Views From the Floor

In this week's edition: we discuss what happens next with Brexit; and euro implied volatility now appears to be inexpensive, in our view.

No Brexit, No Change, No Surrender, No Solution; What Happens Next?

In the lead up to the EU summit on 10 April, common consensus in the media was that despite UK Prime Minister Theresa May’s request for a short extension, a year’s extension (with conditions attached) would be offered. In the end, in the face of fierce opposition from French President Emmanuel Macron to a short extension, the new Brexit deadline is 31 October, 2019 – six months away. The UK will also have to take part in the European Parliament elections if the Withdrawal Agreement hasn’t been ratified by 22 May, or face being booted out of the EU – deal or no deal – at the beginning of June.

It is likely that May will have another attempt to pass at least the Withdrawal Agreement in parliament before 22 May in an attempt to avoid taking part in the European elections. It is difficult at this stage to predict whether this would scrape through. On one hand, there may be fears from hardline Brexiteers that the longer the process drags on, the potential for a second referendum or confirmatory referendum increases. One of the outcomes for this could be the end of Brexit altogether. This may push some to vote for her deal on the premise that any Brexit is better than no Brexit. On the other hand, opposition to some technical points in this deal have become religiously entrenched, with some parties who may prefer to frustrate the process in the hope that it will lead to a no-deal Brexit at a later point or that the EU may decide to renegotiate the Withdrawal Agreement if a new PM was in place (an option that is incredibly unlikely, in our opinion).

The current parliamentary session is due to end summer 2019. At this point, parliament would need to be re-opened with a new Queen’s speech, which sets out the legislative agenda for parliament over the upcoming session. This puts May in a bit of a bind: the government currently relies on Northern Ireland’s Democratic Unionist Party (‘DUP’) for its majority, and as such, the DUP would have to approve the speech. However, if passing the Withdrawal Act forms part of the legislative agenda, the DUP has said it will not support it. The confidence and supply agreement with the DUP is also due to be reviewed at the end of this parliamentary session. If it is not renewed, the government would no longer have a majority and this could trigger a general election. This leaves May with three options:

  1. Get the Withdrawal Act passed before the end of this session;
  2. Extend the current session until the 31 October deadline to avoid the necessity of the Queen’s speech; or
  3. Determine either to leave without a deal or to revoke Article 50.

In the end, six months is not a long time. Constitutional experts have previously stated that it would take at least six months to organise a referendum – if the decision was made to do this, a further extension would almost certainly be required. If May chooses to step down, or the confidence and supply arrangement with the DUP is not renewed and a general election is triggered, this would subsume much of the time available to the Brexit deadline. It is also hard to see either Labour or the Conservatives gaining a majority in the house that would be strong enough to pass any legislation through.

In our opinion, the only way the October deadline will be the end of this is that either a deal is passed or the EU decides a no-deal is acceptable – any other avenues would require a definitive plan and a further extension. There is, of course, the option of revocation and remaining in the EU. However, it is unlikely to us that anyone in parliament would take this course of action without a mandate either from a general election or a second referendum.

Much Worry, Little Vol

Implied and realized volatility has fallen across asset classes after a series of dovish pronouncements from the European Central Bank and Federal Reserve calmed markets earlier this year. This is despite multiple potential catalysts for volatility in Europe in the year ahead – whether Italy, Brexit, bank exposures to the potentially volatile Turkish economy and banking system, or the ECB due to transition to a new president.

Amongst this general trend, the fall in euro implied volatility has particularly stood out. After spending much of 2018 range-bound between seven and eight, euro currency implied 1-year volatility reached a multi-year low of 6.3 in early April, compared with current 30-day realised volatility at 5.5.

With this discrepancy in mind, euro implied volatility now appears to be inexpensive, in our view.

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As of 9 April, 2019.

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As of 9 April, 2019.

ESG, Miners and Iron Ore Prices

Iron ore prices have spiked in 2019, gaining 44% from the beginning of the year through to 12 April.1

The spike has been driven almost entirely by supply contraction: the tragic collapse of Vale’s Brumadinho tailings dam on 25 January (in which at least 206 people were killed) has coincided with an unusually strong cyclone season in Western Australia. JPMorgan estimates that the Brumadinho disaster has led to additional mine suspensions, resulting in 93 million tons per annum of capacity offline,2 while BNP Paribas calculates that production of about 20 million tons of iron ore has been impacted due to cyclone Veronica in Australia.3 These supply dislocations could help support iron ore prices in the medium term.

However, the Brumadinho disaster calls into question the safety culture across the entire industry. We would hope – and expect – that mining companies review safety standards in response, thus increasing spending on existing tailings dams. As such, we expect increases to operational and capital costs as the industry seeks to improve safety standards.

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As of 12 April, 2019.

With contribution from: Man FRM OpRisk; Mark Ashton (Man GLG, Asset Manager) and Peter van Dooijeweert (Man Solutions, Head of Institutional Hedging).

1. Source: Bloomberg

2. As of 10 April, 2019.

3. As of 11 April, 2019.