A Weakening UK Economy Puts Pressure on Brexit Negotiations

The UK economy had been doing relatively well since the Brexit vote in June 2016, with FTSE 100 large caps typically more affected by global events. However, as the political wrangling over how to leave the European Union without overly damaging the economy drags on, the persistent uncertainty is having a downward pull on business and consumer confidence (Figures 1 and 2).

If the Article 50 process is extended as is becoming likely to avoid a No Funds in Focus Fixed Income Fund RangeInvestor Resources[Quick links]Deal scenario, capital investment could continue to fall short. Businesses waiting on a deal following the March 29 EU exit date could remainon the side lines as the A50 extension prolongs uncertainty, or could finally decide to deploy capital elsewhere. If that happens, then confidence could decline further, leading to a more severe slowdown in economic activity and a rise in UK unemployment. Such an outcome would have significant short to medium term implications for investors and further mar the European growth outlook.

How Soon Will This Be Sorted Out?
The countdown to leaving the EU and the damage done to confidence should focus minds as the debate progresses and eventually coalesce support around a preferred option. But, as we see it, there are three ways this could play out (see Figure 3): the PM eventually gets her revised deal through, Parliament backs a No Deal vote and Article 50 is extended or the UK crashes out without a deal. These are not equally likely.

Today we heard from Theresa May on her proposed “Plan B,” following cross-party talks in which the opposition leader Jeremy Corbyn refused to meet with her unless she ruled out No Deal as an option. As expected, she maintains her Withdrawal Agreement but aims to address the outstanding issue of the Northern Irish backstop, which could keep the UK in a customs union indefinitely if the EU and the UK fail to agree a future trading relationship. She will also aim to engage MPs across Parliament in deciding the future trade agreement with the EU.

Why a Customs Union Wouldn’t Work for the Hard Brexiters
If Plan B is rejected later this month, other alternatives will come to the fore. First and foremost, any credible alternative to May’s deal would require an extension or revocation of Article 50, including any customs union or Norway Plus arrangement. Setting the precedent of one extension as well as allowing yet more time for debate could further weaken the economic outlook and lessen the chance of a Hard or No Deal Brexit. Below we look at the two types of customs union with EU, neither of which Hard Brexiters would accept.

Therefore, the most immediate signpost for investors would be if an amendment to prevent a No Deal succeeds, despite the fact that the Prime Minister has ruled it out. In such circumstances, hard Brexiters could be faced with either not leaving the EU at all or accepting a permanent customs union with the EU. Given that choice, they may be persuaded to back Mrs. May’s deal.

Implications for Investors
In any case, time is running out for the economy.  As noted above, while the UK is not in a recession yet and markets now believe a No Deal is less likely than before, industrial production and manufacturing sales growth has turned negative. While markets have rightly fretted about downside risks in a No Deal scenario, a never-ending cycle of political drama could also be highly damaging. Investors who have been sitting on their hands for months may give up waiting and markets may revise their current view that sterling is attractive on a relative basis, causing it to trade considerably below fair value for a longer period.

In bond markets, only tail scenarios are likely to jolt sentiment, either upwards in a surprise soft Brexit recovery or downwards in a disorderly Brexit that causes an unexpected foreign exchange crisis. However, any substantive weakening in the economy may lead to deterioration in the public finances which are currently in a healthy position. This could cause a steepening in the yield curve and a widening of spreads.