Brexit uncertainty could last for another 21 months

The latest installment of the Brexit drama offers good and bad news for investors in U.K. assets and beyond: The good news is the risk of a “no deal” Brexit has receded, but the bad news is it’s still a possibility and the timeline toward resolution is now more extended. This means that persistent uncertainty is likely to continue to weigh on the U.K. and wider European economies, and may elevate the volatility of U.K. asset markets, particularly the currency.

Key events from the past week

• On March 12, U.K. Prime Minister Theresa May’s “Withdrawal Agreement and Political Declaration” was rejected for a second time. The 149-vote defeat, while quite large, represented a marked improvement from the initial, record-breaking 230-vote defeat in January.

• On March 13, the House of Commons voted by a margin of 43 in favor of a motion to rule out a no-deal Brexit at any time, amending a government motion that would have restricted ruling out a no-deal scenario to the current March 29 exit date. However, it is important to recognize that this vote is not legally binding, Parliament will still have to pass legislation to change the March 29 European Union (E.U.) exit date in U.K. law.

• On March 14, the House of Commons agreed that if May’s withdrawal deal is put up for vote for a third time and approved by March 20 (the day before the upcoming E.U. Council summit begins), the government would ask the E.U. for an exit date extension to June 30. However, the motion also notes that a third rejection of May’s deal could mean that the U.K. would ask for a longer delay, and that the U.K. might need to participate in the E.U. parliamentary elections in May.

• On March 18, House of Commons Speaker John Bercow unexpectedly announced that he would not allow a third vote on May’s deal unless the motion brought before Parliament was “substantially” different from that voted down on March 12.

The way forward

Bercow’s intervention has effectively ruled out a third vote ahead of the E.U. Council summit on March 21-22, throwing the government’s strategy of passing the deal and agreeing on a short extension to June 30 into doubt. The government will probably try to bring back the deal for a final vote next week with the aim of minimizing the length of any extension. But, by raising the hurdle for another vote, Bercow’s intervention has made a longer extension more likely. Should Bercow block a third vote on May’s deal or the government suffer a third defeat, the likely next step would be further amendments presented by Members of Parliament (MPs) and/or a series of “indicative votes” to help define a consensus on the way forward. These solutions would require additional time, making it more likely that the U.K. wouldn’t exit the E.U. until at least 2020.

With little clarity on the direction of U.K. politics, we believe E.U. leaders are likely to err towards inducing the U.K. to accept a longer extension, with nine to 21 months being discussed. Before approving such an extension, however, the European Commission, some heads of E.U. government and E.U. Parliament have indicated they will need to see a clear statement of intent on the part of the U.K. It likely that indicative votes, a general election or a new referendum would meet this criterion.

We see five potential outcomes. We assign the following probabilities to each possible scenario:

• May’s deal passes (15% probability): Despite Bercow’s intervention, May’s deal isn’t completely dead yet. A third vote could be held next week after the E.U. summit if a substantive change is made, such as the addition of documents related to a potential extension or additional safeguards for Northern Ireland in the event the Irish Backstop is triggered, or if Parliament can demonstrate that there is a majority for May’s deal.
• Soft Brexit (35% probability): A cross-party coalition could coalesce around a soft Brexit, involving a permanent customs union and even membership of the E.U. Single Market. Indicative votes and backbench amendments could yield this compromise.
• General election (25% probability): The Fixed Term Parliament Act provides two ways to trigger an election. A simple majority of MPs can vote in favour of a no-confidence motion in the government, and if no alternative government can be formed in which a majority of MPs have confidence, an election would follow. Alternatively, if two-thirds of MPs vote for a motion calling for an election, it would be triggered immediately. A general election would extend uncertainty without any guarantee of resolution and raise the prospect of a hard-left Labour government. However, from the perspective of Brexit, an election is likely to still lead toward either May’s deal, a soft Brexit or a referendum. Consequently, it does not fundamentally change the distribution of final outcomes, in our view, but simply delays resolution and increases volatility. It is the most probable downside scenario for U.K. assets.
• Referendum (15% probability): The chances of a second referendum are slim given the scale of parliamentary opposition. Yet, as with almost everything else about Brexit, it cannot be ruled out. Beyond doubts about legitimacy, a future referendum would be complicated by the lack of any obvious and easily agreed-upon format. We would also expect a new referendum to prolong uncertainty.
• No deal (10% probability): On March 13, the House of Commons approved a motion to rule out a no-deal Brexit at any time. However, we keep our probability of a no-deal Brexit at 10% because this motion is not legally binding; Parliament would actually have to pass legislation to fully rule out a Brexit. Nevertheless, we believe that this vote has reduced the perceived risk that Parliament would permit a no-deal outcome.

Conclusion

Parliament’s resolve to reject a no-deal scenario and accept an exit date extension has reduced the negative tail risks surrounding U.K. assets, in our view, and has left May’s deal as the hardest possible model of Brexit that remains viable. We would expect either passage of May’s deal or a soft Brexit to lead to a rally in U.K. assets.

However, the path forward is now less clear. By placing an obstacle in the way of a third vote on May’s deal, Bercow’s intervention has made a longer extension of between nine and 21 months more likely. Alternative paths toward resolution via indicative votes, a general election and/or a referendum would involve an extended period of uncertainty and political volatility. In our view, this would likely cap gains for U.K. assets, raise downside risks to the economy and increase financial volatility.

Taking a step back, we suspect that the Brexit process and eventual resolution may resonate beyond the U.K. and Europe. The U.K.’s Brexit-driven slide from political pragmatism into paralysis has raised consternation about its reliability as a partner in international relations and as a destination for international investment. Furthermore, the political polarization exposed by the Brexit referendum and the ensuing internal tensions and external negotiations can also be seen in much of Europe, the US and many emerging markets, where nationalism has become more prominent.

A negotiated, softer form of Brexit would be an encouraging signal – and this is what we increasingly expect (albeit after further uncertainty and delays). If, however, the U.K. and E.U. cannot find common ground, we believe markets are likely to be more concerned about trade and other political tensions in the global economy among countries that are not so strongly linked.