Brexit uncertainty and tail risks

global perspectives

Brexit uncertainty and tail risks

Salman Ahmed, PhD - Chief Investment Strategist

Salman Ahmed, PhD

Chief Investment Strategist
Charles St-Arnaud - Senior Investment Strategist

Charles St-Arnaud

Senior Investment Strategist

A series of votes in the UK Parliament this week have furthered the case for a delay in the United Kingdom leaving the European Union. 

The House of Commons voted to: defeat Prime Minister Theresa May’s Withdrawal Agreement; reject a ‘no-deal’ Brexit under any circumstances; and back a delay to leave the EU on 29 March. While the very negative tail risk of a ‘no-deal Brexit’ has been diminished, the details of the delay are likely to prolong uncertainty and create more volatility in GBP markets, we believe.

PM May will present her deal for the third time to Parliament next week, ahead of requesting the EU extend the 29 March  deadline at the EU summit on 21-22 March. Should MPs approve May’s deal, then the extension to Article 50 would be until 30 June. Given May’s deal has failed to pass twice already, we consider other options remain distinctly possible, raising the spectre of uncertainty.

Uncertainty would stem from both the length and purpose of the delay. When requesting a delay beyond 30 June, the UK government must set out to the EU what it aims to achieve by extending Article 50, and for how long. Will it extend the deadline in order to hold a general election, hold a second referendum or hold more negotiations? Further UK-EU negotiations seem unlikely to us at this point, as it is improbable anything meaningful would arise to resolve the deadlock.

While a second referendum would be the most democratic and direct way to unlock Brexit, we believe that the main actors, PM May and the opposition Labour leader Jeremy Corbyn, would much rather hold a general election, even though we note that Corbyn has timidly committed to a second referendum. There are many reasons why politicians would prefer a general election to a referendum, the main one being that it avoids further fractioning their own parties. Divisions along the Remain-Leave axis could lead to additional party defections, likely benefitting burgeoning independent groups, and could lead to the disintegration of the traditional parties. Moreover, with recent polls suggesting a small lead for the Conservatives, PM May has a further incentive to prefer a general election.

A Conservative win at a general election could return the UK to its current situation, unable to decide on the best relationship, and even potentially resurrecting the ‘no-deal Brexit’ option. A Labour win would probably bring slightly more certainty, as the leadership has backed a customs union. However, this may come at the expense of increased uncertainty regarding domestic economic policies.

The main downside risk in the coming days is a ‘no-deal Brexit’ that occurs by accident, further confirming that UK politics are in chaos. We believe that this is a low probability scenario of less than 5 percent, but still possible, given that the current motions in Parliament are not binding.

 

investment implications.

The GBP currency should find a floor at current levels against USD and EUR, and is likely to appreciate over the medium term, we believe. However, because such uncertainty remains - from potential next steps, and about the outcome for the new, long-term relationship – the currency is likely to continue being volatile in the months ahead due to cliff-edge effects. Domestic political risks are likely to remain elevated. 

We are also monitoring the potential effect that prolonged Brexit uncertainty would have on the Eurozone economy. Ripple effects, for instance, could spur even more weakness in German manufacturing, as the UK is a key export market for Germany. This could eventually have implications for Eurozone monetary policy.

important information.

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