Theresa May’s proposed Brexit deal was rejected by parliament yesterday by 432 votes to 202. This was widely expected; going in to the vote bookmakers had quoted odds of less than 5% in favour of the vote passing. The margin by which the vote failed was, however, a surprise – the 230 vote margin of defeat is the largest any government has experienced in history. None of the political groups which had voiced objection to the deal shifted their views, despite May’s pressure tactics. 118 Conservative MPs as well as all 10 DUP MPs voted against the deal.
Opposition leader Jeremy Corbyn immediately called a vote of no confidence in the government, supported by other opposition leaders, which will take place this evening. Based on statements from Conservative and DUP MPs, it currently seems unlikely that this vote will pass. Theresa May has said she will start cross-party talks this week.
Initial market reaction has been positive for sterling. The pound is up 1.3% versus both the dollar and the euro. Equity markets are opening marginally higher in Europe and unchanged in the UK. Bond markets have opened on the back foot, with 10 year gilt yields 4 basis points higher. The reason for the positive reaction in the markets seems to be due to the size of the loss for the government. It puts the emphasis on parliament to get a deal and due to the composition of parliament, this would seem to reduce the probability of hard Brexit.
The key questions now are where do we go from here and what are the investment implications of the different scenarios? Thanks to last week’s amendment in parliament we won’t have long to find out – Theresa May now only has three days to bring an alternative plan to parliament, having lost a key vote sponsored by Conservative pro-remain rebels. This only gives the prime minister until 21st January to come up with a plan B. At present, if there is no deal agreed by 21st January, then the UK will leave the EU on 29th March without a transition period. In addition, MPs have the power to amend any response, following another Commons defeat for the government in December. Both of these amendments have seriously restricted the prime minister’s room to manoeuvre and make it very difficult to accurately predict an outcome.
At this stage, all options are still on the table. However, despite the many possible political outcomes, there are fewer possible market reactions. The most immediate and significant asset price moves tend to be seen in the currency markets, i.e. the price of sterling versus other major global currencies. Hence, outcomes can broadly be divided between those that are sterling positive and those that are clearly sterling negative. Here we order potential outcomes from the most sterling positive to the most negative. The significant implications for other markets are also detailed below.
If an amended deal is passed by parliament it would clearly be sterling positive – scenarios range from a 10% to 20% gain versus the Euro – but it would also have major implications for other asset classes. Bond yields are likely to rise, as the Bank of England has made it clear that once Brexit uncertainties have passed they plan to continue raising interest rates, especially if economic fundamentals improve. This will be negative for long-dated gilt holdings. Credit spreads are also likely to tighten as company fundamentals improve and therefore we would expect corporate bond funds to outperform gilts in this scenario.
In the equity markets the picture is less clear. Other international equity markets are currently being driven by more global factors, in particular the US/China ‘Trade War’ and the actions of the US Federal Reserve. Returning to the UK, FTSE 100 companies have a strong reliance on overseas earnings, and therefore the weaker pound has boosted earnings figures since the referendum. A surging pound may reverse this, but equities will most likely benefit from the overall positive sentiment. The FTSE 100 has underperformed other global equity indices since the referendum and this may start to reverse once we have clarity. For domestic focused UK equities, and in particular most FTSE 250 companies, any deal will be a clear positive.
The opposite is to be expected in a ‘no-deal’ scenario. We would expect sterling to drop strongly, bond yields should fall (as talk of a Bank of England rates cut will emerge), credit spreads should widen and domestic UK equities will most likely underperform. A Corbyn government would most likely lead to such similar outcomes, except that bond yields could rise due to Labour’s plans to meaningfully increase government borrowing.
Given the significant tail-risk, which cannot be ruled out, we continue to advocate a cautious stance through lower equity weightings and higher cash levels ahead of any resolution.
Senior Fund Manager