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BNP PARIBAS MARKETSCALL SUMMARY

Core Content

This document provides the BNP Paribas Markets Call for the week of 11 July 2018, focusing on the UK and the latest Brexit developments. It outlines the bank's cross-asset market view, including insights on interest rates, FX, equities, and credit, while highlighting the implications of a potential soft Brexit versus a hard Brexit scenario.

Main Points

Brexit Outlook

• Soft Brexit is the base case: The UK government is moving towards a soft Brexit, which may involve remaining in the Single Market for goods, having flexibility in services, and maintaining a common rulebook with the EU. A "no deal" scenario is considered unlikely but still a tail risk.
• Political uncertainty remains high: Despite the shift towards a soft Brexit, the UK political landscape is turbulent, with potential leadership challenges to Theresa May. However, the likelihood of an imminent leadership challenge is low, and a general election before 2019 is also unlikely.
• Brexit timeline: The UK is still on course to leave the EU on 29 March 2019, unless Article 50 is extended or revoked. A withdrawal agreement is unlikely to be finalized before December 2018.

Interest Rates

• MPC likely to hike in August: The Bank of England is expected to raise interest rates in August, despite political uncertainty. However, the pace of tightening will be gradual over the coming years.
• Impact of soft Brexit: Under a soft Brexit, we anticipate more rate hikes than markets expect, though not to the extent seen in the US. The 10-year gilt yields are expected to rise to 1.75% by end-2018.
• Hard Brexit implications: A hard Brexit could lead to lower yields, rate cuts, and a sharp drop in GBP's long-term valuation. The 10-year gilt yields could fall back to 2016 levels (~0.5%).

FX Market

• GBP pricing only a small likelihood of a hard Brexit: The GBP is currently undervalued by 6%, indicating limited risk premia are priced into the currency. The FX market has added short GBP positions, but at a smaller scale than in 2016.
• GBPUSD and EURGBP targets: If PM May avoids a leadership challenge, GBP is expected to rise slightly against EUR and USD, targeting EURGBP @ 0.87 and GBPUSD @ 1.35 in the near term.
• Low implied volatility: GBP volatility remains at low levels, suggesting the market is not anticipating a large move. However, we believe GBP volatility could rise.

Equities

• FTSE100 outperformance expected: The FTSE100 is expected to outperform due to positive earnings momentum and re-rating as the market prices in a soft Brexit. UK small caps have outperformed large caps since 2017, but we expect caution on UK domestic cyclicals due to a potential slowdown.
• Sector exposure: The FTSE100 has significant exposure to energy, financials, health care, and materials sectors, which are viewed favorably. UK small caps are more sensitive to domestic economic conditions, particularly consumer discretionary, which is 23% of UK small caps.
• Retail sector challenges: The UK retail sector faces multiple headwinds, including rising inflation, which could push real wages negative again in Q3. The retail shakeup is on track to be the worst since 2012.

Key Contributors

• Robert McAdie: Global Markets Head of Strategy Research
• Paul Hollingsworth: UK Economist
• Ankit Gheedia: Senior Equity and Derivative Strategist
• Michael Sneyd: Global Head of FX Strategy & Cross Asset Strategist
• Pierre Mathieu: Cross Asset Strategist
• Benedicte Lowe and Kris Gjini: Cross Asset Strategy Graduates

Summary of Market Prognosis

Trade of the Week

• Trade: UK equities outperformance versus DAX
• Trade ID: TR-7519

Conclusion

The BNP Paribas Markets Call for 11 July 2018 outlines a cautiously optimistic outlook for the UK market, with a focus on a soft Brexit scenario. While political uncertainty remains, the base case suggests a gradual rate hiking cycle, a slight rebound for GBP, and continued outperformance of the FTSE100 over UK small caps. The FX market is pricing in limited Brexit risk, and the equities outlook is influenced by sector exposure and domestic economic conditions.