Possible Brexit Scenarios

UK Parliament is scheduled to hold its Brexit vote tomorrow. The outcome is expected sometime between 7-10 PM London time, and is likely to result in a rejection of May’s plan. What’s unclear is what happens next. Here, we try to put together some possible scenarios. For the most part, the scenarios would seem to favor UK assets for anything other than a no-deal Brexit.

RECENT DEVELOPMENTS

Prime Minister May called off the December 11 Brexit vote when it became clear that it wouldn’t pass. Yet nothing that has transpired over the past month suggests that the same deal can pass tomorrow.

Reports today of a possible Irish backstop compromise were quickly squashed by the EU. This is the single most controversial part of the Brexit plan. The EU wants the so-called backstop to be put in place indefinitely. This is a non-starter for the DUP and the hardcore Tory Brexiteers. For the DUP, it cannot agree to any sort of hard border between Ireland and Northern Ireland. For the Brexiteers, they fear being tied to EU rules indefinitely even after Brexit.

Virtually every vote count points to failure tomorrow. Over 100 Tories as well as coalition allied Democratic Ulster Party (DUP) oppose May’s Brexit plan. As such, May will need the support of the opposition Labour party if she hopes to pass her plan. This seems very unlikely, to say the least.

A BRIEF HISTORY LESSON

The Brexit referendum in June 2016 reversed a decades-long push for greater UK integration with continental Europe. As can be seen below, there has always been a bit of a love-hate relationship between the two sides of the English Channel, but the Brexit vote signaled a sea change in the global economic order.

The earliest precursor to the European Union was the European Coal and Steel Community (ECSC). Created in 1951 after WWII, the ECSC started with member states Belgium, France, Italy, Luxembourg, the Netherlands, and West Germany. The UK declined an invitation to join.

Ostensibly, the ECSC sought to create a common market for coal and steel amongst its members to minimize the competition for natural resources. The ECSC was the first step to regional integration and was really meant to prevent further wars in Europe by increased economic interdependence.

The European Economic Community (EEC) and the European Atomic Energy Community (Euratom) were later established in 1957 by the Treaty of Rome. Both were made up of the same six countries as the ECSC and all three co-existed. In 1961, the UK finally submitted its first application to join the EEC, led by Tory Prime Minister Harold Macmillan. French President Charles de Gaulle vetoed the application. In 1967, the UK submitted a second application under Labour Prime Minister Harold Wilson. It was vetoed again by de Gaulle.

European integration continued with the so-called Merger Treaty of 1965. The executive bodies of the ECSC, EEC, and Euratom were combined into one and created the European Communities (later changed to the European Community) in 1967.

In 1968, a customs union between the six EEC countries was formed. A customs union eliminates all tariffs between the members, whilst enacting a common tariff level on the rest of the world. This is slightly different from a Free Trade Zone, which eliminates all tariffs between the members whilst allowing each country to maintain its own tariff levels on the rest of the world.

The UK made a third attempt to join the EEC under Tory Prime Minister Edward Heath. De Gaulle had resigned in 1969 and was replaced by his Prime Minister Georges Pompidou, who chose not to veto this time. Denmark, Ireland, and Norway also applied for membership, though Norway later withdrew its application after a domestic referendum was held. This expansion became effective January 1, 1973 and was the first of many beyond the initial six countries.

In June 1975, the UK held a referendum to confirm its continuing membership in the EEC. It passed by a 67-33% vote. The European Union was formally established in November 1993 by the Maastricht Treaty. This was the next step of integration as it introduced the single market, which added free movement of labor and capital between member states. The Maastricht Treaty also set forth the conditions for the next step of integration, which was currency (monetary) union. This was eventually seen with the advent of the euro in January 2002.

There are now 28 members in the EU. The UK was the first EU country ever to trigger Article 50 of the Treaty on European Union to exit. Unless something unforeseen happens, the number of EU countries will shrink for the first time, to 27.

 

BREXIT SCENARIOS

Deal or no deal, Brexit means that the UK will exit the EU on March 29. Or does it? There has been much speculation about what may ensue. Here, we lay out the possible paths for the UK. The odds assigned to each outcome are purely subjective and are simply meant to convey a general sense of the likelihoods. We also speculate how UK assets might react to each outcome.

  • Brexit vote fails with no subsequent action. This is the no-deal scenario where the UK crashes out of the EU immediately with no transition period. One benefit of getting a deal done is that it allows for a 21-month transition period until the end of 2020. During this period, nothing really changes, and this would give both sides time to make the needed adjustments. No-deal would be the worst-case scenario for the markets. We put the odds at 20%. UK assets crater.

