July 30, 2019

The UK is scheduled to leave the European Union on October 31, and while Boris Johnson’s rise to prime minister answers one BREXIT unknown, a host of others still remain, leaving Britain’s divorce from the EU far from resolved at this point.


As Prime Minister Johnson enters office, he faces the same challenge that led to Theresa May’s resignation: The divorce deal negotiated between the UK and the European Union has been rejected by parliament multiple times. As the situation currently stands, the House must approve the deal by the October deadline or Britain will suffer a disorderly crash out of Europe.


The promise of Johnson’s premiership, though, is to reopen negotiations with the EU to strike a new and better bargain for the UK; so far, European authorities have rebuffed that idea. But the prime minister appears resolved, and although he indicates he’s not pursuing a “no-deal exit” from Europe, Prime Minister Johnson has said he’s willing to accept that outcome to deliver on the government’s BREXIT obligation. With this backdrop in mind, the London-based consultancy, Oxford Economics, assigns roughly equal probabilities to the three outcomes of “deal,” “no deal,” and extension beyond the October 31 deadline, while assigning only a 5% probability that the UK will back out of the planned EU exit altogether (Figure 1).

 

“We are going to fulfill the repeated promises of parliament to the people and come out of the EU on October 31, no ifs or buts.”
Boris Johnson — July 23, 2019

 

Potential impacts and risks

Leaving the EU under any scenario carries some cost for the UK. Even assuming an orderly transition, the Bank of England estimates GDP will be lowered by as much as 1% compared to the economy’s prospects had Britain otherwise elected to stay within the European Union.


However, the consequences of a no-deal exit, or “hard BREXIT,” would almost certainly prove more severe. The erection of trade barriers, disruption of supply chains, and loss of preferential access to both EU and non-EU markets would shock the economy, likely tipping the UK into recession in the near term and putting economic growth on a lower trajectory out into the future. In an analysis this spring, the IMF calculated that British GDP could be 3.5% lower by 2020 in a hard BREXIT scenario (Figure 2). The government’s own forecasting body, the Office for Budget Responsibility, projects a 2% hit to GDP over 12 months under such a scenario.

 

Markets are concerned that Prime Minister Johnson’s rise to power increases the risk of a bad breakup with Europe. While that may be true at the margin, we believe that a disorderly exit remains the less likely outcome. Hard BREXIT opposition is strong within parliament, even inside prime minister’s Conservative Party. In addition, the prime minister’s coalition government rules by a thin margin, further putting the his political fortunes on the line. Perhaps in deference to these cross-currents, Prime Minister Johnson has appointed multiple cabinet ministers who either voted to remain in the EU or who have voiced opposition to a no-deal exit. He appears to be signaling good-faith intent at resolving Britain’s exit in an orderly fashion.

 

Wider implications

Even though a no-deal exit would likely result in lasting damage to the UK economy, we expect a less severe impact beyond British shores. Continental Europe would also experience some pain, particularly in the near term, adding unwelcomed drag to an EU economy that’s already slowing. But a shifting of business activity in the continent’s favor would likely accelerate post-exit, helping offset the economic drag suffered by the region.


On a global scale, we believe the effects would be even more modest. Contrary to some of the more sensational assessments in the popular press, we don’t view a no-deal exit as a severe threat to the global economy. Instead, we continue to see Fed policy, trade war developments, and Chinese stimulus as the primary economic drivers over the near and medium terms.


By this point, the possibility of a disorderly BREXIT should be understood relatively well by financial markets and be partially, although not fully, priced in if such a negative scenario plays out. Our underweight to Non-U.S. Equities was established earlier this year to hedge against an assortment of overseas risks, and while our baseline projection is for an orderly resolution to the UK’s BREXIT drama, we believe we’re appropriately positioned to ride out a less favorable outcome should it come to pass.

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