"As each camp in the population looks for a political party that represents its preferred Brexit outcome, the landscape of UK politics is changing rapidly."
Does a new prime minister change the Brexit outlook?
The UK prime minister, Theresa May, has announced that she is stepping down on 7 June, and the process has begun to select a new Conservative leader. Will May’s successor face the same problems in delivering Brexit? We consider possible future paths.
What is the problem?
The root of the problem is that the UK’s population is divided over what it wants from Brexit. The 2016 referendum itself was relatively close, with 52% of those that participated voting to leave the EU and 48% wanting to remain. In accepting the vote to leave, the question of the form of departure persists.
Exhibit 1 below highlights the main ‘on the shelf’ options facing the UK and to what extent they meet the most commonly cited objectives in the Brexit process.
Exhibit 1: Brexit options facing the UK
Source: J.P. Morgan Asset Management.
On this scale, the deal Theresa May negotiated with the EU sat just to the left of the customs union option. The deal had two components – a non-legally binding political declaration on a future partnership (details of which were to be fleshed out during the transition period), and a legally binding withdrawal agreement (which included a financial settlement for the commitments the UK had to EU spending).
The future relationship detailed in the political declaration was to be centred on a customs agreement (the UK would evaluate the goods for which it was willing to align with EU regulations). However, the withdrawal agreement stated that if an agreement on a future relationship couldn’t be reached, the relationship would default to one of a full customs union for all goods. This “backstop” arrangement became the undoing of the deal. A large handful (roughly 30) of the prime minister’s colleagues were unwilling to make any compromises – for them, only the full sovereignty provided by a “no-deal” exit would suffice. The Democratic Unionist Party – the Conservative’s Party’s minority government partner, was also unwilling to support the deal. After trying three times, Theresa May accepted defeat.
Has no-deal risk increased?
A leadership contest is now underway to appoint a new prime minister to lead the Conservative Party. This may take between one and three months. Candidates are whittled down in a series of votes by MPs, with the Conservative Party membership selecting the new leader from the final two.
Some investors are nervous that the leadership contest will result in a new prime minister with outright ambitions to leave without a deal. Even if this were the case, the current configuration of parliament has demonstrated on numerous occasions that it is not willing to allow a no-deal departure and has the legislative capacity to stop it. The leader of the House of Commons, John Bercow, has recently made it clear that parliament will continue to play a pivotal role in the final outcome. As a result, when the next Brexit deadline comes around on 31 October we see it as very highly likely that parliament will legislate once again for an extension, potentially overruling the preference of the prime minister and government.
Are we headed for a general election and, if so, what are the investment consequences?
If the new prime minister can change the configuration of parliament, he or she may be able to deliver a no-deal outcome. However, such a shift doesn’t appear likely according to the latest polls (see Exhibit 2). The UK population doesn’t appear to have shifted its Brexit position. Indeed, it seems that both ends of the Brexit spectrum – no deal and remain – are digging in, with 30% of the population having a preference for no deal vs 35% wanting to remain. A further 20% want to leave with some form of a deal.
Exhibit 2: If you had to choose one outcome of Brexit, what would you prefer to see?
Source: YouGov, J.P. Morgan Asset Management. Survey fieldwork was carried out on 10-11 April 2019.
As each camp in the population looks for a political party that represents its preferred Brexit outcome, the landscape of UK politics is changing rapidly (see Exhibit 3). Those seeking no-deal are being tempted by the newly formed Brexit Party. On the other end of the spectrum, those looking to remain or see a very soft Brexit are seeking solace in the manifestos of the Liberal Democrats or Change UK. Support for both the Labour and Conservative Parties are suffering significantly.
Exhibit 3: General election voting intentions
Source: YouGov, J.P. Morgan Asset Management. May 2018 survey fieldwork was carried out on 20-21 May 2018. May 2019 survey fieldwork was carried out on 28-29 May 2019.
Unless these polls change significantly with the appointment of a new Conservative leader, it seems unlikely the new prime minister will feel sufficiently confident to call a snap election.
It appears more likely that a new election could be forced on the government by the Labour Party (with the support of some pro-EU conservatives and/or the DUP) calling a vote of no confidence in the government if the new prime minister tries to pursue a no-deal outcome. In the event of a lost confidence vote, the government would have 14 days to restore confidence. If it failed, a general election would automatically be called.
