AXA IM's David Page: UK reaction: No Brexit scare, deadline shifts to Halloween

After a frantic few weeks of Brexit news flow , this week had been eerily quiet. The government had continued with cross-party discussions with no obvious signs of progress. The Prime Minister had conducted a quick tour of Europe (Germany and France) in advance of the European Summit. And yesterday’s European Summit, for all it’s 5-hours of debate and difference of opinion between nations, delivered a broadly expected extension Article 50. The actual date of the extension was new, an effective 6-month extension to 31 October – a compromise between EU leaders backing President Tusk’s suggestion of a one-year extension and a push by others, most volubly French President Macron, for a shorter extension.

An extension into the next EU parliament will require the UK to hold EU Parliamentary elections on 23 May and preparations for this have already begun. Prime Minister May reminded that this extension could be shortened if the UK approved the Withdrawal Agreement. This could still see the UK leave the EU and enter a transition phase before it holds elections. We expect the Prime Minister to concentrate efforts in this direction over the coming weeks. Although whether this comes about as a separate vote or as part of a series of indicative votes remains to be seen.

The period of the extension allows the European political process to run its course. European elections will be followed by a change in senior positions at the European Commission, as well as a new budget process. The extension allows the EU to focus on this process without the distraction of Brexit. However, more intriguing for the UK will be what political manoeuvres take place domestically. With Prime Minister May having stated she would resign if her deal was passed, her tenure appears to have a limited shelf-life, although it is unlikely anything will break the domestic political deadlock over the next couple of months. The prospect of a failed bid to pass her deal again over the coming weeks, the risk of a disappointing round of regional elections on 2 May and then European Elections on 23 May could culminate in a breaking point. There is growing speculation that the Prime Minister may choose (or be forced) to step down to make way for a new Tory leader. However, the change of the status quo could unsettle a delicate balance. It is difficult to consider a new Conservative leader that could reunite the party (particularly if they come from the Brexiter wing). Given the already slender working majority the government has even with ongoing support from the Democratic Unionist Party, there appears a rising probability of UK General Elections being initiated over the extension period. This broadens the possible outcomes of how the Brexit process goes from here, with the possibility of a “no deal” exit on 31 October, or further extension in the case of political developments.

Turning to the economy, the range of possible outcomes appears to have narrowed only marginally. The avoidance of a “no deal” exit tomorrow avoids what we think would have delivered a material and sharp contraction to the economy. However, a “no deal” outcome on 31 October (depending on political leadership at the time) is still possible and while preparations for a “no deal” could now be six-months further advanced, we think this will mitigate only some of the economic risk of such an outcome. We would still see the likelihood of immediate (although not so deep) recession if the UK exits without a deal or transition at that time. The UK could also still approve the Withdrawal Agreement over the coming weeks, an outcome that would likely boost UK economic activity (via rebounding business investment, recovering consumer spending, and fiscal stimulus). We would suggest this could deliver growth of 1.3% this year and 1.5% next, something that we consider would prompt the MPC to tighten monetary policy later in the year. However, we consider this an unlikely outcome. Most likely, we see this delay with ongoing heighted uncertainty (with raised domestic political uncertainty) continuing to weigh on business sentiment (although less so consumers). We expect the UK to eke out GDP growth of around 1% this year and next. Such a subdued outlook is likely to result in unemployment gently edging higher and likely leaves the BoE cautious of tightening policy this year. Financial markets appear to have perfectly anticipated this outcome. The unexpected timing of the extension date did nothing to unsettle UK markets. Sterling remained at $1.308 to the US dollar, towards the lower-end of the range of the last two months, with euro sterling similar at £0.863. UK gilt yields are 2bps higher than their close last night at 1.11%, higher than the sub-1.0% lows in March, but otherwise still around 18-month lows, but only modestly underperforming international counterparts (UST’s flat over the same period, Ge Bund yields +1bp). In total, the relatively shorter than expected extension delivered by the EU appears to have kept market uncertainties alive, particularly in the context of a febrile domestic and European political outlook for the next six months.