MARKET PULSE: Brexit scenarios and their potential market implications
Below we describe, in a first step, four possible ways the Brexit debate could end. In a second step, we assign an esteemed probability of occurrence to each scenario and estimate each scenario’s potential implications or impacts on the financial markets.
No-Deal – Hard Brexit
The negotiations about how the United Kingdom (UK) will leave the European Union (EU) has now been ongoing for about two years. The resistance against several drafts of the “divorce” deal in the British parliament, led to several extra rounds of negotiations between the EU and UK. Prime Minister Theresa May was forced in January 2019 to renegotiate a treaty within the following two months. Jeremy Corbin, the leader of the Labour Party and, therefore, of the opposition, seeks an exit deal comprising a permanent customs union with the EU. An agreement to the proposal of Mr. Corbin, however, would probably lead to a split in the Conservative Party and subsequently to the loss of the support for PM May. In this case, the chance for snap general elections will increase, as conservative Brexiteers would probably be abstaining from a subsequent confidence vote. For this reason, PM May will presumably refrain from a deal with the Labour Party. The EU’s position on the other hand appears to have hardened, with the EU being frustrated that PM May seems to be trying to bring up more ideas of the pro-Brexit side from her party. All in all, this could lead to a gridlock and a Brexit without any deal at all.
What will be the consequences of a Hard Brexit? In case of a ‘no deal’ withdrawal, trade with UK will be governed by the WTO trade norms. This will lead to a significant increase in tariffs from levels of today. In our view, higher tariffs and the arising uncertainty will affect global economic developments negatively. Although several questions remain currently unanswered, the UK will probably fall in an extended recession while the Bank of England will decrease the interest rate to support the economy.
No-Brexit – Remain in the EU
The negotiated deal between the UK and the EU was rejected by the British parliament in a defeat never seen before for a sitting government. In fact, 118 votes of 432 against the deal came from PM Theresa May’s own Conservative Party. If PM Theresa May will not be able to bring up a proposal which is capable of winning a majority, her confidence in the parliament could disappear. This could lead to snap general elections. In case the forces may be turned, the Labor Party could challenge the Brexit vote, what could end up in the UK not leaving the EU. According to the European Court of Justice, the UK can cancel Brexit without asking for permission form other EU member states. A second referendum with another result could also lead the UK to remain in the EU.
In this case, we expect to see a relief rally in the markets. British companies were likely to release investments, withhold due to the existing uncertainty, and households to increase spending. All in all, this scenario were likely to support economic development and spur growth in the UK.
Delayed Deal – Extend Article 50 period
The deadline for the divorce date, March 29, 2019 is coming closer; both parties are running short of time. Based on that, the time could be too short to find a deal. To prevent an unregulated Brexit one option would be an extension of the Article 50 negotiating period. Currently, the actions in the parliament look like they want to give PM May as much time to find a revised deal as possible. There is also a request for an amendment to the exit regulations by Yvette Cooper MP outstanding, asking to set out legally binding instructions to the government to seek an extension. Furthermore, it can be assumed that Brussels will rather choose a delay over a Hard Brexit and would therefore agree to an extension. The situation of an extension will leave PM May in a situation with little incentive for compromise from her own Member of Parliament and the EU.
Even though markets would prefer an extension in comparison to a Hard Brexit, the remaining uncertainty should prevent companies and households to increase spending. In this case, we anticipate the Bank of England to stay on hold with further rate increases and the economy to decrease further.
Soft Brexit – Exit on some form of a deal
The EU will stick to the main deal but is open for discussions if PM May will come up with new ideas to amend the proposed deal. To get the support from her own party and get a majority, the deal needs to be adjusted or amended so that the backstop rule becomes more clear, i.e. set a time limit, protect labor and environmental laws and clarify the role of the parliament in negotiating the future relationship between the EU and UK after the (prolonged) transition period. In this scenario, both parties approve an updated version of the current agreement.
The current exit agreement contains a transition period, which can be extended until December 2022. This will help to finalize the negotiation about the future collaboration between the EU and UK. The extension will calm markets and help corporates to continue their operations in the current framework.