Brexit Update: May's Departure Is A Game Changer

By Paul O'Connor

Paul O'Connor, Head of the UK-based Multi-Asset Team, discusses the difficult choices facing the incoming Conservative prime minister around Brexit.

Theresa May's widely expected decision to step down as leader of the Conservative Party is likely to be a game changer for the Brexit process. It has been more than a thousand days since the UK voted to leave the European Union (EU), yet little real progress has been made on the negotiations since then. Ms. May's Withdrawal Bill - an essential legislative component of a negotiated Brexit - has been rejected by Parliament three times. Two rounds of indicative votes among Members of Parliament (MPs) have failed to establish a consensus for any form of Brexit. The process has effectively come to a dead end under Ms. May.

The arrival of a new prime minister (PM) will inject a significant impulse of political energy into the Brexit debate and looks set to break the current deadlock. While it is hard to predict where the Brexit process will be when the October 31 deadline is reached, something significant is likely to have happened by then. The negotiated phased-in Brexit that Ms. May was pursuing now seems an unlikely outcome, whereas a no-deal Brexit, a 2019 general election and a second referendum all seem more probable than they were a few weeks ago.

A Euroskeptic Leader

There is a good chance that the new PM will be in office by the end of July. Everything suggests that the new leader will win on a fairly euroskeptic campaign, centered on a "renegotiate or no-deal" Brexit policy. This sort of campaign will delight the grassroots membership of the Conservatives, with a recent Party survey indicating that 75% of members would vote for a no-deal Brexit.* It is also likely to receive broad support from Conservative MPs, of whom 157 voted in favor of no-deal in the March 27 indicative votes compared to 94 who voted against. The sizable vote swing toward euroskeptic parties in the European parliamentary elections will only provide further encouragement for this sort of campaign.

However, it will not take long for the newly appointed PM to realize just how difficult it is going to be to implement the form of Brexit that has swept him or her into power. The first clash with reality will be when the new leader engages with the EU. One of the earliest priorities of the new PM is likely to be an attempt to reopen negotiations with the EU on the withdrawal agreement, particularly focusing on the Northern Irish backstop. Brussels is unlikely to give much ground to a British leader who is actively campaigning for a no-deal outcome. Assuming, as we do, that no meaningful renegotiations take place, the new PM will then be faced with the following difficult choices:

  • Take a softer stance on Brexit, focusing on securing an extension of the October 31 deadline and ultimately a negotiated settlement. The sort of commitments that the EU would probably demand before granting an extension would almost certainly be politically unpalatable for the new PM. Another variant here would be to focus on just changing the nonbinding political declaration, which sets out the framework for future trade relations, and trying to pass the current withdrawal agreement. Given Ms. May's repeated failures with the latter, this would involve huge political risks for the new leader and should probably be seen as a low probability outcome.
  • Push on with a no-deal Brexit, aiming to leave the EU on October 31. This path will bring the government into collision with a Parliament that has a strong majority in favor of an orderly negotiated Brexit. The challenge here will be all the greater if, as seems likely, some moderate Conservatives defect from the Party when the euroskeptic leader takes charge. With the government's parliamentary majority now in single figures, it will not take many defections to tip the balance. The most likely scenario here would be for Parliament to pass a vote of no confidence in the government, giving it two weeks to regain support or face a general election.
  • Prorogue Parliament. In theory, the prime minister has the power to suspend Parliament from sitting, thereby stopping it from impeding a no-deal Brexit. This would be a highly controversial move, given that it would be acting in defiance of the will of a parliamentary majority.
  • Call a general election. Recognizing the difficulty of trying to pass major legislation with little parliamentary authority, a new PM might choose to call a general election to seek a stronger mandate. However, unless there is a decisive swing in popular opinion toward the Conservatives in the weeks ahead, this seems a risky option given that the Party secured less than 10% of the votes in the recent EU parliamentary elections. Time is an important consideration here, with Parliament in recess from July 20 to September 5, and the October 31 Brexit deadline looming.
  • Call another referendum on EU membership. Given the political difficulties associated with all the above options, a new PM could instead decide that a second referendum would be the most effective way to break the deadlock, in the hope that that this would deliver a stronger pro-Brexit message that would be easier to implement. The big risk here would be the backlash from Brexiteers if the vote swung to "Remain." Another consideration is that the government's weak parliamentary position means that it could have little control over the questions on the ballot paper and might not even be able to get a no-deal exit as one of the options.

Decision Time

There are no easy choices ahead for the new prime minister where Brexit is concerned. We will probably know who the new PM will be in a couple of months but might have to wait for weeks or months beyond that before we know what path he or she will take to the October 31 Brexit deadline. One thing that does seem clear now, however, is that the probability of a negotiated exit has fallen significantly with Ms. May's departure. Instead, a number of Brexit outcomes that looked like tail risk scenarios a few weeks ago now seem more likely. If we look to betting markets to help quantify the probabilities here, we see that a no-deal Brexit, no Brexit (Article 50 revoked), a 2019 general election and a second EU referendum are now all seen as being equally probable outcomes.

Brexit Probabilities

Source: Probabilities based on Betfair odds as of 5/28/19.

While it remains difficult to predict how things are going to evolve on the Brexit front, we do know that something significant is likely to happen by October. The era of Brexit delays and extensions is probably over, and some big decisions will need to be made in the next few months. This will not be an easy environment for investors to evaluate, given the inherently political nature of the process and the inevitable bluffing and brinkmanship it will bring. While it is hard to see sentiment toward sterling and UK assets improving through this fog of uncertainty, a certain amount of gloom is already priced in. We would expect the pound to come under downside pressure if the no-deal scenario becomes more probable but to have significant upside on a no-Brexit outcome.

* survey, "How Party members would cast indicative votes. They are overwhelmingly for no deal"

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