What has happened?

 

As widely expected, Prime Minister May’s Withdrawal Agreement (WA) was rejected by the UK parliament tonight. Mrs. May could not convince MPs from the Democratic Unionist Party (DUP) –on whom the Conservatives rely for a majority in parliament –that the EU’s soft guarantees that the Irish backstop would only be a temporary measure were credible. And in addition, she failed to convince the Brexiteersin her party that the choice was now between her deal, an even softer Brexit, or even no Brexit,--and hence that her deal, in effect, was the hardest version of Brexit possible. Many Remain Conservatives also voted against the deal.

 

Mrs. May lost the WA vote by 230 votes, a much larger defeat than markets and political observers had assumed (on average, around 100 votes). She immediately responded by promising a vote of confidence in the government, and the Labourleader, Jeremy Corbyn, confirmed that he had tabled a motion to this effect. The vote will be held tomorrow. Assuming that Mrs. May wins this vote of confidence, which we think is still theoretically possible, she has promised to consult widely within parliament and return with alternative plans on Monday.

 

Market reaction

 

The scale of Mrs. May’s defeat was larger than generally expected, and GBP took a hit, initially weakening against USD by around 1.5%, but reversed the losses following Mrs. May’s remarks following the vote. In equities, futures on FSTE 100 came back from their intraday peaks, while U.S. and European equities recovered relatively quickly from their initially negative reaction.

 

What will happen next?

 

In more normal circumstances, the PM might have been expected to resign at this point. But she has proved her resilience over recent months and she may choose to see the next stage of the Brexit process through, assuming that she wins the vote of confidence tomorrow. While many in her own and the opposition parties may call for her resignation, so long as the government stands, it is up to Mrs. May whether she leads it or not. (She cannot face another leadership challenge from within her own party for another 11 months).

 

The central dilemma in the Brexit saga remains that while there is no majority for May’s WA in its current form in parliament, there is at present no obvious majority for any other way forward on Brexit either –at least not in the current parliament. Nevertheless, we see a number of potential paths going forward. These include the following.

 

a. PM May unveils a “plan B”

Parliament voted recently to require the PM to return to it with an alternative strategy – the so-called “plan B” – within three sitting days. Hence, again assuming that she survives the vote of confidence tomorrow, parliament will likely debate and vote on whatever the PM comes up with on Monday, January 21. This would give her the rest of this week and the weekend to negotiate with Brussels and the various factions of UK parliament from which she needs to win support. But given the size of the defeat, any hopes that Mrs. May might have had that tweaking the legislation would swing the vote in her direction seem completely unrealistic. If Mrs. May cannot come up with a radically different proposal after cross-parliament consultations, or concedes defeat early, it will then likely fall to parliament to come up with a solution.

 

b. Cross-party parliamentary consensus to prevent a hard Brexit

The May plan plus a permanent customs union would allow the controversial Irish backstop to be significantly watered down. This might be acceptable to a few more MPs, but it could tear apart the Tory party as such an outcome would leave the UK exposed to EU rules and unable to strike its own trade deals post Brexit (the whole “taking back control” rationale for it). It is very difficult to see it commanding a majority in the House of Commons. The same holds true for “Norway-plus” relationship proposals which might seem likely to get cross-party majorities at first glance.

 

As things stand today, by law, the UK is due to leave the EU on March 29 2019. A hard Brexit is the default option unless the UK and the EU come up with some agreement for the future partnership. Even if parliament voted by a large majority against a hard Brexit, such a vote would be merely symbolic unless the UK and EU could agree some alternative to Mrs. May’s deal. The UK can unilaterally withdraw Article 50 to stop Brexit altogether (as confirmed by the recent ECJ decision), but that might trigger even more political turmoil as the June 2016 vote for Brexit would be totally ignored.

 

So just transferring the legislative power from government to parliament on the Brexit issue is unlikely by itself to solve the problem quickly. This brings us to the next scenarios:

 

c. Snap elections

To win his vote of no confidence in the government tomorrow, Mr. Corbyn would need support from all his MPs, all MPs from the other smaller opposition parties, and a handful of MPs from the government. Despite all the current uncertainties, and the size of the defeat tonight, this should not be taken for granted. As we have argued before in recent CIO Insights Memos on Brexit, the threat of Mr. Corbyn ending up in Number 10 is probably the only common factor that can bind the otherwise split Conservatives together. While the DUP are also antipathetic to Mr. Corbyn there is a risk however that they could rebel at some point, if not right now, particularly if there is no progress on the Northern Ireland backstop.

