Paul O'Connor, Head of the UK-based Multi-Asset team, discusses confirmation of Boris Johnson's appointment as UK Prime Minister and the highly uncertain outlook for Brexit that he, and his divided government, must navigate, and the likely market response.

As widely expected, Boris Johnson has become the new leader of the Conservative Party and is set to become Prime Minister tomorrow. He inherits a divided government without a parliamentary majority, an economy on the brink of recession and a country polarised by the toxic topic of Brexit. While attention in the next few days will focus on Johnson’s first speech as prime minister and his cabinet reshuffle, it will inevitably soon move back to Brexit and will stay there for many months to come.

New leader, old problems

Although it is now more than six years since David Cameron announced that the UK would hold a vote on its membership of the European Union (EU), the outlook for Brexit remains highly uncertain. No meaningful progress has been made in negotiations with the EU this year but the pressure continues to mount as the clock ticks down to the 31 October deadline.

As things stand, it is far from clear how Boris Johnson is going to tackle Brexit. During the leadership campaign, he did highlight some preferences on how he would like Brexit to proceed but he has not offered a coherent plan for addressing the difficult economic and political trade-offs involved. His team are reportedly still debating two approaches: one focused on amending the Northern Irish backstop, and implementing a modified version of Theresa May’s Brexit plan and another that would abandon the backstop and May’s withdrawal agreement and try to persuade the EU to give the UK a lengthy “standstill transition”, while a free trade agreement is negotiated.

From rhetoric to reality

Whatever direction he takes, Boris Johnson faces the daunting challenge of finding a way forward that will satisfy the EU, unify his party and be acceptable to a parliament that has failed to agree on any form of Brexit so far. While leadership campaigning granted Johnson the luxuries of bravado and inconsistency with his Brexit-related pronouncements, he now has to raise his game from campaign rhetoric and sloganeering to formulating real government policies and forging broad political consensus.

Brexit probabilities

Probabilities based on Betfair odds at 23 July 2019.

The first clash with reality will be when the new PM reopens Brexit talks with the EU. One thing that Johnson has made clear during the leadership campaign is that he will conduct these talks by threatening to pursue a no-deal exit if the EU does not renegotiate Brexit to his liking. It seems likely that he will spend much of August trying to convince the EU to substantially change the backstop and the withdrawal agreement. It is hard to see significant progress being made here. By the time that parliament reopens in early September, there is a good chance that Johnson will have accepted that the EU is unlikely to budge and will be steering the UK towards a no-deal Brexit. The key question then will be whether MPs have the will and the ability to stop this happening.

No-deal, no

A no-deal Brexit will face formidable parliamentary opposition. Although opinion in parliament remains highly polarised on Brexit, opposition to a no-deal exit is one of the few things that commands majority support. Parliament has demonstrated its opposition to a no-deal Brexit on a number of occasions this year, including one vote last week aimed at preventing Johnson from suspending Parliament to force through such an outcome. While the legal mechanism here is not fully water-tight, the message is clear - MPs will oppose any attempt to pass a no-deal Brexit. Johnson has suffered his first defeat, before even taking office.

One key consideration here is that that government only has a working majority of 4 (including the DUP), which could fall to 2 if, as expected, the Conservatives lose the 1 August Brecon and Radnorshire by-election. If the new PM does attempt to override this clear parliamentary preference he will risk facing a vote of no confidence, aimed at replacing his government with an interim one mandated to delay or even revoke Brexit. If any of the rumoured defections from the Conservative Party to the Liberal Democrats do materialise in the months ahead, his position will be weakened even further.

No easy options

It is hard to predict how Boris Johnson will respond, if he does find himself under such political pressure, with little room to manoeuvre, so early in his premiership. One option would be to retreat from his promised no-deal Brexit and to pursue a superficially modified version of Theresa May’s deal. The challenge with this idea is that it is far from obvious where the necessary swing in MP support would come from, for a deal that has already been rejected by Parliament three times.

The alternative would be to call a general election, to seek a stronger mandate from the country. This could possibly be announced at the Conservative Party Conference in late September, and take place in November, shifting the Brexit deadline from 31 October into 2020. Given that the Conservative Party is currently averaging about 25% in national polls, this would look like a triumph of hope over expectation. While calling a general election after securing Brexit could be a great chance for the new prime minister to strengthen his political power, calling it before he has resolved Brexit could look like a fairly desperate gamble.

Ticking time-bomb

Still, it is hard to see where else the new prime minister will be able to turn. As soon as he takes office, he will be under immense pressure to find a quick solution to the greatest political crisis the UK has faced since World War II. Brexit will dominate the first few months of Johnson’s premiership and will probably determine whether he gets to stay in office beyond that. If he gets it wrong, he could destroy the Conservative Party or plunge the country into an economic or constitutional crisis. He will need great skill to defuse the ticking Brexit time-bomb and prevent numerous potentially disastrous economic and political outcomes.

Decision time

The market response has been fairly muted so far, which is not surprising given how widely anticipated this outcome was. The pervasive uncertainty surrounding Brexit has already taken its toll on UK assets and is now somewhat priced in. UK equities have seen sizeable outflows from global investors since the referendum vote in 2016 and speculative positioning in sterling is very negative. If we look to betting markets as a guide to consensus expectations, we see a no-deal Brexit as a one-in-three chance, with investor dread of this being somewhat offset by the view that there is still a one-in-four chance that Brexit is cancelled (Article 50 is revoked). The perceived likelihood of a 2019 general election has been growing in recent months, highlighting another layer of uncertainty surrounding the UK outlook and yet another reason for global investors to stay away.

Growth remains a key concern, with 2019 looking set to be the fourth consecutive year of sub-2% UK GDP growth. Confidence is deteriorating across the construction, manufacturing and services sector and among consumers as well. With the economy looking like it is one stumble away from recession, a policy response is needed. A 2019 interest rate cut seems increasingly likely and a Johnson fiscal stimulus a near certainty. While both of these can help cushion the impact of Brexit-related uncertainty on the economy, a full restoration of confidence seems unlikely until the big issue gets resolved.