OCBC OneWealth App– Brexit Part II

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Brexit Part II

17 December 2019

Labour’s loss is Tory’s gain

The UK voters have spoken. Get us out of the European Union, they said firmly, evidenced by the sweeping majority won by the Conservative Party which ran on a platform of delivering a quick Brexit.

“Get Brexit Done” was their slogan. The electorate responded strongly to that simple message, delivering a stunning rebuke of the Labour Party’s seemingly confounding message on Brexit. Constituencies that had once been Labour Party strongholds for decades since World War II unexpectedly swung to the conservative end of the political spectrum.

Importantly, these were areas that had voted for Brexit. And just like that, a blue curtain swept over a once impervious red wall, delivering the worst election result for the Labour Party in more than 80 years. The Labour Party won only 203 seats in the House of Commons, down 59 seats from 2017 (Chart 1) and the lowest number of seats in parliament since 1935 (Chart 2). The party’s share of votes during the election declined from 40% in 2017 to just 32% this year (Chart 3).

The electoral earthquake has left the party reeling, trying to make sense of the stunning flip in support, especially among working class voters who until very recently almost always denied victory to the business-friendly conservative elites in their respective constituencies. The Labour Party’s epic failure has led to the resignation of Mr Jeremy Corbyn as the party leader.

Labour’s loss was necessarily Tory’s gain. After all, politics is a zero-sum game. The Conservative Party won 365 seats, a gain of 47 seats from 2017 when then-Prime Minister Theresa May called for snap elections. The Tory Party delivered their best performance since the hey days of conservative politics under Margaret Thatcher in the 1980s. Interestingly, the share of votes for the Conservative Party and the number of seats won per election has crept up gradually since 1997, perhaps reflecting a gradual shift in political preferences among UK voters.

In any case, with an 80-seats majority in the House of Commons, the election has given Mr Boris Johnson a strong mandate to “get Brexit done” and pass a conservative agenda.

The political gamble paid off. Now what?

Indeed, Mr Johnson’s political gamble has paid off handsomely. He did exactly what Mrs May had hoped to achieve in 2017 but failed to deliver. With a strong, outright majority, Mr Johnson need not engage in the types of backdoor negotiations and compromises in the name of alliance building that have been characteristic of parliamentary negotiations over the past three years, just to get his Brexit deal through. Importantly, all the conservative candidates who ran for election had pledged their support for his deal, meaning that he will also be able to avoid the type of internal dissension that had plagued both his Mrs May’s term in office.

Exiting the European Union by 31 January 2020 looks more or less like a done deal.

An outright majority also affords Mr Johnson the rare flexibility to pass a conservative agenda through the House of Commons which could include higher government spending. Some fiscal stimulus and a meaningful decline in Brexit uncertainty should help support the UK economy in 2020.

Unsurprisingly, the Pound has priced in such optimism, having jumped more than 2% on news that a Conservative majority was in the bag. Investors may also be relieved that the Labour Party’s far left socialist agenda including the nationalisation of key industrial sectors and steep increases in taxation rates for high income earners and corporations have fallen by the wayside.

A withdrawal agreement is different from a trade deal

Yet, it’s premature to celebrate the end of Brexit. Alas, passing the divorce bill only marks the beginning of the real work ahead.

After the withdrawal agreement is passed in parliament and the UK officially exits the European Union on 31 January 2020, the country will enter a transition period where EU and UK officials will negotiate a new trade deal.

This would go into the mind-numbing specifics of tariff rates, regulations governing the movement of goods and services and all other associated trading rules. If many thought the divorce proceedings were painful, negotiating an entirely new and lasting trading relationship between the EU and the UK might be excruciating. Moreover, the negotiation timeline is tight, given that the transition period ends on 31 December 2020. Without an extension, the UK faces the equivalent of a no-deal Brexit if a trade deal is not agreed by the deadline.

Unfortunately, Mr Johnson has handcuffed himself to an unrealistically tight timeline by ruling out an extension of the transition period beyond December. To begin with, he has far less than a year to negotiate a new trading arrangement given that negotiations are not expected to start immediately after 31 January. EU officials have said that it would take a few weeks for all the remaining 27 members of the EU and the European parliament to agree on a negotiating mandate, which means official talks should begin sometime in March.

This leaves Mr Johnson with less than ten months to arrive at a comprehensive deal that other countries had taken years to negotiate. For perspective, Canada took nine years to finalise a trade deal with the EU.

Admittedly, with his new parliamentary majority, Mr Johnson is less beholden to his campaign pledges and might seek an extension anyway. Also, with the diminished influence of Brexit hardliners in the Conservative Party given the solid majority, Mr Johnson could easily yield to a soft Brexit. The market seems to be pricing such an outcome. But these are yet uncertain variables that will only get clearer with time. It remains to be seen if Mr Johnson could credibly swing to the other direction after having maintained a hard Brexit posture for much of his time in office.

If indeed the December 2020 deadline remains non-negotiable and talks do fall through, Mr Johnson’s Brexit deal leaves little in the way of a trading safety net. Mrs May’s deal would have “trapped” the UK in a single customs union which would ensure minimal disruption to trade. In contrast, Mr Johnson’s deal would essentially trigger a no-deal Brexit, where the UK will trade with the rest of the EU on World Trade Organisation’s (WTO) terms. This would be greatly disruptive as it effectively upends existing regulatory and tariff agreements between the two trading blocs.

The UK could possibly negotiate a straightforward bare-bones Free Trade Agreement with the EU as a last resort to avert a no-deal outcome, but the contours of the negotiations are yet unknown. After all, the EU has little incentive to make the divorce a sweet deal for the UK lest they inspire more defectors.

Positive in the interim, until reality sets in

On balance, the near-term boost to markets is not unfounded. A material easing of a no-deal Brexit risk coupled with higher probability of a fiscal boost should buoy the UK economy in 2020. However, it is naïve to think that animal spirits will suddenly return and spark a robust recovery just because the path to Brexit is clearer. Firms will still have to contend with an uncertain UK-EU trading relationship in the months ahead. This might still curb investment spending and weigh on business sentiment until such time that there is more clarity on the trade front. Things are looking up yes, but it is far from looking picture perfect

Amid these uncertainties, further upside for the GBP might be limited as investors turn their attention to the inherent turbulence that will likely bubble to the surface when the UK starts negotiating a new trade deal with the EU. The outcome of these talks will have long-term implications on the UK’s economic standing. As it stands, without the EU, the UK has limited leverage in securing future trade deals with other countries. At the very least, Mr Johnson should aim to achieve the most frictionless trading relationship possible with its largest and most important trading partner. Short of staying in the EU, this will be a tall order.

Indeed, after three years swaying in limbo, the Brexit story is hardly over. The good news is that it has finally progressed to Chapter 2. Only time will tell if the new chapter is as interminable and arduous as the first.

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