What might be the result of a general election? It is worth remembering that the UK has a first-past-the-post electoral system that strongly favours the two main parties. Given the shifts in political preference seen in Exhibit 3, this makes the outcome of a general election very difficult to predict. For example, a voter who has historically voted Conservative but is strongly averse to a hard Brexit may choose to vote Labour based on a Brexit preference in a constituency that is finely balanced between Labour and Conservative voters.
What we can say is that it looks highly unlikely at this stage that any party could gain an outright majority. As such, coalitions would need to be formed, which could alter the agendas for both Brexit and broader government policy significantly.
Is a second referendum likely? What would be the result?
Given the political muddle and uncertainty around an election outcome, it might seem more appealing to put the options directly to the UK population. This would give parliament an official mandate on which to act. Designing the ballot, however, would be fraught with difficulties. Asking the population whether they now wish to leave or remain may not lead to a different outcome, and if leave prevails again the question is unchanged: leave on what terms? If a more detailed choice was presented, the population would have to be given the full range of options, including no deal, to ensure democratic legitimacy. Those overseeing such a referendum would have to feel confident that the population would be given a balanced assessment of the options and consequences on such a highly complex menu in order to risk proceeding in this manner. This may explain why the Labour Party are struggling to decide whether to formally adopt a People’s Vote as an official policy. As such, we think another referendum is a relatively low-probability scenario.
How long will the EU let this continue?
If the UK population remains polarised and struggles to resolve the impasse, how long will the EU allow the deliberations to continue? So far, the EU has been willing to provide extensions well ahead of the midnight hour in negotiations. In our view, this shows that heads of state on the continent – particularly in the Republic of Ireland and Germany – are as averse to no deal as the UK’s parliament. In addition, with a significant proportion of the UK population showing an inclination towards a new referendum and remain, the EU may hope that the UK will stay after all. If, after all this time and fuss, the UK chooses to remain, it could serve to discourage other EU members from considering leaving the bloc.
What are the market implications?
Sterling has reacted negatively as the perceived risk of either no deal or a change of government has risen.
The Tory leadership contest may well result in considerable further volatility if the candidates feel they need to advocate no-deal to appeal to the hard right in the Tory Party membership. It will be important to see how the rhetoric changes when the new prime minister takes office, as well as their approach to the first discussions with the EU.
A prime minister that focuses on a cross-party solution from the outset and approaches the negotiations with the EU in a non-combative manner appears the most likely to complete the Brexit process.
If, by contrast, the new prime minister focuses on preparations for no deal rather than further negotiations, the market could quickly shift from worrying about the risk of no deal to worrying about the risk of a change of government. Investors are concerned about the possibility of less market-friendly practices, such as a renationalisation of utilities and transport networks, higher minimum wages and higher government borrowing, in the current Labour Party manifesto.
While the risk of no deal and the risk of a change of government may both put downward pressure on sterling, the two different potential scenarios are likely to have a different impact on UK stocks and the Gilt market.
A no-deal outcome is likely to put considerable downward pressure on domestic-facing UK stocks exposed to weaker growth. But a steep drop in sterling would boost repatriated earnings of the larger cap international stocks. In addition, the Bank of England would likely cut rates which would put upward pressure on the price of Gilts and lower their yield.
Fears of a change of government may put the most downward pressure on some of the traditionally most defensive domestic FTSE 100 stocks, with utilities and transport hit by renationalisation risk and retail stocks by the risk of higher minimum wages. Gilt prices may also fall if the change of government was likely to be associated with considerably higher government borrowing. Given that the next governor of the Bank of England has not yet been appointed, the market may also be concerned about the risk that the new prime minister will choose Mark Carney’s successor based on a political objective.
Understanding the differences between these risks is important for investors considering how to hedge Brexit risks. Relying on Gilts and the traditionally defensive stocks in the FTSE 100 may not be enough to ensure portfolios weather the Brexit storm.
Will it ever end?
Our core assumption of how Brexit eventually ends has not changed. We expect the UK to leave the EU but to remain in a customs union for goods. This appears to strike the compromise between achieving some of the Brexit ambitions – control of migration and budget contributions – and preserving important supply chain and economic links and the union of Northern Ireland, Scotland, Wales and England. At some point, we suspect the leaders of both the Conservative and Labour Party will see the need to work together to stem the damage being done to their respective parties. How quickly we get to this realisation… well, that’s a more difficult question.