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Can the U.K. Election “Get Brexit Done”?

Wells Fargo Investment Institute - December 13, 2019

by Peter Wilson, Global Fixed Income Strategist

Key takeaways

  • After the U.K.’s general election on December 12, Boris Johnson will have the largest Conservative majority in Parliament since Margaret Thatcher.
  • The next step will be to pass the Brexit Withdrawal Agreement (WA) legislation, perhaps before Christmas, and “Get Brexit Done” before the current deadline of January 31.

What it may mean for investors

  • The WA just sets the terms of disengagement. The real challenge will be negotiating the details of the new U.K.-European Union (EU) trading relationship before the end of the “transition period,” and avoiding another “cliff-edge” or “No-deal” Brexit in December 2020. The size of the victory raises the probability that a pivot toward a “softer” Brexit could be seen.

What just happened?

With the results in, it is clear that the Conservative Party (the Party) has achieved a resounding victory in Thursday’s U.K. general election. The Party will have a parliamentary majority of around 80 seats, ahead of virtually all predictions, and the largest majority since Margaret Thatcher’s 1987 win. The pound and U.K. asset markets have rallied, judging (appropriately, in our view) that the size of majority means that the U.K. will finally be able to “get Brexit done” (to quote the Conservative election slogan). Financial markets are also taking the view—appropriately again, in our opinion—that the large majority and Prime Minister Boris Johnson’s enhanced position should allow the country to avoid crashing out of the European Union without a trade deal in place at the end of December 2020. That second judgment, however, remains to be confirmed.

What next? Key dates

The size of the Conservatives’ majority in Parliament (as well as the purging of many anti-Brexit Conservative Members of Parliament) should put Boris Johnson in a position to fulfil his promise to “get Brexit done” as soon as possible. Parliament will reconvene on December 17, although the crucial vote on the Brexit Withdrawal Agreement—repeatedly defeated earlier this year, and now likely to pass without difficulty—may not happen until early January. Whenever it takes place, the U.K. seems set to leave the European Union, formally and with a “deal” in place, on or before the deadline of January 31.

Is this “getting Brexit done”? Yes, in the sense that the debate over whether or not Brexit will happen is over: “Leavers” have won, “Remainers” and those pushing for a second referendum have lost. Brexit, in one form or another, we believe will happen. Financial markets are not celebrating the fact that the U.K. is likely leaving the EU, but investors seem reassured that three years of uncertainty have ended, we believe justifies the rally in U.K. risk assets. But in another sense, Brexit is far from “done.” Indeed, the real business of Brexit—negotiating a new, looser relationship between the U.K. and the remaining EU member states—will only start once the Withdrawal Agreement is finally passed and the U.K. formally leaves.

Once this happens (for convenience, let’s assume it is on January 31), a “transition period” begins, which is scheduled to last until the end of December 2020. During this period, nothing is expected to change in terms of the trade or economic relationship, as the current EU-U.K. trade rules will continue to apply. However, before the end of 2020, the U.K. and the EU need to negotiate the terms of the new relationship (in trade, especially, but also in other areas such as security—so these are very complex negotiations).

The transition period can be extended beyond December 2020, but any request for an extension must be granted by July 1, and the Conservative Party has so far ruled out any further extensions. If that promise holds—and it may not—then Conservative policy is to negotiate a new comprehensive Free Trade Agreement (FTA) with the EU in that 11-month period between February and December 2020. That’s a big ask, considering that previous free-trade agreements the EU has negotiated have taken a minimum of two years (with South Korea) or five years (Japan, Canada). With no extension, failure to conclude an FTA by December 2020 will mean a new “no deal” exit, another cliff-edge for U.K. trade and the economy similar to what was feared in 2019.

This will be the key question for the U.K. economy and market sentiment in 2020. Current euphoria may evaporate quickly if it becomes clear that the new U.K.-EU negotiations will reprise the Withdrawal Agreement talks—bad faith, bitterness, and brinkmanship. Its current position is that the U.K. seeks to maximize access to the EU’s single market at the same time as achieving flexibility to diverge from EU rules and standards to allow greater freedom in global trade.

However, more optimistically, we believe the size of Boris Johnson’s majority and his own personal triumph will allow him, if he chooses, to break free from the influence of Brexit hard-liners and move toward a “softer” form of Brexit, with much closer alignment to EU rules and standards than had been previously envisaged. Markets may take this as a positive development that may lead to less short-term disruption to U.K. trade and industry and to a more positive medium-term growth environment, in our opinion.

Which path will be chosen should become clear in early 2020, perhaps in the second quarter. If Brexit formally happens by January 31, there will then need to be parliamentary debate and votes on the U.K.’s negotiating stance, and the EU will have to decide its own objectives and tactics. It may not be until late February or early March before the FTA negotiations begin in earnest.

It seems likely that the U.K. will want to see how initial talks progress before making any (politically embarrassing but now far from fatal) decision on whether to ask for an extension to the transition period. Given that any such extension must be requested and agreed by July 1, the April-June period may be a testing time for markets. Will Boris Johnson’s government take an ideological approach to pursue greater freedom from EU rules and standards, or be more pragmatic and use its greater parliamentary power to achieve closer alignment than had previously been thought possible? In short, will it be “no deal is better than a bad deal” déjà vu, or a pivot to “any deal will do” to get Brexit done?

Our perspective on investments

We believe that the same pragmatism and charm that allowed Boris Johnson to spin a Withdrawal Agreement essentially unchanged from May’s unpopular deal into a major breakthrough will allow him to achieve a market-pleasing pivot toward a longer extension and ultimately a more closely aligned, softer form of Brexit. There are risks to this view, if the Prime Minister feels compelled to avoid an extension and to keep the “no extension” election promise. But if we are right, in the short term, the pound and U.K. risk assets can rally further, perhaps taking Sterling back above $1.40. We expect the euro to also benefit, and together a pound and euro recovery would support our view that the U.S. dollar in 2020 will depreciate modestly against most developed-market currencies.

In terms of risk assets, we expect U.K. equities should benefit from stronger growth prospects and lower risk premia—both in terms of Brexit risk itself, and in terms of domestic U.K. politics and policy. A lower Brexit risk premium may narrow the discount between U.K. stock markets and their EU counterparts. In terms of U.K. bonds, it should be noted that the need to keep the support of many ex-Labour voters may contribute to the (cautious) fiscal expansion. However, given that we believe the Bank of England will likely keep interest rates on hold until the shape of the future trading arrangements are clearer, the near-term response may well be a modest rise in U.K. long-term bond yields.

Finally, if the above is a relatively optimistic short- and medium-term view for markets, all is not rosy in the U.K. garden. Another important aspect of the election was the expected strong showing by the Scottish National Party. Another Scottish independence referendum (the last was in 2014), while not likely under this government, is surely just a matter of time. According to a December 12, 2019 poll by the polling company, Survation, Ltd. and reported in the newspaper, The Courier, Scottish respondents were evenly divided on the question of Scottish independence, though the proportion favouring independence has been rising. An eventual referendum on Scottish independence could yet bring the breakup of the United Kingdom.

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