The scale of the government’s defeat over its Brexit deal may be unprecedented, but it has failed to shake investors from their key bet: that the chances of a no-deal Brexit are receding while the prospect of a soft Brexit, or none at all, are gaining ground.
That view has been steadily gaining support since prime minister Theresa May was forced to abandon her first attempt at bringing her deal to a parliamentary vote last month.
Having reached its lowest level against the dollar in more than 18 months, the pound has since rallied, with the recovery gaining pace after last night’s huge parliamentary defeat for the government.
‘The market is very good at recognising when historically unprecedented political events won’t change the likely future course of events,’ said Guy Foster, head of research at Brewin Dolphin.
‘Investors are betting the UK moves towards a softer Brexit, and away from a no-deal Brexit. The chances of a delayed Brexit, or indeed no Brexit, are also creeping higher.’
Crucial to this calculation has been the parliament’s wrestling of control from the government over the Brexit process, seen in last week’s successful Finance Bill amendment intended to deter the UK leaving the European Union without a deal.
‘The power shift from the executive toward the legislature has continued as the government’s wafer-thin majority is exposed,’ said Kamal Sharma, foreign exchange strategist at Bank of America Merrill Lynch.
‘Part of the reason we think sentiment towards the pound has improved in recent weeks has been increasing confidence that a no deal Brexit will be avoided. As parliament exerts its authority, it has showed that it has the majority to put in place circuit-breakers to avoid a no-deal scenario.’
Slimming chances of no-deal Brexit
Richard Buxton, manager of the Merian UK Alpha fund, agreed. ‘There is in my view, an increasing likelihood that a ruinous no-deal Brexit is likely to be averted,’ he said, adding that stock markets, as well as the currency markets, were now reflecting that view.
‘The UK equity market has similarly strengthened recently, with the strongest bounces seen in most domestically focused companies such as retailers.’
The fund manager argued that any form of deal that avoided a cliff-edge Brexit would be welcomed by markets, boosting both the pound and the UK economy.
‘Sterling would once again strengthen, although I do not see it regaining pre-referendum levels,’ he said.
‘A strengthening in the region of 5% to 8% would seem more likely than the approximately 15% rally by the pound that would be required to regain those pre-referendum highs.’
Sluggish UK growth of between 0.2% to 0.3% per quarter would meanwhile return to the 0.5% to 0.6% levels enjoyed before the EU referendum, he said.
On the stock market, ‘UK equities could experience a relief rally, with domestically-oriented stocks outperforming UK-based multinationals,’ added Edward Park, deputy chief investment officer at Brooks Macdonald.
But not all are so sure...
Anthony Gillham, head of investments at Quilter Investors, said markets were now pricing in just a slim prospect of the UK leaving the EU without a deal, at between 5% and 10%.
But not all believe investors are right in that view. ‘The risk of a no-deal or cliff-edge Brexit is probably as high as it has ever been,’ argued Azad Zangana, senior European economist and strategist at fund group Schroders.
‘Markets seem to be pricing in a greater probability of a “soft Brexit”. However, we believe that investors are getting ahead of themselves.’
Peter Dixon, analyst at Commerzbank, agreed that the chance of a no-deal Brexit should not be underestimated.
‘One of the proposed amendments [yesterday] evening was one which called for a rejection of the deal but which committed parliament to ensuring that the UK did not leave the EU without some form of safety net in place,’ he said.
‘This was not called to a vote, presumably because its backer, Jeremy Corbyn, saw a tactical advantage in not doing so. Consequently, the UK finds itself looking over the edge of the cliff with just 72 days until it legally leaves the EU. This position could yet be remedied but it is not a very comfortable one right now.’
Were the UK to leave the EU without a deal, Zangana argued the UK economy would likely fall into recession given its ‘fragile state’.
Buxton said the Bank of England would respond by cutting interest rates from their already-low levels, while ‘the resumption of monetary stimulus, in the form of quantitative easing would, in my view, be a possibility’.
Where next for the government?
Having seen its Brexit deal defeated, the government’s next challenge will be to survive a vote of no confidence this evening, one few believe will succeed.
Presuming the government survives that vote, it has until Monday to return to parliament with its ‘plan B’.
A reworking of the existing deal looks unlikely to succeed, given the scale of parliament’s opposition to it.
‘The bar to get the revised deal through parliament remains high,’ said James Smith, developed markets economist at ING.
‘The approximate 115 to 120 votes required to turn things around means that there are a seriously high number of lawmakers needing to be convinced.’
The only hope for a form of the existing deal getting though, it seems, is if MPs are sufficiently worried a ‘no-deal’ Brexit will be the alternative.
This has become known as the Tarp strategy, taking its cue from the US targeted asset relief repurchase programme, voted down by US lawmakers during the financial crisis only to be voted through weeks later as stock markets collapsed.
Had that been the strategy, it isn’t working as planned. Stock markets aren’t yet playing their part, as investors have refused to assign much probability to the risk of a hard Brexit.
Article 50 extension looms
‘In reality, it now looks much more likely the UK government would try to apply for an extension to the Article 50 period to avoid a hard exit,’ said Smith.
‘If MPs make a similar calculation, then they are arguably less likely to be persuaded to back a deal simply to avoid an exit on World Trade Organisation terms.’
Sharma agreed. ‘We think the options are narrowing and a delay in Brexit seems inevitable,’ he said, adding that last night’s defeat had imposed further delays to the legislative process, given bills that make up the EU Withdrawal Bill still required royal assent.
‘A technical extension of Article 50 may be an easier first step as both sides can argue this is needed to conclude the legislative process in the UK.’
This would require unanimous backing from the 27 EU member states, though Dixon argued this would almost certainly be granted ‘if the alternative is a no-deal Brexit, which will certainly worry the EU’.
This, claimed Sharma, would be welcomed by markets. ‘While some have suggested that an extension of Article 50 merely prolongs the uncertainty hanging over the UK, we would argue [it] will be a bullish signal for the pound. It reveals the UK government’s preference for an orderly Brexit rather than a cliff-edge no-deal,’ he said.
But then what?
This would buy the government more time, albeit not an indefinite amount. ‘It is only likely to get an additional three months because the next European parliament, which will be elected in May and in which the UK will not be represented, must convene on 2 July,’ said Dixon.
‘It is difficult to see how the Article 50 period can be extended into the next parliamentary session for all sorts of constitutional reasons.’
So how would the government use this time? Dixon sees four options:
- (i) try and negotiate a more acceptable agreement with the EU;
- (ii) hard Brexit;
- (iii) call a second referendum;
- (iv) unilaterally withdraw the Article 50 notification.
Smith and Sharma add another variation of option (i) into the mix: adopting an existing model, like Norway’s, which is part of the single market, or a variation of it, the so-called ‘Norway plus’, also featuring membership of the customs union. This would likely be acceptable to the EU, but less so for the Conservative party.
‘Option (i) appears increasingly unlikely whilst (ii) is still unpalatable to most MPs. Option (iv) would probably be seen as a betrayal of the democratic process,’ said Dixon.
‘This leaves option (iii) – a second EU referendum. There are many reasons why this is a bad idea: for one thing it will further deepen the many divisions that were laid bare in the June 2016 vote. But if parliament is unable to reach an agreement on how to deliver a Brexit without sending the economy over a cliff, it may have little choice.’