as follows:

• It will remain volatile with big swings
• A dive in its value is not probable unless there is a break down in talks.  There are no such indications at the moment.
• It will continue to range at the levels it has been moving the last months, and a further uptrend is highly probable as soon as the trade talks begin.
• Constant re-evaluation is needed of the political situation is essential.

So positioning on #GBP is more on the direction of long and on taking advantage of the range, and not in short.  Uncertainty and volatility dictate extreme caution in position sizing, distance of TP which should be at very modest, distance of SL which should allow for flexibility, distance between orders, and ability to support open orders with extra capital.

In other words, trading #GBP require more "institutional" like approach, than usual.

The above is based on the political fundamentals.  The economic fundamentals support the same approach and this will be analyzed on the second part of this post.

As always, positioning and trading refers to medium and long term trading and not to short term.  H4 or greater, Daily and Weekly charts are considered only.

This is a general assessment on positioning.  There are individualities in each pair and these will be discussed in future posts.