Global Daily – Brexit scenarios

by: Nick Kounis , Bill Diviney , Aline Schuiling

UK Politics: Less confidence in an orderly Brexit – Given recent political developments in the UK and the difficulties in negotiations between the EU and the UK, we set out a number of scenarios for the UK’s future relationship with the EU.

Orderly Brexit (45%) – An orderly Brexit scenario would require some form of agreement with the EU, which maintains significant and relatively frictionless trade in goods, albeit less than the current situation, while services trade would become more restricted. There would be a transition period, while  the UK would remain in a number of arrangements, or reach new agreements, such as on aviation and financial derivatives trading.

This has been our base case since the outcome of the referendum, albeit with relatively low conviction. Although it remains the most likely single scenario, our confidence in this scenario has recently declined further, and the eventual outcome remains a very close call. This reflects a number of factors. First, the UK and EU remain far apart a two big issues (the Irish border and the post-Brexit economic relationship between the UK and EU). The two sides are not budging. UK Prime Minister Theresa May wants to stick to the Chequers plan, while Donald Tusk, Head of the European Council, said the plan ‘won’t work.’ So there is a possibility the EU and UK will not reach any agreement. Second, even if they do reach an agreement, there is a significant risk it will not gain sufficient support in parliament. Opposition parties look set to vote against the plan, with the Labour party being particularly vocal on this point, while Conservative MPs may also vote against the plan.  There are those that oppose the plan as it represents too close a relationship to the EU, and those that feel it is not close enough.

Why do we still see it as – marginally – the most likely scenario then? The UK and EU could still reach an agreement and compromise as time passes and the prospect of a No-deal Brexit looms. For the same reason, parliament may pass the deal to avoid a No-deal scenario. Finally, if the government eventually collapses, a new government could be returned with a stronger mandate to push through an agreement, whether Conservative or Labour.

Disorderly Brexit (35%) – A disorderly Brexit is one where no agreement is reached. That would have a number of likely consequences. First, there would be no transition period and the new relationship would then begin as of April of next year. The UK’s trading relationship with the EU would be defined by WTO rules. This would mean tariffs on goods trade, but also no customs arrangements. The UK could fall out of other arrangements, such as aviation.

As noted above, a no deal scenario is made possible by the possibility that the EU and UK do not strike a deal, either because of a failure of negotiation or lack of flexibility on either side or simply put because it is not possible to find an agreement that both respects the ‘spirit of the referendum decision’ as the government sees it, solves the Irish border issue and secures some of the economic benefits of trade. If the government falls following a no deal outcome, then it could potentially be re-elected again on the basis of leaving with no deal.

UK remains in the EU (20%) – This scenario is one where the UK either remains in the EU, or the EEA/customs union, as the likely economic implications are similar. If the UK government either fails to reach a deal, or reaches a deal but is unable to get it through parliament, a second referendum could result as a way to break the impasse. The opposition Labour party has become more open to the possibility of a second referendum, but it still seems to prefer the option of trying to trigger new elections and then subsequently resuming negotiations with the EU. The  current Conservative-led government has ruled it out. If there was a referendum, polls seem to now point to a slight lead for remain, but the outcome still looks very uncertain. (Nick Kounis & Bill Diviney)

Euro Macro: German inflation rises on food, energy and core inflation – The preliminary data for harmonized HICP inflation in Germany showed that it increased to 2.2% in September, up from 1.9% in August. No details were published yet for nationwide inflation, but data from Germany’s main regions suggest that the rise was distributed amongst food, energy and core inflation, with the latter mainly due to a rise in the inflation rate of package holidays (which is a volatile item and could well be reversed going forward). Core inflation in Germany has been hovering around 1.2% since the end of 2016 and the most recent number (August) was 1.0%. Considering that Germany’s labour market is one of the tightest in the eurozone at the moment, with some sectors reporting serious labour shortages, it is striking to see how subdued core inflation has remained so far. We think this illustrates the fact that there are very long lags between tightness in the labour market translating into higher wage growth, and also between higher wage growth pushing up core inflation. Besides Germany, Belgium has also already published inflation data for September (up to 2.35% from 2.24% in August). Tomorrow, HICP inflation for the eurozone as a whole will be published. We think the risks to our forecast (headline stable at 2.0%) are tilted to the upside. (Aline Schuiling)

US Politics: The midterms could be more significant than they appear – The 2018 midterm elections take place a little over a month away, on 6 November. At stake is control of both the House (all 435 seats contested) and the Senate (33 of 100 seats contested), and the outcome will decide whether President Trump is able to execute further on his agenda, and potentially even, whether he survives the full term of his presidency. While our base case is that the Democrats win the House, with Republicans retaining the Senate, an interesting risk scenario is if the Republicans were able to retain majorities in both. With growth projected to slow by 2020 on the back of fading fiscal stimulus, and with an eye on the presidential election that year, we think the temptation to pass additional fiscal stimulus would be too much to resist for Republicans in Congress. This would have significant implications for the growth outlook, Fed policy, and markets – with the risk of an overheating scenario. For further detail on the main possible outcomes of the election, see our new publication, The 2018 Midterms – Three scenarios. (Bill Diviney).