The great Brexit gamble paid off

The “great Brexit gamble” paid off: Prime Minister Johnson got his majority in the House of Commons. The final result is still due, but it is certain that his majority is comfortable enough to get his Brexit-deal through the Commons. The UK will leave the EU by January 31.

At the time of writing, the Conservatives are projected to win 364 seats in the House of Commons, versus 203 for the Labour Party. This would give the Conservatives a 78-seat majority, which is their best performance in terms of seats since the 1987 election. Crucially, the Conservatives have won dozens of Labour seats in the Midlands and the North, piercing the so-called “Red Wall” that belonged to the Labour Party for generations. As a consequence, the performance of Labour is the worst since 1935. It is striking how poorly Labour has performed in working class seats, despite their radical economic programme. This morning, Jeremy Corbyn has announced that he will stand down as Labour Party leader.

While the political context seemed promising for a breakthrough of a third party, this did not materialize. The election had been labelled as an unpopularity contest between Johnson and Corbyn, as both scored negative approval ratings prior to the election. But the leader of the Liberal Democrats, Jo Swinson, didn’t fare any better and even failed to get elected. So even though there were large segments of the electorate supposedly dismayed by Corbyn’s radical policies or Johnson’s demagoguery, the choice between the two was so stark that the other parties have been squeezed (see figures 1 and 2). This is a direct result of the UK’s first-past-the-post system and in our view the reason why Johnson decided to go the ballot box in the first place. Meanwhile, the main opposition for Johnson could come from SNP leader Sturgeon, whose party has gained more than a dozen seats and is expected to press the case for a second referendum in Scotland. It’s a clash waiting to happen.

After the eventual passage and ratification of the Withdrawal Agreement Bill, the UK will only have concluded the first phase of Brexit. It will mark the start of the transition period, which allows the UK to gradually move from full EU membership towards a new but still undefined relationship. The UK remains subject to all EU rules (and the ECJ…) during this period, but loses its say in the EU’s political institutions. It would also require the two sides to agree a new financial settlement and any trade agreements signed by the UK with third countries will not enter into force until the transition ends. While Tory politicians will argue that the UK will consequently be “vassal state” of the EU, this period is crucial to make sure that doing business remains broadly the same, allowing UK businesses and households time to adapt to a new future.

The transition period runs until end-2020, but Prime Minister Johnson has repeatedly ruled out an extension (see box). And even though it has been a long campaign, in which the prime minister visited numerous places for all sorts of staged photo opportunities, he has not been seriously challenged on how exactly he expects to negotiate a trade deal without an extension of the transition period. It is expected to take much longer than the remaining eleven months (Feb-Dec) to really negotiate (“I give you this, and you’ll give me that”) and ratify a free trade agreement.

If the UK indeed uses Brexit to undercut EU regulations –in order to pivot to and strike deals with the United States, for instance– the best trade deal that it can probably get with the European Union is a very basic one. Various EU leaders have frequently flagged the risk of the UK developing into another competitor on the continent's doorstep. So even though the EU’s chief negotiators, Michel Barnier and trade commissioner Phil Hogan, have said that it is possible to negotiate a free-trade deal with the UK in eleven months, it is likely that they referred to an FTA in which the UK still fully adheres to the level playing field provisions, i.e. signing up to EU competition, taxation, labour and environmental rules.

Prime minister Johnson hasn’t formulated a coherent strategy yet, but the EU is already trying to move on. The European Commission is looking for a negotiating mandate, which they should get from the European Council. This may not be straightforward: while Brussels would like to prioritise and then link future relationship issues (e.g. the goods FTA, security, fish, services access, or dispute settlement), several member states may have an incentive to take a bilateral or more flexible approach. We should learn more later today, when the Council publishes its conclusions.

So even if the prime minister will claim that Brexit is “done” on January 31, the uncertainty about a disruptive change to the EU-UK trading relationship is unlikely to vanish anytime soon. While some of the domestically-oriented firms might feel a little more confident, businesses with significant exposure to foreign markets will continue to hold back investment spending until there is more clarity on the depth and breadth of the eventual future trading relationships. This is worrying: investment spending on fixed assets such as plants, equipment and machinery is already 3% lower than two years ago.

Brexit will continue to leave its mark on activity. The latest GDP data show that the UK economy is already flat-lining, growing at its slowest annual pace in seven years (see figure 3). Whilst the economy has avoided falling into a technical recession (i.e. two consecutive quarters of negative growth), it is indeed a discussion on technicalities as the level of GDP in October was actually lower than it was in February. As a consequence, the employment outlook has also started to soften, with growth in jobs slowing down and vacancies falling. The PMI’s, which have long indicated this trend (figure 4), continue to point to very soft conditions.

As Brexit uncertainties will continue to cast shadows on the UK economic outlook, we do not see activity firming into 2020. And whilst previous fiscal measures –introduced in September as part of Spending Round 2019– should provide some stimulus to demand, the Conservative manifesto lacks any fresh and significant policy measures. Unless Prime Minister Johnson reveals a much more ambitious budget in February, we therefore continue to expect quarterly growth rates of around 0.2%-0.3%, which would lead to an annual growth rate of 0.8% in 2020. This baseline forecast is still based on the premise that the transition period will commence in February 2020, eventually extended until the end of 2022, and that the EU and the UK will reach a free trade agreement that commences in 2023. But it should be clear that the risks to this forecast are tilted to the downside, mainly due to the continued risk of either a hard “WTO” Brexit or a relatively abrupt transition towards a basic trade relationship at the end of December 2020.

Currencies tend to react favourably to expectations of a strong, liberal and market-friendly government. The extremely weak performance of “Corbynism” therefore goes a long way in explaining the positive overnight reaction in the value of sterling.

Moreover, the strong parliamentary majority for the Conservatives is vital, as prime minister Johnson should now be less exposed to the Brexiteers of the European Research Group, which have seen their influence rise relative to the moderate Tory MPs. This could give Johnson some more room for manoeuvre, allowing him to change tack and ask –if push comes to shove– for an extension of the transition period.

But this is far from certain, as Prime Minister Johnson has yet to show his true colours. What the market reaction does not seem to take fully into consideration, is that the trade negotiations still have to be tackled. Will the UK pivot towards the US, or do they want to keep close economic ties to the European Union? If these trade negotiations are unsuccessful the UK may still face a disorderly Brexit at the end of the transition period in just over a year’s time. The risk of a cliff-edge Brexit therefore remains. So after an initial period of relief, there will be plenty of scope for sterling volatility in 2020.