Head - EMEA Investment Strategy
July 11, 2018
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PM May faces growing pressure as two Cabinet ministers quit over Brexit stance
Two years after the UK voted to exit the EU, PM May finally revealed her proposed negotiating stance last Friday. The outline had the initial approval of her entire Cabinet. However, even before the publication of the follow-up white paper, her Brexit Secretary David Davis as well as her Foreign Secretary Boris Johnson resigned in protest. As she reshuffled her government today by replacing the outgoing ministers – and assuming no further resignations follow – it is possible that her Cabinet becomes more cohesive in the coming months.
That said, the situation remains fluid, with two particular concerns. Firstly, the risk of a Conservative Party leadership challenge has risen. Secondly, there is increasing time pressure to not only agree a Brexit negotiation stance but also to come to an agreement that can then be approved by Parliament.
Mrs May has been working with three major limitations: no majority in the House of Commons, a business community increasingly vocal in their demands for a ‘softer’ Brexit, and the need to preserve the Irish Good Friday agreement (the 1998 peace deal between Northern Ireland’s various political factions, the UK government and the Irish government).
Her proposed softer negotiation stance seems to meet three important criteria:
In order to trigger a leadership challenge, 48 Conservative MPs – 15% of the 316 total – would need to write a letter to the Chairman of the Party’s 1922 Committee of backbenchers.
Our view is that an immediate leadership challenge is possible but not probable. A failed challenge would then require a twelve-month wait before another challenge could be mounted. Potential challengers may thus decide that their chances of winning could improve at a later date.
If there is an immediate challenge, PM May could win, but would need a resounding victory for her to remain in control with the power to negotiate with her preferred softer approach. Her credibility and support was helped by the recent successful passage of the EU Withdrawal Bill with amendments through Parliament. In addition, the business community is increasingly vocal about its needs for clarity, as well as for a longer transition period which is more likely to be forthcoming from the EU if the UK softens its approach.
Early 2019 could now be the highest risk period for the worst-case scenario of an early UK general election. This could be one of the consequences of no EU deal achieving majority approval in the UK parliament. To trigger a snap general election at that time, a two-thirds majority vote in the House of Commons would be needed. Recent polls have shown that voting intentions between Conservative and Labour parties are closely matched.
The Global Investment Committee remains neutral in UK large-cap equities, underweight UK small cap equities, and continue to advise reducing Sterling FX exposure into any rallies. The possibility of a leadership challenge immediately or at a later date, as the two-year negotiation period with the EU draws to a close, is likely to increase volatility as well as add further downside pressure on UK assets over the summer.
The asset likely to be the best barometer of sentiment over the coming months is Sterling, which despite being cheap in REER terms - figure 2 - is down 7.8% versus the USD since mid-April. We continue to advise reducing Sterling FX exposure into any rallies.
Longer-term, it is far too early to make a bullish case for UK large-cap equities. Even as a stronger coalition with a softer Brexit negotiating stance is possible, there remains a possibility of the EU deal not being approved, potentially leading to an early UK general election. Even with the Brexit deal approval, we still await the detail at the sectoral level.
In fixed income, Gilts could be a ‘safe haven’ in the coming months despite being expensive, while the likelihood of a second rate rise in August is lessening as the political uncertainty is likely to exacerbate the economic slowdown.