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16 January 2019

Brexit: certain uncertainty 

To the surprise of virtually no one, including financial markets, Prime Minister Theresa May’s proposed Brexit deal was rejected yesterday by parliament. While bookmakers had quoted odds of less than 5% in favor of the vote passing, the historic 230-vote margin of defeat was nevertheless stunning.

Initial market reaction has been positive for sterling, with the pound up 1.3% in early trading versus both the dollar and euro. Equity markets, in turn, opened marginally higher in Europe and unchanged in the UK.

The reason for the positive market reaction? While the widely expected outcome had already been priced in, the scale of the defeat for the May government put the onus on parliament to reach a deal and, due to the composition of that body, this would seem to reduce the probability of a so-called “hard” Brexit.

Meanwhile, it’s worth noting that last night’s vote was immediately followed by a motion by opposition leader Jeremy Corbyn to hold a no-confidence vote.

This evening, we’ll find out if the May government will survive to fight another day.

Assuming Corbyn’s motion fails, where do we go from here? We won’t have to wait long to find out: May now has only three days to bring an alternative plan to parliament. 

With barely two months left until the deadline for invoking Article 50 – which will kickstart the formal exit process – all options are nevertheless still on the table.

May’s deal could be passed in a slightly amended format, perhaps on the second or third attempt and on the back of minor EU concessions. While such a scenario now appears increasingly unlikely, it could lead to a strong sterling rally, reflecting far greater market certainty.

Alternatively, parliament could come up with a new plan and approach Brussels for an extension to renegotiate, although it remains to be seen if EU officials would be willing to consider either option following 18 months of negotiations.  

A second referendum – the favored option of many pro-Remainers – is another possibility, but has gained little political traction so far. In such a scenario, sterling would likely rally in the short term, with subsequent gains tempered based on the direction of opinion polls.

If no other option receives sufficient parliamentary support, a general election could be called. Both markets and sterling would likely react negatively to such a move, as that would significantly increase the possibility of a Corbyn government – an event that is broadly perceived as strongly negative for the UK currency and equities.

Finally, all parties may be forced to agree to disagree, and the country would face a potentially catastrophic “no-deal” Brexit. In such a scenario, sterling would be likely to drop strongly, bond yields to fall (as talk of Bank of England rate cuts would emerge), and credit spreads to widen.

“No deal” is the most negative potential outcome for markets, representing the greatest potential threat to the country’s long-term growth. Consider that the Bank of England has predicted a GDP shortfall of 4.75% by 2023 under a “disruptive no-deal Brexit” and a whopping 7.75% shortfall under a “disorderly no-deal Brexit.”

Does this mean that we can expect a formal agreement in the next two months? Nothing could be less certain.