The Brexit drama has dragged on longer than most folks imagined it would. The British system of government seems ill-equipped to resolve a problem of this magnitude in an environment where Parliament is so fragmented and there is little cohesion even within parties. Market participants who were tired of hearing about Brexit three years ago still react to each headline on their screens, even if that reaction is sometimes dread. This week there may finally be a glimmer of hope for these harried paper-pushers. Not hope that the UK and the EU will come to a miracle solution that sets the table for economic growth in both the Continent and the Isles, but rather hope that we can finally stop talking about it and that the interminable uncertainty will be behind us.
This sense of an ending began when Boris Johnson reached a new agreement with the EU. 1 1 Close Washington Post: “U.K. and E.U. approve new Brexit deal, setting up potentially close vote in U.K. Parliament,” 10/17/2019. Of course, coming to agreement with the EU is not enough. Theresa May was able to do that multiple times. 2 2 Close The EU has redefined the term “unrenegotiatable.” If it was a term to begin with. The challenge is to come up with an agreement that can pass through Parliament. The biggest sticking point has been how to treat Northern Ireland. Many folks in Northern Ireland, including the leaders of the Democratic Unionist Party (DUP), do not want a hard border with the rest of Ireland, but also don’t want any kind of restriction of trade or movement with the rest of the UK. In other words, post-Brexit Northern Ireland wants to be a part of the European Union and not part of the European Union at the same time. It sounds like a paradox concocted by British empiricist philosopher David Hume. Theresa May had to some degree punted on it with the backstop in her agreement. The much-maligned backstop said that the UK and the EU would try to work something out, but if they didn’t they would maintain an open border between the EU and Northern Ireland. 3 3 Close To do so, Northern Ireland would have to remain under EU law – there was some concern that this would mean the rest of the UK would remain under EU law as well. Boris Johnson’s plan attempted to resolve the issue by keeping open trade on the island of Ireland and creating an effective customs border in the Irish Sea. Customs rebates would be used to support continued trade between Great Britain and Northern Ireland. If enacted, it will be interesting to see how enforcement works in practice.
Part of what has made Parliamentary approval so difficult is that the DUP, which has voted against previous and current agreements, is part of the ruling coalition. However, the new plan could still pass if it got support from a few MPs from other parties such as some independents or Labour folks from Brexity districts or maybe just a few who want this to end. Unfortunately, in the UK it’s never that simple. On Saturday, Parliament passed something known as the Letwin Amendment, which said that the agreement could not be confirmed before its implementation is legislated (whatever that means). 4 4 Close BBC: “Brexit delay voted through by MPs: What has just happened?” 10/19/2019. From a practical perspective, it means that there is no agreement in place, so according to another piece of legislation known as the Benn Act, Boris Johnson was obligated to write a letter to the EU asking for an extension, something he vowed he would never do. 5 5 Close He had said he would rather be “dead in a ditch” than ask for such an extension. That may have been because he wanted to keep the threat of a no deal Brexit credible. Reuters: “No more delays, UK PM Johnson appeals to parliament to back Brexit bill,” 10/21/2019.
Boris Johnson did send a letter asking for a three-month extension, but he didn’t sign it. He also sent two other letters. 6 6 Close Financial Times: “Boris Johnson asks for Brexit extension in 3 letters,” 10/19/2019. One was signed by the UK’s representative in Brussels asking the EU Secretary General to read the first letter. 7 7 Close It seems the purpose of this letter is to point out that the first letter complies with the Benn Act despite lacking a signature. The other said that the extension requested in the first letter would have a “corrosive impact” and was generally a bad idea. Johnson signed that letter. The European Council President Donald Tusk seemed to like the first letter better than the third and has advised that the EU should grant the extension.
The withdrawal agreement went to Parliament, where it was approved for a second reading by a majority with some cross-party support. End of story? Is Brexit complete? Not so fast. Parliament still must give final approval to the deal and all of its details. The MPs want to take some time to digest it, because they also voted not to “fast-track” it, so Brexit cannot be completed by the deadline at the end of the month.
Financial Times: “Boris Johnson wins Brexit deal vote but is thwarted on deadline,” 10/22/2019.
