Prime Minister Theresa May survived a no-confidence vote on her leadership, which makes her immune to another challenge by her Conservative Party over the next 12 months. With more than one-third of Conservatives having voted against her, she is weakened, but unlikely to resign in the short term.
May will press on with attempting to get the Withdrawal Agreement that she negotiated with the EU approved by Parliament. With the Brexit clock ticking, and critics of her deal no more likely to back the deal in its current form, high drama and extreme market volatility in UK financial assets—particularly in the pound—will continue to test investors’ nerves. The issue will also likely keep global financial markets on edge.
Path of least resistance to prevail?
May’s deal includes both the detailed and legally binding Withdrawal Agreement—which sets the terms of the UK’s exit from the obligations of EU membership—as well as the political declaration, the non-legally binding, loosely defined statement of intent of the post-Brexit economic relationship between the UK and the EU.
The deal faced strong opposition from various fronts. Ardent Brexiteers fear the relationship with the EU will remain too close for too long. Most other MPs feel that leaving the EU without much certainty as to what the future relationship might be is worse than the status quo.
The prime minister will now attempt to extract some concessions or clarifications from the EU so as to make her deal more attractive. The EU is unlikely to offer more than reassurances and perhaps non-binding statements regarding the political declaration—that will probably not be enough to sway the passionate Brexiteers.
A House of Commons vote on the Withdrawal Agreement is likely to occur in January, and we believe the deal is likely to be rejected. Visibility as to how the events may unfold is very low. There remains a low probability of a general election, a second referendum, an extension of Article 50, or a hard Brexit, though the prospect of the latter has receded after a recent European Court of Justice ruling giving the UK the right to revoke its Article 50 notification unilaterally.
Our base case remains that MPs will eventually opt for a soft Brexit as the difficulties and impracticalities of other options become more and more apparent in the face of the March 29 deadline.
For now, the absence of a Withdrawal Agreement acceptable to Parliament will continue to weigh on UK economic activity through the beginning of 2019. In November, the UK’s composite Purchasing Managers’ Index reached its lowest level since the aftermath of the 2016 Brexit referendum as firms have started to postpone or cancel spending and investment decisions in the face of uncertainty. Business investment has also contracted in each of the first three quarters of the year.
UK composite PMI tumbles
Source - IHS Markit, Haver, RBC Capital Markets estimates
The slowing economy is not yet reflected in the labour market, with unemployment stable at 4.1 percent and wages growing by an average of 3.3 percent for the past three months compared to the same period last year.
A weakening economy and wage pressure make for an uncomfortable environment for the Bank of England. The Brexit uncertainty means interest rate hikes are likely to be pushed out.
Taking it all in
The pound is the barometer of this uncertainty and now hovers at an 18-month low. We would expect some—but limited—upside should a deal be eventually agreed to by Parliament, given the weak economy and a rising current-account deficit. The currency could weaken even further should a general election be called or in the event of a no-deal Brexit, given the heightened uncertainty around these outcomes. Conversely, an increasing probability of a second referendum would likely lift the pound.
GBPUSD is at an 18-month low
Source - Bloomberg, RBC Wealth Management; data through 12/13/18
We upgraded UK fixed income to Market Weight in September, as we expected investors to seek safe-haven assets in the UK We may review this position once uncertainty settles, but suggest investors should reduce duration to 3–5 years as 10-year UK Gilt yields have fallen below 1.30 percent. Yields may end up materially higher from current levels under several scenarios, i.e., should May’s plans succeed, Brexit be overturned, or the Labour Party take the reins of power.
For UK equities, we maintain a Market Weight stance that is predicated on the market’s attractive valuations and defensive nature, with a higher proportion of the Consumer Staples, Health Care, and Utilities sectors than other equity markets. Should a deal be secured, we would expect domestic stocks to enjoy a relief rally.
The political situation in the UK remains extremely complex and events are still in motion. Resolve in Parliament to avoid the harshest form of Brexit gives us slightly more confidence that our base-case scenario will prevail, though many hurdles remain.
Non-U.S. Analyst Disclosure : Frédérique Carrier, an employee of RBC Wealth Management USA’s foreign affiliate Royal Bank of Canada Investment Management (UK) Limited; contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since she is not an associated person of RBC Wealth Management, she may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.