 

Overall, we see a growing chance of a new general election, but would not see this as particularly positive development. As well as the approaching deadlines around any possible Article 50 extension (see below), it is far from clear that the result would change the current gridlock in parliament, with both parties close in the opinion polls. There are also serious market concerns about the likely domestic economic policy priorities of a Corbyn government.

 

d. Second referendum

So far, both PM May and Mr. Corbyn have consistently ruled out a second referendum and only a minority of MPs at present back such an outcome. However, a cross-party majority could emerge in the next few weeks based on the view that this is the only way to break the current logjam in the Commons. Even so, the path to a second referendum would face a lot of procedural obstacles, would take a lot of time to prepare for, would have an uncertain outcome and the devil would be in the detail – in particular, the question(s) put on the ballot paper.

 

e. Extension of Article 50

All of the scenarios above would probably involve some delay to Brexit currently scheduled for March 29, 2019 and this increasingly looks like the baseline case, with the EU side now signallingsome flexibility on the deadline/timeline as well. The extent of the delay required varies quite a bit, however, rising from scenario a) to d) in our view:

  • If May can create a convincing plan B (i.e. majority support in parliament for a changed version of her deal after a second or multiple voting attempts, which looks unlikely after tonight’s result), the March 29 deadline might be met or only 1 or 2 months’ extension is needed.

  • If there is an attempt in parliament to create cross-party consensus on a Brexit deal, which looks increasingly necessary, this would probably require at least a modest extension of a couple of months with all necessary legislation in the UK and required approvals in the EU as well.

  • To hold a general election would almost certainly require a much longer extension or suspension/time-out just to hold the vote, and if Labourwon it would need time to negotiate with the EU27 again. Most political observers are reckoning that April 2019 would be the earliest timing for a new general election.

  • Most time would be required for a second referendum. Academic estimates suggest that the minimum possible time is 22 weeks. This would postpone the whole process well into the summer of 2019 and well behind the May 23-26 EU Parliamentary elections and even might go beyond the start of the first session of the new elected EU parliament (July 2, 2019).

 

The latter point might cause some legal problems from today’s point of view, as the UK would be legally obligated to participate in these elections, if there was no Brexit. Aside from the political embarrassment of such a situation, it could be exploited by populist parties in the Eurozone for further attacks against the mainstream. We believe the EU27 will be hesitant to offer such populist parties an easy target.

 

Our view

 

Whichever path is finally followed by politicians and markets, we now see an extension to Article 50 as extremely likely with the Brexit date pushed out. This is probably the only secure and safe statement we can make at this point with high conviction and a high likelihood of materialising.

 

Reports suggest that the EU27 is considering extending the Article 50 deadline until July should the UK request it. To extend beyond the Euro Parliamentary elections would show the EU are keen to avoid a no-deal. It is possible that there could be a rolling extension until we got a deal, the U.K. decided to stay in the EU, or there was a Parliamentary majority for a no-deal exit (highly unlikely). If such a rolling extension were to be adopted, this would ultimately reduce the possible pathways to a hard, cliff-edge Brexit.

 

We are now probably about to enter a phase of peak uncertainty, now parliament has clearly rejected Mrs. May’s plan but does not yet have an alternative. Given our argumentation above it is obvious that positioning on UK capital markets remains cautious and the situation is extremely fluid. As seen since the Brexit vote in June 2016 the fate of UK equities is highly dependent on the direction of GBP. Any decisions or policies that would lead into a “no deal” Brexit would amplify investors’ aversion to UK assets. While a sharp fall in GBP could act as cushion for UK stocks, such scenarios would add significant uncertainty, and could lead to a spike in volatility, accompanied with generally negative market sentiment and strong risk-off re-positioning by market participants. While the current depressed level of UK stocks and GBP could limit the initial downside, markets would likely assign a higher probability to a 'no-deal-Brexit and demand a higher risk premium across the board. On the other hand any developments and measures to ensure a soft/smooth or no Brexit at all – which are possible in coming weeks – would remove significant uncertainty for markets and would likely to provide a boost to the UK economy. Investor position on UK assets – equities and GBP in particular – is bearish at present, so both could rally in tandem as short covering set in.

 

 

Download this CIO Insights Memo as a pdf here.


 
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