Brexit and UK politics

In our view, Brexit is a political decision with an economic cost: it will hamper UK trade with its largest trading partner.

One year on from triggering Article 50 and commencing Brexit negotiations in earnest, the UK remains on course to leave the EU in March 2019, initially under transitional arrangements that extend the status quo to end-2020. In our view, this transition period will be followed by a tariff-free trade deal largely restricted to trade in goods. The Brexit end-state will leave the UK with access to EU markets that falls well short of the status quo. These views on the outcome of Brexit negotiations have not changed since the Referendum vote.

An ongoing risk is that the mechanics of Brexit act as a catalyst for the creation of broader political and policy risk in the UK. Prospective UK economic policy is unusually uncertain at present. Aside from the uncertainties stemming directly from Brexit, the official Labour party opposition advocates a more interventionist and less business-friendly economic policy which challenges some of the assumptions about the UK economic environment that have held sway for the past 40 years. By the same token, a group of ‘hard Brexit’ politicians advocates a more aggressive reduction in intervention than has been considered over this period, such that the policy risk is two-sided.

Currently, a weak UK government needs to ensure the passage of contentious Brexit legislation through a divided Parliament, where it lacks a parliamentary majority. PM May faces opposition from both (i) within her own party, as members of her party (and cabinet) take differing views on Brexit-related policy choices; and (ii) the official Labour Party opposition to her government, where policy differences extend to many non-Brexit-related policy choices. The official parliamentary opposition would likely seek to take advantage of any further weakening in the government to pursue a more interventionist economic agenda. Yet, the official opposition is not seeking a soft Brexit; nor is the official opposition able to precipitate a change in government without the tacit support of some segment of the Conservative Party.We view this political environment as helping to sustain current Brexit policy: since it runs the risk of bringing down the current government, thus creating an opening for the opposition to implement its own agenda, opponents of Brexit within the Conservative Party are constrained from weakening PM May further.Nonetheless, a difficult political process pursued by a weak government poses genuine challenges to Brexit and to broader domestic politics. Here, we outline them.

Next month poses two key challenges which could exert pressure on PM May and the Conservative government.

Base case is that neither challenge will lead to a change in government or shift the UK from the Brexit path it is currently on.

Both do, however, represent significant event risks.For the main event risks of the next six months to change Brexit policy requires sufficient opposition from within the Conservative Party. Our base case assumes that current UK politics discourages such opposition within the Conservative Party on a risk / reward basis: it implies running the risk of bringing down the Conservative government without the reward of a distinctly ‘softer’ Brexit, given that the opposition Labour Party’s policy remains to leave the EU Single Market.

Yet, incentives for ‘hard Brexit’ supporters within the Conservative Party are different. Our base case assumes this group chooses to sustain the current government so that the UK leaves the EU in March 2019. An attempt to engineer the hard Brexit that this group prefers, by bringing down the government, jeopardises Brexit and leaving the EU Single Market (and its related body of EU legislation as it applies in the UK). That said, we discuss below how two parliamentary votes could potentially upset that view, increasing tail risks, including that of a ‘No Deal’ outcome.

An alternative scenario: PM May’s position as leader of the Conservative Party could come under pressure if the party suffers heavy losses in the upcoming local elections, without this precipitating a change in government. In our view, such a scenario has a higher probability than remaining in the Single Market in a ‘soft Brexit’ or a ‘No Deal’ scenario. This would also keep the UK on the current path to Brexit.

If the Conservative Party suffers significant losses in the local elections and this is attributed to PM May’s leadership, then the Conservative Party may choose to change leader and select a new prime minister, in an attempt to avoid a General Election. Avoiding an election while changing leader (and PM) is feasible: it has happened twice in the past 11 years. In this case, the next Conservative PM would likely come from the ‘Leave’ side of the Conservative Party. (The alternative would risk splitting the Conservative Party.)

But a harder Brexit would result if the replacement PM does not simply continue along the same Brexit path as PM May but instead presents a ‘hard’ Brexit view. With the current Parliament opposed to a hard Brexit, this would then raise the risk of needing to hold a General Election.