 

    1. Brexit vote fails with the UK and the EU agreeing to extend the Article 50 deadline beyond March with the hopes of getting an elusive compromise. This would admittedly be a can-kicking exercise of the highest order, but it would also be taken well by markets, at least over the near-term. We put the odds at 50%. After initial sell-off, UK assets rally.
    2. Brexit vote fails followed by a parliamentary effort to try for a second Brexit vote. This has been long rumored (and denied). This is a high-risk exercise in the sense that a second vote could still favor Brexit. Then, we would be back at square one after another period of uncertainty. We put the odds at 20%. After initial sell-off, UK assets rally.
    3. Brexit vote fails followed by a parliamentary effort to reverse Article 50. This too has been rumored (and also denied). This is another high-risk exercise in the sense that Parliament would seek to circumvent the first Brexit vote. After another period of uncertainty, a large share of the voters could see their wishes ignored. We put the odds at 20%. After initial sell-off, UK assets rally.
  • Brexit vote fails followed by a vote of no confidence called by Labour. This seems likely to fail, however. No Tory or DUP MP would vote for this, as they would be most likely to be punished in fresh elections. In the event that the no confidence motion fails, we are back at square one as the current parliamentary term isn’t scheduled to end until 2022. We put the odds at 40%. UK assets sell off.

 

  1. Brexit vote passes. This seems the most unlikely outcome of all, as the numbers simply don’t add up for a yes vote. We put the odds at 10%. UK assets rally.

Note that some of these possibilities are not exclusive, and so the odds add up to more than 100%. That is, a failed Brexit vote could be followed by any combination of an extension, a second vote, or no confidence vote. For the most part, the scenarios would seem to favor UK assets for anything other than a no-deal Brexit.

 

INVESTMENT OUTLOOK

The Bank of England released its Brexit analysis late last year. The worst-case scenario for a no-deal Brexit saw the economy possibly contracting 8%, property prices plunging around 33%, and the pound weakening by 25%. This possible outcome was worse than the government’s own scenario analysis. Governor Carney has defended the bank’s analysis whilst stressing that these were not forecasts but simply possible outcomes. He noted that it was seen as a low-probability event, though that now seems too optimistic.

Bank of England meets twice before the planned Brexit of March 29 and is widely expected to keep policy unchanged. Those meetings will be held February 7 and March 21, though we clearly cannot rule out an emergency intra-meeting move if needed. Until Brexit has been cleared up one way or another, the BOE is simply stuck in a wait and see mode. In the event of a no-deal Brexit, it’s hard for us to see the bank hiking rates. Yes, there may be inflationary impulses from a plunging pound, but the recessionary impulses are likely to be even stronger.

Sterling is outperforming so far this year after underperforming last year. In 2018, GBP fell-6% and was behind only the worst performers AUD (-10%), CAD (-8%), and SEK (-7.5%). So far in 2019, GBP is in the middle of the pack at +0.8% despite the uncertainty surrounding the Brexit vote. Perhaps markets have the same view as us in that the most likely scenarios favor UK assets, at least near-term.

Ahead of tomorrow’s Brexit vote, GBP traded at its highest level since November 15 near $1.2930 before falling back. Charts suggest that cable is on track to test the November 7 high near $1.3175, but this will depend very much on the Brexit vote and its aftermath. The 200-day moving average near $1.3115 should also provide some resistance.

UK equities continue to underperform. In 2018, MSCI UK fell -12.5% and compares to -11% for MSCI DM. So far in 2019, MSCI UK is up 1.7% vs. a 4.1% gain for MSCI DM. With growth likely to remain at risk due to Brexit, we expect UK equities to continue underperforming.

UK bonds continue to underperform. The yield on 10-year local currency government bonds is +2 bp YTD and is ahead of only the worst DM performers Italy (+10 bp), Switzerland (+9 bp), and Ireland (+8 bp). With inflation likely to remain low and the central bank on hold for now, we think UK bonds could start to outperform a bit.

Our own sovereign ratings model showed the UK’s implied rating steady at AA-/Aa3/AA-. Actual AA/Aa2/AA ratings are likely to be kept steady until the full impact of Brexit is known. If we get anything near the BOE’s scenario for a no-deal Brexit, many of the UK’s credit metrics would deteriorate sharply and likely push its implied rating into A+/A1/A+ territory. Most of the rating agencies are taking a wait and see approach with Brexit but it’s hard not to look for imminent downgrades if the things go pear-shaped after tomorrow.