Brexit – Markets will only pay attention if ‘No-Deal’ becomes a reality.

After twenty months of political brinkmanship and the painstaking negotiations of a small army of technocrats, the UK parliament votes on Tuesday on a Brexit deal that Theresa May’s government has negotiated with the EU. The vote is almost certainly going to fail.

What happens next will be a function of the margin of the defeat. In the event of a narrow defeat the government will likely fight on, hoping that a combination of arm-twisting and word tweaking will allow them to rescue the bill and put the vote to parliament once again. This outcome however seems unlikely. Up to 100 Tory MP’s have stated that they oppose the bill. Combined with the opposition of most of the Labour party and the Liberal Democrats, the government could face the prospect of defeat by up to 200 votes.

Under a heavy defeat scenario all options come back onto the table, ranging from a ‘No-Deal’ Brexit (where the UK crashes out of the EU with no agreed future relationship), through to no Brexit at all. The intractable problem that both the government and parliament face however, is that after 20 months of fighting, the only thing that is clear is what does not have support, namely all the options currently on the table. There is still no majority, either in parliament, or in the British public, that supports any alternative.

At face value then, there seems to be a great risk of chaotic disruption. Yet to-date, financial markets have taken the unfolding Brexit mess largely in their stride. The reason for this is that the only outcome that could really rattle financial markets is a ‘No-Deal’ Brexit. The current proposed deal with the EU keeps the UK closely aligned with the single market. (In truth it leaves the UK as closely aligned as is possible, whilst being able to reinstate immigration controls – one of the key drivers behind the vote to leave).  Thus, from a financial markets point of view, both the current deal, or no Brexit (i.e. the UK remains in the EU) are both neutral to positive developments.

A ‘No-Deal’ Brexit however would have enormous consequences which markets have not yet priced in. To put the impact of a ‘No-Deal’ Brexit into context, the Bank of England recently warned that it could cause a recession as destructive as the 2008 financial crisis. Despite the shrill cries of the British tabloids, the reality of what a ‘No-Deal’ Brexit means has not been lost on the clear majority of British MPs. By some estimates, up to 90% of MPs oppose a ‘No-Deal’ outcome.

It is for this reason that markets, to-date, have ignored most of the chaos, the narrative being that parliament will not allow a small minority to burn the house down.

Where financial markets would start to worry however, would be if the small minority in favour of a ‘No-Deal’ outcome were able to take control. What they have in their favour is that on the defeat of the deal on offer, a ‘No-Deal’ outcome becomes the default option with very little time to find an alternative solution. Most of the commentary about what happens next focuses on two probable outcomes.

1. Parliament decides to hold another referendum where the public can directly vote on the proposed deal with the EU.
2. Or, that an alternative deal is put forward which is based on the EEA model that countries like Norway use. This model would leave the UK even more closely aligned to the EU than the deal on offer (and with no ability to control immigration) and is therefore hated by the hard-wing of Brexiteers.

Neither of these outcomes would seem to pose much of a concern for markets however, as the key metric remains that both MP’s and the population at large do not support the ‘No-Deal’ option. The greater risk however will be what, if anything, happens to Theresa May herself. If she is removed from her post by her own party, the likelihood that she is replaced by a Hard Brexiteer is very high. While Conservative members of parliament would select a short-list of potential new candidates, it is the rank and file members who pick the leader. This small section of the population overwhelmingly favours a ‘No-Deal’ Brexit. Thus, one plausible route to force a ‘No-Deal’ outcome would be to replace Mrs May with an ardent Brexiteer while running out the clock between now and 29 March next year, when Brexit takes effect. It is these less talked about scenarios that markets will be most keenly following.

One of the most endearing British qualities is an ability to muddle along through both dreary weather and the most trying of circumstances. So long as financial markets continue to believe that a ‘No-Deal’ Brexit remains highly unlikely, the final push towards a Brexit consensus should be a relatively uneventful affair for markets. If, however, the risks of a ‘No-Deal’ Brexit begin to rise, the rain will really start to fall over London.