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Brexit Deal—Can They Get It Over the Line?

Wells Fargo Investment Institute - October 21, 2019

Key takeaways

  • A last-minute attempt at passing a new Brexit Withdrawal Agreement faces knife-edge votes in Parliament this week. The European Union (EU) will likely grant a further extension if needed.
  • Near-term scenarios lead away from a chaotic “no-deal” Brexit. The deal may pass, and softer Brexit versions, even a confirmatory referendum with the possibility of remaining in the EU, are still just possible. The pound may, therefore, stay firm or even extend gains.

What it may mean for investors

  • If the latest Withdrawal Agreement is passed, initial market euphoria may soon give way to a more realistic assessment of challenges to come.

In the past week, the U.K. Prime Minister (PM) Boris Johnson surprised many by managing to negotiate a new Withdrawal Agreement with the EU, which was to be put to a parliamentary vote at Saturday’s sitting.

Despite the government’s optimism, many commentators viewed the new deal as inferior in several aspects to former PM Theresa May’s Withdrawal Agreement: 

  • Instead of a U.K.-wide customs union, the Johnson deal reverted to a 2018 EU proposal, rejected by May, of separate customs treatment for Northern Ireland and effectively a customs border within the U.K. (in the Irish sea). Critics see this as leading to further fragmentation of the U.K.
  • Regulatory alignment has been changed from legally binding text to a nonbinding statement of aspirations about the future U.K.-EU relationship.1
  • The Withdrawal Agreement would not be the end of the Brexit process. Rather, it would be the start of a “transition period” to end-2020—where economic arrangements remain the same, and a new trade relationship (likely a free-trade agreement) is negotiated. 

Parliament was called to an unusual Saturday session on October 19, but instead of voting on PM Johnson’s Withdrawal Agreement, Parliament passed a provision that first requires passage of legislation to implement the deal. Parliament inserting an extra step forced PM Johnson to send a letter to the EU to ask (reluctantly) for an extension of time beyond October 31. This extension allows the U.K. Parliament to consider the legislation to implement a deal first. We believe the next most likely step is that Parliament will consider the Withdrawal Agreement Implementation Bill on Tuesday, October 22.

There remains a tantalising possibility that the latest Withdrawal Agreement may pass unamended. Several members who voted to consider the implementation legislation first stated that they did that to avoid the risk of a “no deal” and would likely support the Withdrawal Agreement itself. 

We view the odds that Parliament will approve the new Withdrawal Agreement as about even, because PM Johnson faces very close calls on some key, undecided issues. First, some in Parliament favor approving an agreement only after putting a confirmatory referendum to voters. Also, some members will not approve unless the deal includes a whole U.K. customs union, rather than the Irish Sea border concept. We believe there may be support for the confirmatory referendum, but Parliament will ultimately reject the idea of a whole-U.K. customs union. 

For its part, the EU is considering the extension request. The EU will likely reserve judgement on whether it will grant an extension until it sees how Parliament will act— in part to focus minds by keeping “no-deal” fears alive and because U.K. developments will determine what extension length may be needed. But we believe that, if an extension is needed, the EU will grant it, being ultimately reluctant to expel a member state, and thereby, precipitate no-deal disruption.

Our perspective regarding investment

The most likely scenario is arguably that, faced with a tired and divided Parliament, the Boris Johnson government succeeds in getting Parliament to pass the latest Withdrawal Agreement by October 31, thus “getting Brexit done” as PM Johnson has championed. If the latest Withdrawal Agreement is passed, subject to a confirmatory referendum, then the possibility of “no Brexit at all” (i.e. remaining in the EU) comes back into play. Possibilities of softening an agreement by reverting to an all-U.K. customs arrangement are less likely but cannot yet be totally ruled out.  

The bottom line is that, with 10 days to go, many scenarios remain viable, but they all lead away from the most damaging scenario of a “no-deal” Brexit—i.e., leaving the EU with no agreement to discuss new trade terms. The recent appreciation of the British pound aligns with the improving base case. Investors should bear in mind, however, that while some initial relief rally for U.K. and European assets is understandable, the medium-term prospects for the U.K. economy are far from rosy. Following any Withdrawal Agreement, the U.K. and the EU would have until end-2020 to negotiate a likely complex free-trade agreement as the basis for their new relationship. Failing to agree in only 14 months could lead to a new “no-deal” cliff-edge in December 2020 (with no extension possible then). If there finally is a deal, then we would expect initial euphoria to fade in the coming months, as the reality of another new and difficult negotiation commences.

Investment implications

In the near term, further fading of no-deal risks and/or the passage of a Withdrawal Agreement should continue to support currencies and provide relief for risk assets, especially in the U.K. and Europe. Specifically, this may mean that the pound might rise above 1.30 versus the dollar, and the euro could also see gains, extending the recent correction seen in the dollar index (where together the euro and the pound make up 70% of the constituents).

For bonds, the removal of cliff-edge Brexit risk—even if only temporary, given another potential deadline at the end of 2020—may allow eurozone bond yields to rise further, taking more yields out of negative territory. Removal of the Brexit risk premium could raise long-end Gilt yields and would likely steepen the curve, since it is unlikely that passage of a Withdrawal Agreement would be sufficient to allow the Bank of England to consider raising policy interest rates.

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1 The regulatory alignment attempts to create similar requirements on workers’ rights, environmental protections, etc.