Our Opinion: 2018

Brexit is heating up

The Prime Minister seems to have broken the deadlock at home with the cabinet agreement on the direction of Brexit. It hasn’t been cost free as two cabinet ministers, two further ministers and two Vice-Chairs have resigned from government.Speculation around further resignations and the potential for a leadership challenge will no doubt ensue.

The hard work of agreeing a deal with the EU can now start in earnest. There are likely to be many concerns from the EU about the UK’s proposals, which points to months of tortuous negotiations ahead.

Meanwhile, the economy has picked up momentum, surprisingly so in recent data releases, raising the risk that the Bank of England (BoE) increases interest rates when it next meets. The uncertainty around Brexit is likely to keep activity subdued in the second half of the year, which will keep the BoE on hold for the time being.

Sterling remains a cheap currency, but lacks a short-term catalyst to see it trade higher. In fact, the risks in the short term are for more weakness until some tangible progress is made on the Brexit negotiations.

Fireworks were expected from the cabinet meeting at Chequers, but it seems that the PM managed to calm tempers enough to finally agree the government’s position on Brexit. That was until Sunday evening, when David Davis tendered his resignation. Only to be folowed by Boris Johnson on Monday.

Davis’s resignation did not come as a complete surprise, as he has hinted in the past that he is unhappy with the way the negotiations are heading. This anxiety seems to have been compounded when the main task of negotiating the EU withdrawal agreement was taken from him and moved to the PM’s office. His replacement, Dominic Raab, is an MP who campaigned for Brexit, which should please some elements of the Conservative Party.

As for Boris Johnson, again his resignation will surprise few given how critical he has been of the PM and her plans for some time now. However, given his profile, especially during the referendum campaign, this is currently being interpreted as much more destabilizing for the PM.

The full details of the government’s revised proposals are about to be published in a White Paper, but the broad thrust is that the UK will leave the Single Market and Customs Union while seeking to remain closely tied on regulation covering goods. The hope is that this would maintain access to the Single Market for goods; as for services, there seems to be less effort to maintain access, but we will learn more on this as the negotiations unfold. At this stage, in their present form, the proposals look like they can break the deadlock in the talks with the EU.

This fresh approach will no doubt frustrate the purest of the Brexiteers, as it significantly blurs the government’s famed “red lines”. Whether or not the Brexit wing of the Conservative Party, buoyed by the Davis and Johnson resignations, feel that this latest approach is enough for them to challenge the PM and force a leadership battle, only time will tell. As things stand, it looks as though the PM would survive a leadership challenge, but this alone may not prevent it.

For the time being, concerns over a leadership challenge will linger. However, having May at the helm of the government should ensure that Brexit is delivered, the key objective of the Brexiteers. A leadership challenge may have unintended consequences that could see this ambition reversed.

On balance, the PM is likely to survive this latest bout of uncertainty about her leadership. Whether she can survive to see the UK leave the EU in March 2019 will depend on how the EU takes to May’s plans. If the EU continue to show no flexibility in the talks, it could force further political ruptures in the UK.

The initial reception to the white paper will be telling. Given the UK’s desire to maintain aspects of access to the single market in goods, cries of “cherry picking” are likely. There is still much to be negotiated for there to be an agreement, but to make progress it feels like there will need to be some flexibility from the EU. The UK has, as expected, conceded a lot, but as exemplified by Davis’s resignation, the government is reaching the limits of what will be politically deliverable.

When it comes to the economy, Brexit continues to weigh on sentiment as seen by the sluggish performance of business investment. The consumer hasn’t escaped unscathed either as higher inflation has hit household incomes. Nevertheless, the economy continues to make steady progress.

The short-term outlook for sterling continues to be clouded by the political backdrop. Although the Prime Minister seems to have broken the deadlock domestically, questions about her leadership will not go away. Every day that we see further delays and disagreements, concerns about the possibility of the UK leaving the EU without a transition deal increase.

But what if there is no deal? In this case, or the risks thereof substantially increasing, Sterling would fall. However, any drop would be contained. This is for a few reasons: first, weaker sterling would likely push inflation higher, prompting the Bank of England to hike rates. Second, sterling assets (equities, property, bonds) would become attractive to overseas investors who would likely start to allocate investments towards the UK, much like what happened in early 2017. Finally, even at current levels, the pound looks undervalued on most measures of fair value.

Further undervaluation of Sterling would unlikely to be sustained, even under a no deal scenario, as the UK economy would eventually return to some semblance of normality.

11th July 2018