Ahead of a crucial vote on Prime Minister Theresa May’s amended withdrawal agreement, the J.P. Morgan Research team examines what’s likely to happen next and looks at the economic and market implications of the latest developments.
The House of Commons rejected May’s previous negotiated deal by 432 votes to 202—a majority of 230. The Prime Minister then narrowly survived a motion of no-confidence. Members of Parliament are currently debating changes to the agreement and are due to vote January 29th, 2019 on the way forward.
With two months to go, how, when and if the U.K. will leave the European Union are still unclear. However, according to J.P. Morgan analysts, the chance of a disorderly “no-deal” Brexit is now very unlikely—at only 5%. Among the latest developments, a majority of MPs appear set on ruling to give themselves the power to direct the Prime Minister to seek an extension to Article 50 beyond the March 29 deadline in order to block a "no-deal" scenario.
This means the probability has grown of an extended stalemate, second referendum or “no Brexit” at all. But at 45%, still the mostly likely outcome is that Theresa May gains support for a slightly modified deal at a second or later attempt. Not as a result of major changes to the deal, but from a growing realization among MPs that other options will not succeed. A second referendum is the next mostly likely outcome at 25%, followed by a general election at 15%—both of which would require an extension to Article 50.
While Brexit-related uncertainty has been a drag on growth since the referendum, recent data shows that heightened uncertainty as the March deadline approaches is affecting confidence and behavior. However, the U.K. labor market remains strong and wage growth is accelerating. That said, with Parliament looking to “take back control,” the risk of Brexit uncertainties pushing into 2Q and beyond has grown.
U.K. stocks have underperformed by roughly 35% relative to the overall MSCI world index over the past few years. As the risk of a "no-deal" Brexit diminishes, their valuations are now trading cheap, balance sheets are very strong and dividend yields look highly attractive. Analysts remain cautious on the overall equity index—FTSE100—and prefer U.K. domestic stocks over exporter plays, and advise adding to homebuilders and real estate. The political backdrop is likely to remain volatile, but in the event of a benign Brexit outcome, U.K. growth momentum is likely to pick up with domestic stocks in real estate, banking and insurance set to benefit. However, any strengthening in the pound is likely to hit U.K. exporters.
The idea of a softer Brexit has prompted sterling to rally. Investor sentiment on the British pound has improved ever since the European Court of Justice unexpectedly ruled that the U.K. had the unilateral right to revoke Article 50. The unprecedented scale of the government’s defeat in Parliament over the withdrawal agreement was more good news for the currency. The broad GBP index has appreciated by 3% since the start of January and is now 1% stronger than its post- referendum average, and GBP/USD could bounce to 1.34.
With the possibility that a delay to the Article 50 deadline, the Bank of England is likely to postpone rate hikes until there is greater clarity on the political process. In the event of May’s amended withdrawal agreement succeeding, ten-year gilt yields could jump to around 1.55% by 2Q19, with yields falling to 1.35% in the event of any delay.
The cost of insuring exposure to Britain’s sovereign debt has spiked amid uncertainty surrounding Brexit. But with the risk of a "no-deal" exit receding, investors have the opportunity to reset any hedges against an adverse outcome or economic slowdown in the U.K. The past couple of weeks has seen a substantial rally in domestic credit default swaps, with most single names retracing 50-75% of their widening from the previous three months.
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