What’s next for Brexit?

After the dramatic defeat of the UK Prime Minister’s EU withdrawal plan, Arnab Das and Michael Siviter predict five scenarios for the future EU-UK relationship.

Jan 17, 2019 | Arnab Das and Michael Siviter
  • After the dramatic defeat of the UK Prime Minister’s EU withdrawal plan, we see five scenarios for the future EU-UK relationship. 
  • We expect further debates, amendments, challenges, and even attempts to extend the departure time line as the UK gets to grips with what precisely Brexit means. 
  • Even so, we believe the chances have risen for a softer version of Brexit or perhaps even no Brexit at all.
     

On Tuesday evening, the UK Parliament rejected Prime Minister Theresa May’s Brexit Withdrawal Bill by a 230-vote margin — the largest defeat of legislation in nearly 250 years, when Parliamentary records began.1 That the defeat exceeded consensus by as much as 100 votes reflects the depth and breadth of dissatisfaction with May’s Brexit plan. Many Members of Parliament (MPs) fear it could further undermine the economy, contribute to secession in Northern Ireland or Scotland, or might not confer the freedom for which Brexiters campaigned in the referendum. 
 

The immediate next step was a no-confidence motion against the May government, which she survived on Wednesday by a vote of 325 to 306. Now, we expect something of a return to the Brexit drawing board, with a continuum of potential outcomes from a no-deal “Brexident,” to a softer version of Brexit, to even cancelling Brexit and staying in the EU. Both the UK short- and long-run economic outlook hinge on how Brexit is ultimately executed — if at all.
 

What are the odds of each scenario? 
The plethora of issues in the UK’s contentious relationship with the EU boils down to membership of the EU’s Single Market (SM) and Customs Union (CU). The Single Market comprises four freedoms — free movement of goods, services, people and capital. Continued membership would be highly desirable for services trade in which the UK is a world leader and enjoys sizeable services trade surpluses, including with the rest of the EU. But continued membership would require free EU migration, the jurisdiction of the European Court of Justice (ECJ) and contributions to the EU budget. Rejection of these three key items is seen as the main motivation behind the 2016 Brexit referendum result in which 52% of participants voted to leave the EU. 
 

The Customs Union is highly desirable for goods trade, but requires abiding by the EU’s common external tariff and regulation, disallowing free trade agreements with other countries. The UK’s legal treaty commitments to Ireland and political commitments to Northern Ireland are tantamount to avoiding a hard border on the island of Ireland, which would require remaining in the Customs Union. 
 

We would assign the following probabilities to each potential outcome. 
 

  • Brexident, 10% probability: If nothing is done, the UK will crash out of the EU with no transition. But the risk of a no-deal Brexit has fallen sharply as the UK Parliament has restricted the prime minister’s ability to manage a hard Brexit, and the ECJ has confirmed the UK’s right to revoke Article 50.
     
  • Hard Brexit, 10% probability: This would entail an exit from both the Customs Union and the Single Market. The chances of a Hard Brexit have significantly receded, in our view, as it has long been clear that there is only a minority, albeit a vocal one, for Brexit at any cost. But it is still conceivable that a new referendum or general election might lead to another majority for Brexit.
     
  • Medium Brexit, 30% probability: This would include an exit from the Single Market, but membership in the Customs Union, similar to the EU’s relationship with Turkey. 
     
  • Soft Brexit, 25% probability: We could see a compromise by Parliament in which the UK remains in the Customs Union and Single Market. While this would retain most of the UK-EU economic relationship, in line with the desires of most major firms and financials, it would be politically contentious within the UK, given the Brexit referendum. 
     
  • Bremain, 25% probability: This scenario, no Brexit at all, would likely require a new referendum or election. While their public positions indicate that a majority of MPs favor remaining, such a political choice would likely be portrayed as a betrayal of the will of the people, unless preceded by some sort of “people’s vote” endorsing a reversal of the 2016 referendum result. But a new plebiscite would be more complicated than before, given the need for several alternatives in line with these scenarios instead of the binary choice offered in the 2016 referendum, based on negotiations since then and increased awareness of EU rules. 
     

Figure 1: The tangled web of potential Brexit scenarios and outcomes 
The following chart represents our expectations for what each scenario could potentially mean for the economy, inflation, central bank policy and markets.

