Two important political developments in the UK over the last week have raised new questions about the Brexit outlook. While there’s still time for a compromise to be reached, we think the risk of the UK leaving the EU without a deal has increased.

Last week’s dramatic events were not entirely unexpected. First, Prime Minister Theresa May announced that she is stepping down. Second, the newly formed Brexit Party cantered to victory in European parliamentary elections. Now, the key question is how these events impact our thinking on Brexit and the broader UK political backdrop.

May’s Departure Resolves Nothing

May’s resignation is not a gamechanger, in our view. The prime minister has been widely condemned for her handling of the Brexit process but that’s not the main reason why negotiations have failed so far. The bigger obstacles have been the refusal of key stakeholders to compromise— including the hard-Brexit and Remain wings of the Conservative Party, Labour MPs and the EU—as well as the failure to find a solution to the Irish border backstop. Neither problem has gone away.

The European election results will make it even more difficult to reach a compromise. The success of Nigel Farage’s Brexit Party (31% of the vote) means it is now imperative for the Conservative Party to deliver Brexit (almost regardless of what it looks like) before facing the electorate again. Meanwhile, five pro-EU parties won a combined 40% of the vote, adding to pressure on the Labour Party to support a second referendum.

New Prime Minister to Face Big Constraints

What happens next? The Conservative Party must choose a new leader, a process that will probably take six to eight weeks. Boris Johnson, one of the leaders of the Brexit campaign, is strongly favored to win this vote and become Britain’s next prime minister—though Tory leadership contests have a long history of delivering unexpected results (May, John Major and even Margaret Thatcher were not initially expected to win). Whoever wins, we can be sure of two things. First, the successful candidate will take a more aggressive stance on Brexit than May. Second, the new prime minister will face several formidable constraints:

  • The Parliamentary arithmetic has not changed. Most MPs still favor either a soft Brexit or no Brexit at all and will therefore continue to resist a no-deal Brexit.
  • The government has a working majority of just six seats. The defection of a handful of disaffected Tory MPs would prompt the government’s collapse.
  • Rising support for the Brexit Party means it will probably be too risky for the new prime minister to call a general election before delivering Brexit.
  • Despite rising support for a second referendum, there is still no majority for this in Parliament.
  • There is no guarantee that the Remain camp would win a second referendum (it’s not even clear what the question would be). The European elections and recent opinion polls suggest that Remain is narrowly ahead but that was also the case shortly before the 2016 referendum.
  • The EU is highly unlikely to reopen the withdrawal agreement. If anything, its position on a further extension of Article 50 has probably hardened.

In light of these constraints, the next prime minister will face an even more daunting task than May did in 2016. The government has lost its majority, the Brexit debate has become even more polarized (making it more difficult to find common ground), Article 50 has already been triggered and the British public and EU leaders are running out of patience.

There are many ways that Brexit could play out in coming months. The EU might buckle and change the withdrawal agreement (highly unlikely), the next prime minister might favor a no-deal Brexit (this would probably be vetoed by Parliament), Boris Johnson might be the one person capable of selling a compromise to Brexit hardliners (good luck with that) and yes, we might ultimately be headed towards a second referendum (though the numbers simply aren’t there yet). Unfortunately, each scenario faces formidable obstacles, making it difficult to have a high degree of conviction in any of them.

Brexit Projections: Refocus on October 31 Deadline

Until now, we have focused our Brexit probabilities on the three possible ways of completing the Article 50 process of withdrawing from the EU: the UK leaves with a deal (55%), the UK leaves without a deal (15%) and remain/revocation (30%). In light of recent developments, it’s clear that the probability of leaving with a deal is too high and that the probability of leaving without a deal is too low.

But focusing on the Article 50 endgame—which could still be some way off—is probably not the best way of looking at developments and how they might affect markets in coming months. Instead, we’re focusing on the October 31 deadline, for which there are three plausible scenarios: leave with a deal, leave without a deal and a further extension (perhaps with a specific commitment to hold a second referendum).

At present, we believe the odds of the UK leaving with a deal or leaving without a deal are about the same at roughly 25%, with a 50% chance of a further extension. If the UK leaves the EU without a deal, we would expect a sharp devaluation of the pound against the US dollar. In the other two scenarios, the pound would probably remain stable or appreciate somewhat from current levels.

It’s important not to overinterpret these numbers. The outlook is highly uncertain and the probabilities are meant to give a rough indication of how likely each one is. They’ll begin to change as we gain further information and insights, including the identity of the next prime minister. That’s when the Brexit fun and games, and resultant market volatility, is likely to begin again in earnest.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

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