UK: A Shakespearean Brexit until the last minute

UK: A Shakespearean Brexit until the last minute

Brexit is proving much harder to tame than a Shakespearean shrew. As expected, the UK House of Commons rejected Prime Minister (PM) Theresa May’s Brexit deal. The deal only received 202 favorable votes out of 650 MPs (31%). What is more worrying is that 118 Conservatives and 10 MPs from the Northern Irish DUP (Democratic Unionist Party) from May’s own majority voted against it. Why is it not a surprise? Remember, 117 Tories voted against the PM in the no-confidence vote held last December.

Quick elementary school mathematics gives us a total of 432 votes against the withdrawal agreement submitted to Parliament, if we add to Tories and the DUP the Labour Party, the Scottish Party and the Liberal Democrats. This is the largest defeat in Parliament for any UK government since the 1920s. What does it tell us? First, that political parties mirror the divisions of society over Brexit. Second, it should set the European alarm bells ringing: we now expect more concessions from the EU in the coming rounds of negotiations.

May could seize this opportunity and see the Brexit battle through to the end. She now has 3 working days to try to win concessions from the EU, followed by a 5-days parliamentary debate on the deal before a second vote (probably around January 25th). We cannot exclude a third vote on the deal; in our view the true deadline – which leaves just enough time to allow a ratification of the EU Parliament before March 29th – is mid-February. Indeed the planned plenary sessions of the European Parliament are on 11-14 March and 25-28 March. However, should the next attempts to ratify the deal in the UK Parliament be unsuccessful, an extension of Article 50 until May 2019, July or even later is likely. Such extension would most probably be unanimously backed by all EU member States as required.

Granting more time for negotiation would avoid a disorderly UK exit from the EU or what has been labeled so far as a “No-deal Brexit” scenario. However, as May exhausts her political capital, she could choose to resign. What would happen next? Another Conservative Leader would take over and seek a Parliamentary confidence vote (within 14 days) or general elections could be called (i) by PM Theresa May herself or (ii) automatically should the new Conservative leader lose the confidence vote. The earliest date for elections would then be 25 working days later, most probably in March. In this scenario we would not exclude a second referendum should two-thirds of the Parliament vote in favor of this solution of last resort. For the moment neither the Labour nor the Conservative Party supports this scenario as they would prefer a renegotiated deal instead. During the renegotiations with the EU, PM May could try to converge towards the Labour view (permanently staying in the custom union and Single Market). Or it could lean towards that of the Tory “rebels” (118) by having a clear time limit included in the Irish backstop.

A No-deal Brexit looks unlikely in the short-term given the possibility of extending Article 50 and the possibility that the UK Parliament has to block a no-deal Brexit. However, a No-deal Brexit could become more likely (currently at 25%) in case of a continued political gridlock, and should the UK ask for a renewed extension of Art 50. In this scenario some EU states could reject it. Yet it would be a delicate political move for the EU, amid growing anti-European sentiment in the UK and in other states where populism is rising.  

We expect the prevailing uncertainty to continue to cut 0.1-0.2pp to GDP growth per quarter, hence we see downside risks to our +1.2% GDP growth forecast in 2019 and insolvency forecast of +9%. Indeed, the prolonged high Brexit uncertainty has significantly reduced the pockets of resilience of the UK economy. Hence, GDP growth in Q4 2018 and Q1 2019 should prove much weaker (around 0.2% - 0.3% q/q). While labor shortages should keep wage growth above +3% y/y, potential growth is damaged. In addition, households have less leeway to boost spending as the savings rate stands at a low level of 4.4% and positive wealth effects are diminishing with housing prices adjusting downwards and the stock markets underperforming European peers.

The sterling should depreciate further in the coming weeks and could go below 1.1 vs the EUR and be accompanied by high volatility. This will in turn increase the import cost and drag further down corporate margins. Real imports in 2018 are expected to grow below 1%, the lowest level since 2011. This translated into lower outlets of Western European companies into the UK. We estimate that the Eurozone as a whole missed around EUR60bn of potential outlets into the UK market since the Brexit vote.

A rebound in the sterling is expected with the last-minute agreement (either a ratified deal or an extension of Article 50) and we see it reaching 1.15-1.20 vs the EUR on average in 2019. 

In the long-term, what matters most is the type of FTA the UK and the EU will after the formal exit. A good compromise in solving the Irish border issue, maintaining zero tariffs on goods, keeping the “passporting rights” for the financial sector and allowing the UK to autonomously negotiate FTA seems to be a Norway-type of agreement. But expect intense negotiations between both parties and prepare yourself for a longer transition period… probably beyond 2021! Hence, the process of Brexit will continue to feed the uncertainty that has kept UK growth below potential. We estimate UK growth to average +1.5% over the transition period, half of the 2000-07 levels.