Sliding toward a no-deal Brexit and a US recession?

A couple of things today.

The default is no-deal, the base case is extension of article 50

I waited until the bust settled on the no-confidence vote before I decided to write again about Brexit. It was clear that the fear of Corbyn as PM would cause Conservative MPs to hold together. And the DUP has long said they would back May in a no-confidence vote. But, notice that May would have lost the no-confidence vote without their support. So, it is vital now that she return the favor by working on an Irish solution they can accept.

On the situation overall, think of there being three basic factions in parliament: one has the hardcore leavers. Three years ago, they would have bitten their arm off for a deal like Theresa May’s. And, indeed, they espoused such views before the referendum. But, as things have progressed, group-think has shifted their position to the right. Boris Johnson is an example. Then, there are the MPs, both pro-Leave and pro-Remain who are in the pragmatic middle, believing they need to implement the will of the people. And so, they support Theresa May’s deal. Michael Gove is a perfect example of these. And then, there are the Remainers, who never wanted to leave the EU and still don’t. Dominic Grieve is an example.

Not one of these factions has a majority in parliament. And so, not one single Brexit option enjoys majority parliamentary support. That makes an exit from the EU without a deal the default case. Unless the UK does something, it will leave without a deal. And so the clock ticks toward that outcome every second.

The ticking clock is the key constraint in all of this mess. And because of that ticking clock, and the risk associated with no deal and its unpopularity, it is likely that the UK will attempt to stop it. We’ve heard grumbling about doing so for some time. But as the deadline grows nearer, those grumblings have increased to the point where even Theresa May is admitting as much.

Because of the political situation, you have to ask for a delay first. You can’t just revoke Article 50. Otherwise it seems like you’re trying to stop Brexit. If you don’t get the delay, you are basically forced to revoke Article 50 and start again. But if you get that delay agreed by the EU27, you try and renegotiate the troublesome bits of the Withdrawal Agreement. If that fails, you either get another extension or you have a referendum.

If the referendum is for Remain, you simply revoke Article 50. For me, everything points toward delay or revocation to stop the clock because a no-deal Brexit is so reckless. But don’t let anyone tell you one option or the other is more likely now than before. That simply isn’t true. This is pure chaos. And how the markets will react is as unknowable as what the outcome will be.

The shutdown is harming growth

When I wrote you the other day about three economic policy debates, I was thinking about catalysts to a non-garden variety style recession. And certainly, a no-deal Brexit is one possible catalyst. The US government shutdown is another.

The partial government shutdown is inflicting far greater damage on the United States economy than previously estimated, the White House acknowledged on Tuesday, as President Trump’s economists doubled projections of how much economic growth is being lost each week the standoff with Democrats continues.

The revised estimates from the Council of Economic Advisers show that the shutdown, now in its fourth week, is beginning to have real economic consequences. The analysis, and other projections from outside the White House, suggests that the shutdown has already weighed significantly on growth and could ultimately push the United States economy into a contraction.

While Vice President Mike Pence previously played down the shutdown’s effects amid a “roaring” economy, White House officials are now cautioning Mr. Trump about the toll it could take on a sustained economic expansion. Mr. Trump, who has hitched his political success to the economy, also faces other economic headwinds, including slowing global growth, a trade war with China and the waning effects of a $1.5 trillion tax cut.

Speaking of the trade war, eight of China’s provinces have cut their growth levels for 2019. And the trade war is seen as the culprit. But the Chinese are pulling out all the stops now. It does seem the central bank is adding liquidity at a massive rate. The US doesn’t have that option. On both the fiscal and monetary fronts, we cannot expect a robust reaction to falling growth.

The key here is corporate debt.

UBS estimates there’s a record $4.3 trillion in lower-quality corporate loans and high-yield bonds – up from $2.4 trillion in 2010 – that could begin to see rising defaults if the healthy U.S. economy starts to wobble.

“I view this as the most severe threat to the economy and financial system,” says Mark Zandi, chief economist of Moody’s Analytics.

And, indeed it is. There is a lot of BBB rated paper that is trading like its high yield, simply because it is high yield. Low rates starved investors of yield. And so, investors have had to take on risk or duration to get yield.  Investors’ willingness to take on risk to get that yield has allowed these BBB-rated companies to have access to funds at low rates. But the tide is now turning. And, when the economy droops and default rates begin to rise, there will be a wholesale re-pricing of risk. These firms will see a sudden stop of capital. And the world will change overnight.

The shutdown brings that day closer. Of course, it also makes the likelihood of Fed cuts higher. But, the Fed is working with a very limited arsenal to counteract these forces. It will quickly be overwhelmed.

Moreover, in Europe, where interest rates are still negative, the cyclical policy arsenal is even more limited. There is no rate policy runway and the stability and growth pact means there is equally no fiscal runway either, especially in places like Italy.

So I want to come full circle to Brexit. It’s ironic that the Brits would be the first to try and leave the EU since the UK has a great deal, opt-outs and its own currency. And Brexit has been utterly shambolic thus far. That has to put other countries off from even attempting to leave the EU. But when the next cyclical downturn hits, the lack of policy space will make the EU a living nightmare. And so, despite the farce now ongoing in the UK, we could well see groundswells of anti-EU sentiment take form and threaten to rip it apart.