Brexit Update – Curb Your Enthusiasm

Paul O’Connor, Head of the UK-based Multi-Asset Team, comments on the market reaction to last week’s plot twist in Brexit negotiations and why he is not convinced the emerging pathway will lead to a more stable political environment in the UK or to constructive economic outcomes.

Key Takeaways

  • UK stocks surged following last week’s news that the UK and Ireland had found a potential Brexit solution, but few details of the plan have been released.
  • The suggestion that the UK’s proposal now has the broad support of the Irish government implies a deal with the EU may be within reach, but parliamentary approval remains the biggest hurdle facing Boris Johnson’s proposed Brexit.
  • We see the exuberant response from financial markets as reasonably reflecting the diminishing probability of a no-deal Brexit. However, we are not convinced that the emerging Brexit pathway will lead to a more stable political environment in the UK or to constructive economic outcomes.

Last Thursday’s announcement that the prime ministers of the UK and Ireland had found a potential “pathway” to a Brexit deal was a big surprise. The proclamation came just a few days after Downing Street sources described such a deal as being “essentially impossible” after an unproductive phone call between Prime Minister Boris Johnson and Chancellor Angela Merkel.

The unexpected breakthrough had a sizable impact on financial markets. Domestically focused UK stocks, such as banks, surged, and sterling had its biggest two-day bounce in a decade, taking it to a three-month high of $1.27. By the end of the week, options prices indicated that investors had moved from dreading the October 31 deadline to actually being bullish about the outlook for sterling on a one-month horizon.

Pivotal Moment

Clearly, investors have embraced the conversation between Mr. Johnson and Irish Prime Minister Leo Varadkar as being a pivotal moment in the Brexit negotiations. Fears of a crash-out Brexit on October 31 have been banished, and expectations have now shifted toward some sort of negotiated departure from the EU. However, few details of the plan have been released.

The broad outline seems to involve Great Britain leaving the EU’s customs union and single market, but arrangements for Northern Ireland are more complex, with it retaining some sort of status within the EU’s customs union while also being a member of the UK customs area. This would broadly amount to the mainland of the UK moving to a “Canada-style” free trade arrangement with the EU and Northern Ireland having its own special status. Importantly, the proposed customs border would be in the Irish Sea, rather than on Irish soil.

Will the Plan Get EU Approval this Week?

The week ahead is likely to see frantic activity on the Brexit front, with the government hoping to seal the deal in just a week. The plan seems to involve getting approval for a deal at the European Council (EC) meeting on Thursday, October 17, and then securing UK parliamentary ratification at a special sitting on Saturday. This looks like a highly optimistic timeline given that the UK has not yet produced any details of its complicated Brexit plan. While EC President Donald Tusk said last week that he saw “promising signals” from the UK side, he also said that “the UK has not come forward with a workable, realistic proposal.” The dual customs proposal for Northern Ireland is complex, and it would not be surprising if it took weeks – or months – to fully evaluate. Getting EU approval this week is probably an unrealistic expectation, but the suggestion that the UK’s proposal now has the broad support of the Irish government implies that a deal with the EU may be within reach.

Will Parliament Ratify the Deal?

Still, as former Prime Minister Theresa May found out, securing EU approval is clearly necessary for a Brexit deal, but it is far from sufficient. Despite getting EU agreement on different versions of her Brexit plan, the UK legislature voted it down three times. Parliamentary approval remains the biggest hurdle facing Mr. Johnson’s proposed Brexit. The prime minister is now without an effective majority in the House of Commons, and it is far from obvious that his proposed deal will transform this parliamentary arithmetic. It will take an act of extraordinary political skill to swing opinion enough to get parliamentary support for the deal by Saturday. Failing that, he will be legally obliged, under the Benn Act, to request an extension of the Brexit deadline.

No Deal Recedes, Hard Brexit Looms

As Parliament begins to scrutinize the proposed Brexit plan, one important feature that will get some attention is that it effectively offers a soft Brexit for Northern Ireland but a hard exit for the rest of the UK. Analysis published last weekend by the UK in a Changing Europe think tank suggested that the current proposed version of Brexit would cost the UK 6%-7% of GDP growth over the next decade. While this is a better outcome than a no-deal Brexit, it is a worse outcome than Ms. May’s final plan. The government’s own analysis of Brexit outcomes, published last November, came up with similar conclusions. A number of trade bodies wrote to the government over the weekend warning of the adverse impact on their sectors of the sort of regulatory divergence from the EU that Mr. Johnson is proposing.

Too Early for Celebrations

We see the exuberant response from financial markets to last week’s developments as reasonably reflecting the diminishing probability of a no-deal Brexit. However, we are far from convinced that the emerging Brexit pathway will lead to a more stable political environment in the UK or to constructive economic outcomes. UK assets will almost certainly rally further if Mr. Johnson can get his deal approved this week, but even in this unlikely scenario, celebrations must be tempered by the recognition that this is a course to a fairly hard Brexit. If the deal doesn’t pass and the Brexit deadline is extended, then the outlook remains very hard to call. A large part of Parliament wants a deal close to this one, while another part is campaigning for a second referendum. However, there is no evidence of a majority for either.