 

Brexident Crash-Out 2019

Hard Brexit
2021

Medium Brexit
Mid-2019

Soft Brexit Mid-late 2019

Bremain Mid-late 2019

Imputed Probability

10%

10%

30%

25%

25%

Political Process

No compromises

Referendum/election goes to Brexit

Compromise to stay in CU

Compromise to stay in CU, SM

Referendum/election goes to Remain

 

 

 

 

 

 

Economy – Long Run

Uncertainty reduces potential growth via drags on investment, immigration

Transition cushions investment; lower migration curbs potential

Maintaining Customs Union supports activity

No change in potential GDP as economy adapts

Stability leads to broad GDP recovery

 

 

 

 

 

 

Growth 2019-2021

Severe, front-loaded recession

Continued slowdown

Continued slowdown

Gradual recovery

Transitory rebound, then normalization

  Unemployment

Significant rise, amid net emigration

Gradual rise amid slow immigration

Slow fall as immigration rises

Ongoing slow fall on immigration

Slow fall offset by strong immigration

Wages

Severe pressure

Modest pressure

Weak

Slow real rise

Gradual real rise

   Consumption

Severe pressure

Sustained weakness

Stabilizes

Recovery

Rebound

   Investment

Collapse then recovery

Grinds down

Stabilizes

Gradual recovery

Rebound, normalization

   Net Trade

Imports collapse; surpluses possible

Imports compress; exports rise

Imports weak

Imports recover; neutral for exports

Trade, current account deficits rise

 

 

 

 

 

 

Inflation

Stagflation on rising prices of tradables and commodities

Tradables inflation offset by services disinflation

Worst of inflation shock has passed

Inflation falls despite recovery as GBP rises

Inflation falls despite recovery as GBP rises

 

 

 

 

 

 

Policy Environment

Negative

Unhelpful

Gradual reform

Mixed

Positive

Budget

Large deficit despite budget cuts

Deficit under control on budget cuts

Fiscal balances to be managed

Deficit gradually declines on recovery

Deficit declines as tax revenue surges

Bank of England

Pro-cyclical hikes possible

Rates on hold

Eventual hikes

Gradual hikes

Slightly faster hikes

 

 

 

 

 

 

Markets

UK, General Risk-Off

UK Risk-Off

Slow UK Risk-On

UK Risk-On

UK, General Risk-On

   Sterling

Sharp fall

High volatility

High volatility

Volatile rally

Sharp rally

   Gilts

Yields volatile but fall

Outperform

Neutral

Underperform

Real yields rise

   Credit Spreads

Surge higher;

highly volatile

Widen;

volatile

High volatility;

no trend

Modest outperformance

Significant outperformance

   Equities

Sharp fall led by UK-facing small-cap

Fall; large-cap multinational corporations outperform

Delayed recovery high volatility

Recovery led by UK-facing firms

Rebound led by UK-facing firms

Source: Invesco. The scenarios mentioned may not come to pass
 

The bottom line of this tangled web of possibilities is three key investment implications: 

  • UK politics is still fertile ground for high economic uncertainty and market volatility.
     
  • We see a sizeable 20% chance of an adverse outcome in the short term (either Brexident or Hard Brexit).
     
  • And yet, we believe there is a relatively strong likelihood of more favorable outcomes for the UK economy in the near term with a decent outlook over longer horizons. 


What to look for beyond the (first) no-confidence vote    
Brexit has been gearing up for two-and-a-half years since the June 2016 referendum, yet only now is it shifting into high gear as the clock runs down into the planned home stretch this quarter. The political strategies of both the Tories and Labour will be crucial during what should be the final stretch. 
 

May’s game plan has in effect been to balance opposing forces and preferences within UK politics with EU rules. It has become clear with repeated capitulations that the EU has so far proven far more united and the United Kingdom anything but united on all key issues, especially the Single Market and Customs Union. 

 

We therefore expect an iterative process in which Parliament and parties rely on opinion polls — and possibly even a proper electoral poll — to solve for the least common denominator. This process is likely to involve considerable debate, probably with the acrimony and fireworks common in the UK’s famously no-holds barred Parliamentary debates and tussles. Further votes on amended versions of the bill, with some likely defeats as well as subsequent and repeated no-confidence motions, are likely.

