On March 12th Parliament is to vote on the Prime Minister’s (PM) Deal that has been agreed with the EU. The PM’s deal consists of “the backstop” linked to the border issue in Northern Ireland, a Withdrawal Agreement and a Political Statement. There has already been considerable political opposition to the backstop, the main one being the UK could not leave it unilaterally.
It has been our view for some time that the most likely outcome would be some sort of face-saving adjustment to the PM’s deal that would lead to it being approved by Parliament. This, in turn, would allow the UK to leave the political structures of the EU at the end of March and enter a transition period, lasting until at least the end of 2020. During that transition the aim would be to agree to a future trading relationship, based on the parameters laid down by the PM’s deal.
But given the raw politics evident in recent months, it has been our view that this outcome is by no means certain, and this has been reflected in our attitude towards UK assets. Indeed, the possibility of a no deal had begun to rise significantly recently, contributing in turn to the significant political events of the last two weeks, including defections from the main two parties. Now, it seems, following the latest events, no deal is less likely with the Labour leadership choosing to back a second referendum and the PM’s decision to allow a vote on an extension to Article 50 (A50).
The dynamics have changed, but PM deal still the most likely outcome
While the alternatives to the PM’s deal, namely no deal and an extension to A50, are still on the table, the dynamics have changed. If Parliament does not vote for the PM’s deal on the 12th of March, then on the 13th it would vote on a no deal, with the general expectation that Parliament will rule out no deal. In which case, there would then be a vote on the 14th as to whether to support an extension of A50.
An extension of A50 is full of challenges. It is up to the EU to agree to it, which they likely would, but the issue is how long for? It is by no means clear why the set of circumstances that would conspire to force us into such an extension, would be addressed during an extension anyway.
If the extension is for only two months, as has been speculated, then the present worries about the end of March will surely just be replaced by new concerns about the end of May. This date is chosen because if it is any longer then there is the complication of a possible legal challenge to force the UK to elect new Members of the European Parliament (MEPs) in European elections at the end of May, something the UK government and the EU appear keen to avoid.
The danger is, once an extension is triggered, it could drag on, adding to uncertainty. There would likely be an increased possibility of a second referendum. In these circumstances, there would be a political risk premium attached to sterling and to UK assets. Given all this, even though we anticipate an amended PM deal being approved and a transition period occurring, there is sufficient uncertainty for us to keep in mind other possible outcomes, including a move towards a Norway-style EEA relationship.
Also, while a general election is not seen by the market as likely, it too cannot be ruled out. An extension of A50 could force it. But also, the PM could opportunistically decide to call one if she saw a favourable reaction to her deal being approved and if the Opposition was behind in the opinion polls.
The 'Nike swoosh' path for GDP
Our view has been that leaving the EU, by whatever route, is difficult for the economy. I have talked previously of a ‘Nike swoosh’ effect to describe the profile of growth. Uncertainty has not been helped by the political dynamics in the UK and the path taken in the negotiations. But the further ahead one projects, in our view, the better the economic outlook becomes.
As we have seen, relative to what it might otherwise be, the uncertainty attached to leaving has deterred and depressed investment plans over the last two years. This was illustrated fully in the Bank of England’s recent Inflation Report. Notwithstanding this, the UK has still grown at a stronger pace than the euro area over the last three quarters. This highlights that there are still many other factors impacting the economy than Brexit, and that the UK economy still has some strong underlying dynamism and resilience.
The perception in the markets is that anything that makes the UK remaining in the EU or staying closely aligned to the EU more likely strengthens sterling and helps the economy. Thus, the pound has rallied in recent days.
Previously, we have agreed with the idea that if Parliament approved a deal, then there would be a deal dividend, as a removal of uncertainty and greater clarity about what lies ahead should be positive for business and investment. Therefore, if a no deal is ruled out and a deal with a transition period occurs, the initial market response may be positive going into the second quarter. Investment plans, previously delayed, could be given the go ahead.
Large firms trading directly with the EU have indicated that they would be relieved by this outcome of a deal. Of course, there are many other factors at play – globally as well as domestically – impacting prospects.
Monetary policy is on hold, but that could change
Monetary policy is on hold, at present. This is largely because of the slowdown evident recently, although this is not particular to the UK as the euro area, too, has weakened significantly. Strangely, the tightening in monetary policy that has occurred over the last one and a half years in the UK receives little attention but helps explain some of the slowdown.
It would not be a surprise that if there was a rebound in the economy – perhaps helped by an easing of political worries – then the Bank of England would soon move towards a bias to tighten. If no deal was reached, prompting additional near-term uncertainty, we would expect additional policy stimulus, both in terms of monetary and fiscal policy.
This week, however, the Governor, in testifying to a Parliamentary committee, tried to rule out any automatic link between no deal and easing, drawing attention to a possible near-term inflation shock. In terms of fiscal policy, the budget deficit continues to improve quicker than the market expected, but in line with our thinking, and this, along with any funds retained as a result of no deal, would provide scope for a fiscal boost.
Relief may be tempered by concerns
One future complication is that the markets may start to digest more fully the well documented opposition to the PM's deal.
These include that it constrains the UK’s future room for manoeuvre, particularly in terms of both the domestic economic policy and future trade options, as well as giving the UK no veto over EU policy during the transition period, with the danger that the EU could legislate in a way not favourable to the UK. Hence, there is a degree of uncertainty attached to it.
What then of a no deal? The trouble about this is that it is unclear as to how much preparation has been carried out. The City, for instance, appears well prepared, but the sectors most exposed and worried about a no deal include autos, chemicals and the farming sector. Thus, the uncertainty and also the market expectation is that there would have to be policy stimulus if there was a no deal.
Of course, one thing often overlooked is that a no deal is not an end in itself and would be in all likelihood a prelude to a series of sector specific deals, particularly in areas where bilateral UK-EU trade is high, such as in the auto sector. It is only last spring, ahead of the summer Chequers meeting, that the markets were focusing on a Canada Plus trade deal as the likely outcome.
Overall, there is still considerable near-term political uncertainty overhanging sterling and UK assets. Financial markets are heavily influenced by raw politics at the moment, by the expected sequence of likely votes in Parliament. As we have outlined in a previous report on this area, it is sterling’s performance that is most influenced by the likely Brexit sequence of events. Here, though, one needs to be careful as to what the immediate and eventual outcome may be.
Sterling has rallied whenever the prospects of a deal have improved. While the market has focused on the near-term consequences of any deal, the longer-term implications have yet to be factored in. These can only be analysed fully once the terms of the deal and the expected future trading relationship are agreed.
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