aerial view of Big Ben and Parliament house

The outcome of the recent elections for the European Parliament is having far-reaching consequences on the UK’s political landscape and is resetting the debate about Brexit, with the UK still insisting on improving the terms of its exit from the EU scheduled for Oct. 31.

The results

The Brexit Party, which campaigned on a “no-deal” platform (to leave the EU even if there is no formal agreement on terms), was the clear winner with 31.6 percent of the votes in the UK It benefitted from the support of disgruntled Conservative voters annoyed that Brexit has not yet been delivered. The Liberal Democrats, which campaigned on a clear platform of “Remain,” did much better than the polls had predicted, claiming second place. They benefitted from disillusioned Labour voters put off by the party’s ambiguous stance on Brexit and a second referendum. The big losers were the UK’s two traditional parties, Conservatives and Labour, both suffering from bitter in-fighting over Brexit. The former, in particular, languished with a mere nine percent of the vote, its worst performance in any election in its history.

Traditional parties lose significant support
Breakdown of UK seats in the European Parliament
The Brexit Party 29  
UKIP 24  
No deal Brexit Parties 24 29 +5
Change U.K. 0  
Lib Dems 1 16  
Greens 3 7  
SNP 2 3  
Plaid Cymru 1 1  
Anti Brexit Parties 7 27 +20
Labour 20 10  
Conservative 19 4  
Mixed/Ambiguous Brexit Views 39 14 -25
Others 3 3 0

Source - European Parliament, BBC, RBC Wealth Management

The fallout

The elections are having a profound effect on the Conservative Party. Even before the results were out, Prime Minister Theresa May succumbed to party pressure and announced she would resign as Conservative leader on June 7, though she will stay on as prime minister until her successor is chosen. Leadership candidates are adopting a more aggressive tone towards the EU, including a willingness to pursue a no-deal Brexit if necessary in order to reverse the exodus of voters to the Brexit Party.

Labour, aware its ambiguity cost it dearly, is shifting its stance towards supporting a second referendum, though with some conditions attached, for now.

What happens now?

The Conservatives hope to install a new leader—who will inherit the role of prime minister—before September. The process will see the 313 Conservative Members of Parliament select two candidates (among the 11 who have declared their candidacies so far) to stand in a run-off to be decided by some 120,000 Conservative party members. Polls currently favour former Foreign Secretary Boris Johnson, but it is too early to predict whether he will emerge as the winner. Over the past 50 years, only once did the early favorite clinch the top role. His closest challenger is Dominic Raab, the former Secretary of State for Exiting the European Union, though he trails Johnson by a wide margin at present.

Given hardening attitudes towards Brexit in Conservative circles, it is highly likely an ardent Brexiter will become party leader on the platform of pushing for no deal if necessary. In April, a Conservative Home survey found that 75 percent of party members supported no deal.

But the same complex political environment—a minority government, a bitterly divided party, and a polarized Parliament—will greet the next prime minister. Moreover, a prime minister who is a hard Brexit proponent is likely to have even less political capital than May had in Europe, particularly as the EU Parliament will receive 29 potentially highly disruptive members from the Brexit Party.

Much to accomplish in very little time
Timeline to Brexit day
May 24 PM May announces she will step down
June 10—14 Nominations for Conservative leadeship close
June 18 Conservative MPs start voting in secret ballot
June—July 2 remaining candidates put to a vote among 120,000 party members
3rd week July Parliament summer recess starts
September 3 Parliament returns from summer recess with new PM
Sept 29—Oct 2 Annual Conservative Party Conference
October 31 Brexit day

Source - RBC Capital Markets

Probability set

For financial markets, the question is whether a more ardent Brexiter as prime minister increases the probability of a no-deal Brexit, which would likely lead to a substantial loss in economic output, or of a general election, with the prospect of a far-left, possibly fiscally excessive Labour government with a nationalization agenda.

We think so, given the hardening of positions, and we assign a 30 percent probability to a no deal and the same for a general election, slightly higher than is currently discounted in markets. We also see a 30 percent chance of a Withdrawal Agreement being passed, leaving a 10 percent likelihood of Brexit not happening. Given our equal probabilities for these three scenarios, the visibility going forward is clearly murky:

No deal: This outcome remains the legal default on Oct. 31. Parliament has some tools to prevent it, but whether they are deployed effectively and in a timely manner is questionable. Remember that the “Cooper” amendment that previously prevented a no deal from occurring was passed by only a single vote.

General elections: Encumbered by unhelpful parliamentary arithmetic, a new prime minster may seek a fresh mandate from the electorate. A general election under a new leader may be seen as the best alternative to seek this, as it would be less time consuming to legislate for an election and face less opposition from Brexiters than a second Brexit referendum would.

Withdrawal Agreement: An orderly exit is still possible should a new, pragmatic leader try and extract concessions from the EU, using a no-deal Brexit as a bargaining chip—a strategy May had eventually refused to use. While the EU may grant small concessions, we doubt it would substantially change the Withdrawal Agreement, particularly with respect to the Irish backstop—that would mean treating a departing member state more favorably than an existing one (Ireland). The new prime minster could try and sell the hardly altered Withdrawal Agreement to the House of Commons, as being presented by a fresher face may make it more amenable to Brexiters and improve its chance of passing.

How to approach UK financial markets

With this hanging cloud of political uncertainty, market expectations for the Bank of England to increase rates are being firmly pushed out to 2020. The pound has come under pressure on the back of the flare-up in political frictions, falling from 1.318 versus the U.S. dollar just over a month ago to 1.2653. Greater volatility is likely, in our view, as Brexit uncertainty persists through the summer.

U.K. 10-year Gilt yields slipped below 0.9 percent, from a high of 1.2 percent, over the same period. We maintain a Market Weight stance on UK government bonds with a bias towards short-duration positioning. We also see the yield pickup for UK corporate credit as attractive and retain a Market Weight allocation, though we recommend a selective approach.

We are also Market Weight UK equities, which offer good value on a FY2020E price-to-earnings ratio of 11.6x. We think selectivity is prudent and continue to prefer globally diversified companies.

Required disclosures

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.