Losing the customs union vote: Should PM May lose next month’s vote on the amendment which seeks UK participation in a customs union with the EU – which would require around 10 Conservative MPs to vote against the government – then the political risks would extend further than the risk to Ms. May’s position as PM/party leader.

The government has presented a ‘Global Britain’ vision of Brexit. An amendment to participate in a customs union could have a material impact on the government’s Brexit policy.

Participating in a customs union with the EU would require agreeing a process between the UK and EU whereby the UK adopts the EU’s Common External Tariff applied to all imports into the EU. It would deny the UK the ability to implement its own independent trade deals with countries outside the EU.

It is a close call whether the number of ‘rebel’ Conservative MPs will reach the ten or so needed to defeat the government. The amendment is sponsored by five Conservative MPs, including Anna Soubry.

An amendment vote to participate in a customs union with the EU might be seen by some as implying a soft Brexit. We would resist this view. In particular, if losing the customs union vote saw Sterling strengthen on the grounds that it meant a ‘softer’ Brexit, then we would expect any further strengthening in Sterling to be temporary for three reasons.

If disagreement about a soft or hard Brexit end-state within the Conservative Party became entangled with a leadership contest, then the prospect of an election would no longer be the stabilising influence we envisage in our base case, by discouraging opposition. Instead, in order to force the issue within the Conservative Party, an election under a new party leader might be needed.

A heightened election risk. If the Conservative Party were to win the election, and continued to advocate not participating in a customs union with the EU, then the existing policy would be maintained.

An election win for the Labour Party would imply, based on current policy, staying in the EU customs union but not a much softer Brexit as the UK would still leave the Single Market.

In practice, and looking beyond current party policy, a change of government could mean the UK requesting a ‘stop the clock’ arrangement for Brexit negotiations. A pause in the withdrawal process of up to one year is possible, although not straightforward.

If the economic outlook deteriorated and this was attributed to the previous government’s approach to Brexit, then a change in Brexit policy could be advocated to favour a Norway-style membership of the Single Market via the European Economic Area. There is currently little to no momentum behind holding a second referendum.

As the above outline makes clear, we are some way from being on this path to a soft Brexit and remaining in the Single Market. And getting on to this path would involve the risks associated with shifting to a much more interventionist economic policy associated with a change of government which may not address the UK’s key supply-side weaknesses.

The Conservative government has committed to a “meaningful vote” in Parliament on the terms of the EU Withdrawal Bill when the Article 50 negotiation has reached its conclusion. This will include the terms of the UK withdrawal (covering legacy issues), the transitional arrangements for the period to end-2020 agreed at the March European Council Summit and a framework for the future trading arrangement between the UK and EU.

Losing the October vote would clearly put the government under pressure and lead to risks similar to those outlined above. It could make it more difficult to change PM without also calling a General Election if a major vote at the conclusion of the Article 50 negotiations is lost. Recent press reports suggest supporters of a soft Brexit, including from within the Conservative Party, are more focused on the October vote than on next month’s customs union vote. This suggests that the real market-relevant event is more likely in six months, rather than next month.

Moreover, a rejection of the deal in October increases the likelihood of a ‘No Deal’ Brexit in March 2019. This remains the most disruptive outcome, both from a practical business perspective and from a market impact perspective.

As with the customs union vote, it is not clear that enough Conservative MPs would risk bringing down the government in order to reject the Brexit deal, having supported the triggering of Article 50 one year ago. We continue to believe that the risk / reward discourages such a step.

Summing up. We think the UK remains on a path to leave the EU in less than a year. While the next six months pose some risks to that view, we continue to expect the current government to remain in power and implement Brexit. Once the UK has given up its seat at the EU table in a year’s time, it will become even more difficult to reverse Brexit.

The difficulties faced by a weak UK government in getting contentious Brexit legislation through a divided parliament pose some risks to Brexit, especially over the next six months. Yet, they pose bigger risks to the government itself than to whether the UK leaves the EU and the EU Single Market at the end of the Brexit process.