Two become one

With the European Union (EU) agreeing to extend the UK’s Brexit deadline by six months to 31 October, critics of the Conservative Party might argue that the two extra quarters afforded in which to strike a new deal have in reality become one, given that the first quarter has been taken up with the Tory leadership election.

While the Spice Girls have undertaken their reunion tour, over the course of the Conservative Party leadership contest, we have seen a dozen or so ‘wannabes’ whittled down to just two, and now one, as Boris Johnson becomes the new prime minister. Pro-Johnson Conservative politicians and party members will be fervently hoping that he will not only ‘spice up’ a divided party, but also re-energise the UK’s Brexit strategy.

The UK’s departure from the EU looks set to be arguably the most pressing issue facing the new prime minister. During the leadership hustings, Johnson underlined his hard-line Brexit credentials by pledging to take the UK out of the EU by 31 October, while he has consistently supported a UK withdrawal from the EU and campaigned strongly for Brexit during and since the 2016 referendum.

Renewed volatility

With markets digesting the latest news, we would expect to see some renewed volatility and uncertainty ahead, as a number of question marks remain over the Brexit terms and negotiations. While we don’t see massive market moves (because Johnson was the clear favourite and this outcome was largely priced in), we would expect some increased volatility in sterling and gilt markets to persist if there is further renewed uncertainty over Brexit, or if the likelihood of a ‘no-deal’ Brexit persists.

Johnson’s stated commitment to leaving the EU by 31 October could have a slightly weakening effect on sterling, unless he makes some more conciliatory comments on negotiating with the EU. At this stage, this seems unlikely. The new prime minister faces some difficult choices: while not leaving the EU on the set deadline (or at all) could be politically damaging for him, a ‘no-deal’ Brexit could also be very economically damaging to the UK.

Economics rule

We would also expect to see further market volatility if the EU refuses to renegotiate the existing UK withdrawal agreement. From a currency perspective, there is scope for sterling to fall further; while it has already weakened considerably in recent weeks, it is also possible that we might see sterling revisit some of the lows it hit just after the EU referendum result in 2016 if there is no sign of movement from either side in any further withdrawal negotiations. That said, on many measures sterling appears cheap, so the scope for it to appreciate is probably greater should the new leader succeed in orchestrating an orderly Brexit (or indeed be thwarted in seeking a disorderly Brexit).

Overall, however, we believe that the recent fall in gilt yields owes less to continuing Brexit moves than to wider national and global economic trends. Gilt yields have broadly dropped in line with US Treasury and German bund yields over the last few months, so while the prospect of a ‘hard’ or ‘no-deal’ Brexit may play a small factor in gilt-yield falls, the key drivers are economic: slower global growth, lower inflation, and the prospect of more accommodative monetary policy from central banks.

Public spending to rise

In wider policy terms, we would expect a Johnson administration to boost public spending and gilt issuance, with Theresa May having already flagged an end to some austerity measures. Some level of contingency for a potential ‘no-deal’ Brexit also seems likely, but we do not expect public spending to rise to the levels we would anticipate under a Jeremy Corbyn-led Labour government.

Beyond government spending, we think the wider UK political picture holds the potential for further surprises. With a divided Parliament and a divided Conservative Party, speculation persists that there may be a vote of no confidence in Johnson’s government with the potential for a snap general election. We think the latter is less likely, but we do see the possibility that Parliament could move quite swiftly to test confidence in Johnson’s administration.

However, while the chances of triggering such a vote are reasonably strong, the scenario of Conservative MPs bringing down their own government without giving their new leader a chance looks far less likely.

Authors

Howard Cunningham

Portfolio manager, Fixed Income team