BoAML | The risks of a no deal Brexit have risen in our view. No deal is not our base case, but that is now a close call.
- We think a general election is more likely than no deal on 31 October.
- What is our base case? Persistent uncertainty and elevated downside risks. We illustrate that with a Markov switching model.
Brexit risks have been rising
We detailed our framework for thinking about Brexit negotiations in UK Macro Viewpoint: Primer on Brexit negotiations 02 March 2017. In this game of chicken we initially thought the UK would ‘blink’ first, in the face of economic pressure, and agree to a soft Brexit (see note). But the pressure didn’t materialise. We then thought a hardish Brexit deal most likely, as it traded off economic costs with delivering a key Brexit pledge of restricting migration (see here, here, and here). But parliament rejected the deal 3 times. So we upgraded no deal risks, giving that outcome the same probability as a deal and no Brexit (see here). Where now?
Now no deal close to being the base case
The question is whether no deal should now be the base case: we offer 10 reasons why it should be and 10 more why it shouldn’t. We still think the probability of avoiding no deal is greater than 50%, meaning it is not our base case, but it’s becoming a close call.
General election more likely than no deal on 31 October
Why is no deal not our base case? The biggest reason is that we think MPs would likely trigger a general election if the alternative was no deal on 31 October. Having confidence in what would happen after that would require conviction on the result of an election. It is also possible that the Conservative leadership candidates change their views after the campaign. There are still too many ifs and buts. However, we note that a General Election may just delay rather than prevent a no deal. The question is whether the Conservative Party can unite the Brexit vote better than the centrist and left-leaning parties (Labour, Liberal Democrats, Greens) can unite the anti-Brexit vote.
So risks up but base case remains extended uncertainty
Until we have conviction on the timing of a resolution we think persistent uncertainty is the most appropriate forecast. We illustrate this formally using a Markov switching model. This provides two important insights. It shows how reasonable assumptions about the various scenarios suggest Brexit risks could alone explain markets pricing in a BoE rate cut by mid next year, but that it is more difficult to justify very heightened inflation expectations one to two years ahead.