 

The scale of May’s defeat suggests that only a softer form of Brexit will be acceptable in Parliament – which we believe would point to upside in sterling and UK equities, tighter sterling credit spreads and probably higher Gilt yields. But the real questions now are: How much softer can Brexit be and still fly without requiring a new referendum or election? How long will it take to get there? And what might be the collateral economic damage if the clock continues to run down toward a game of brinksmanship between hardline Brexiters and Bremainers?
 

So far, May has been if anything defiant in Parliament — not conciliatory despite her unparalleled loss on Tuesday — which suggests that negotiation toward a compromise may well be fraught with ups and downs as she will try to keep hard-liners onside by pushing back against softening Brexit so much that it betrays the referendum. One metric of this approach — her plan to reach out to senior MPs (as opposed to party leadership) suggests that she still plans to at least try to divide and conquer and bring MPs around to avoid really softening Brexit.
 

The underlying problem for both Tories and Labour is the political elevation of deep divides in UK society – young/urban/elite Bremainers versus older/more rural/more middle- or working-class Brexiters; and these are divides which cleave MPs, who prefer to remain or at most have a very soft Brexit, from much of the party rank and file who prefer exit. Indeed, we concur with the consensus view that MPs on average want a significantly softer form of Brexit than the May Withdrawal Bill; if anything, we would rank the average MP’s preferences as:
 

  1. Bremain(full membership): Although rejected in the referendum, this provided the UK with the closest partnership and most influence on EU policy, without having to adopt the euro. 
     
  2. Soft Brexit: Called Norway Plus because it adds the Customs Union to Norway’s Single Market membership. 
     
  3. Medium Brexit: Continued permanent Customs Union membership to maintain the integrity of the UK as well as the closest EU relationship that does not run afoul of the standard view of the referendum result. 
     
  4. Hard Brexit: Even if softened by a transition period and Customs Union participation for as long as it takes to do an EU trade deal (essentially May’s deal, now dead in the water but which she may yet try to resurrect). 

 

Conclusion
The center of gravity is clearly a softer rather than harder Brexit, but getting there may be fiendishly complex. What Brexit ultimately means may well hinge on balancing what qualifies as Brexit for the referendum majority against Parliamentary preferences for as soft a Brexit as possible. That in turn is likely to turn on May’s adherence to her “red lines” about free movement; Brexiters’ desires for the UK to be able to strike its own trade deals; and Labour leader Corbyn’s apparent desire to strike the right balance between Labour’s own internal splits on Brexit against those of the wider electorate and economy. 
 

In short, Brexit is still up in the air.
 

Hence, our scenario analysis and imputed probability distribution still maintain a full spectrum of outcomes. We would expect the UK economy to remain weak, sterling volatile, Gilt yields suppressed and equities undervalued – until and unless Parliament figures out how to opt for the softer Brexit it would prefer. 

1 sources: Hansard, CNBC

 

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About the authors
    
Arnab Das
Global Market Strategist, EMEA

Arnab Das is Invesco’s Global Market Strategist for EMEA (Europe, Middle East and Africa), based in London. Previously, he was head of EMEA and emerging markets macro research for Invesco Fixed Income. He joined the firm in 2015.

Mr. Das began his career in finance in 1992. He has served as co-head of research at Roubini Global Economics; co-head of global economics and strategy, head of foreign exchange and emerging markets research at Dresdner Kleinwort; and head of EMEA research at JP Morgan. He has also been a private consultant in global and emerging markets, and previously consulted with Trusted Sources, a specialist emerging markets research boutique in London.

Mr. Das studied macroeconomics, economic history and international relations. He earned a BA degree from Princeton University in 1986, and completed his postgraduate and doctoral work at the London School of Economics from 1987 to 1992.
 

Michael Siviter
Senior Fixed Income Portfolio Manager

Michael Siviter is a Senior Fixed Income Portfolio Manager in the Invesco Fixed Income Global Multi-Sector fixed income team based in London. He re-joined Invesco in September 2018, having previously worked for the firm as a fixed income portfolio manager from 2011 to 2013. 

Between his times at Invesco, Mr. Siviter was a director at Taconic Capital Advisor in London, managing the firm’s macro risk allocation. He has 15-years’ experience, having also previously worked for Brevan Howard and Aberdeen Asset Management. 

He earned a BA degree from the University of Cambridge. 
 

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