If the EU doesn’t approve the request for an extension, then we get a no-deal Brexit. In the interim, this may trigger Operation Yellowhammer, the contingency plan for a no-deal outcome. Sometimes it seems that this whole Brexit thing may just be an excuse for some MPs to say, “we are triggering Operation Yellowhammer.”
Michael Gove, 10/20/2019. A yellowhammer is a songbird, but the name was picked randomly. Some have alleged that there was an Operation Black Swan and an Operation Kingfisher, but officials have denied that any plans with such dumb names have been considered.
This delay shouldn’t lead to panic in asset markets. Unless there is something unwelcome hidden in the details of the 110-page agreement that will only become evident on a second reading, the votes should be there to pass it. There will probably be another parliamentary election, but at least we may finally get some certainty on how the UK will leave the EU. Many articles in the financial press have attributed the recent weakness in UK economic data to this mysterious thing we call uncertainty. As quants, we find it very difficult to evaluate something as nebulous as uncertainty, but this agreement may give us a rare opportunity to observe it in real time. If we see the agreement pass followed by big pick up in business investment in the UK, then it is likely that Brexit uncertainty had been holding back growth.
The markets, especially global equities, seem to be pleased with the improvement in tone on Brexit. Our in-house “Brexit Portfolio” seems to be indicating a lower probability of a hard Brexit. Still it will be instructive to see how local UK assets perform after we get some certainty on Brexit. Even in a best-case scenario the UK faces some serious questions about its economic model. For the past twenty-five years, the UK has been financing large current account deficits with capital inflows into the financial sector and the London property market. This may prove unsustainable if investors look to other places to park money post-Brexit. The next parliamentary election may be about what that economic model will be. It could determine the long-term performance of British assets. As far as what the best economic strategy would be for post-Brexit UK, you can write at least three letters on that.
What We Are Watching
U.S. FOMC Meeting (Wednesday)
Policymakers at the Fed decided to cut rates at each of the last two FOMC meetings, responding in particular to “sources of uncertainty” such as “slower growth abroad and trade policy developments.” 10 10 Close Transcript of Chair Powell’s Press Conference, 9/18/2019. Officials have largely framed these moves as providing insurance against downside risks and have emphasized that the baseline outlook for the U.S. economy remains positive. The forecasts published alongside the September FOMC meeting showed that only a minority of meeting participants thought another cut was likely to be necessary in 2019. Nonetheless, signs of continued deterioration in global and domestic data (more on this below) have led market participants to price in a high probability of additional cuts this month and beyond. If the Fed chooses to leave rates unchanged or if a rate cut is accompanied by hawkish guidance, it could lead to weakness in both stocks and bonds.
U.S. GDP (Wednesday)
U.S. economic data has shown signs of weakness in recent months as the global manufacturing slowdown and heightened trade tensions appear to be weighing on some areas of domestic activity. Household consumption appears to have moderated after a very strong second quarter but should remain a positive contributor to headline GDP growth. The environment appears more challenging for investment, as the ISM Manufacturing PMI has fallen into contractionary territory and durable goods data has shown declines in capital goods shipments. 11 11 Close Census Bureau, ISM. One bright spot may be housing activity, where indicators such as housing starts and new home sales have pointed to improvement after several quarters of weakness. Next week’s GDP data will inform the debate over recession risks in the U.S. economy. A weak number could fuel concerns that growth is stalling despite the Fed’s recent rate cuts.
U.S. Employment Report (Friday)
The unemployment rate is widely considered to be the best summary statistic of labor market strength, and on that metric the U.S. labor market appears quite healthy. While employment gains have slowed from an average of about 220k per month in 2018 to around 160k in 2019, this may reflect labor supply constraints, as low levels of unemployment make it difficult for employers to find qualified workers. 12 12 Close Bureau of Labor Statistics. Next week’s data will provide an update on how the labor market is responding to slower economic growth. Payrolls this month were likely impacted by a prolonged strike at a major U.S. automaker. If other sectors also show weakness in the September data, it is possible that the headline job growth figure could fall below zero for the first time since 2010. Such a disappointment would likely have significant market impact in the current environment, weighing on equity market sentiment and boosting fixed income.