This is going to be a quick post to update you on where I think things are headed now that we have the two final candidates for UK Prime Minister. My overall view continues to be that the base case is for a moderate negative economic, assuaged by currency, fiscal and monetary offsets, causing the UK to avoid recession but with longer-term hits to growth from trade frictions and a loss to jobs in the financial sector. The issues now are immigration, the timing of the invocation of Article 50 and the single market.
For more on the economic fallout, see my initial post-vote post on the downside risks introduced by the UK Brexit referendum. Right now, I want to talk about odds for Leadsom and May and negotiating strategies. First, let me say that Leadsom and May were the likely final candidates all along as I highlighted in my first two post-Brexit posts. The reason is clear: The highest profile EU referendum campaigners – Cameron, Osborne, Johnson and Gove – now have all sorts of political baggage. Osborne and Cameron were not in the running. Boris Johnson was toxic post-EU referendum and Michael Gove could not credibly stand in for him given the circumstances behind his standing for Tory leader. And so, Andrea Leadsom was clearly the least-damaged pro-Leave Tory MP that was left to stand. On the Remain side, clearly Theresa May was the only choice given her high profile as a minister and low profile during the campaign.
Theresa May came out with her position very early (see my synopsis here) and I see this as a credible choice. Leadsom has an equally credible outcome from the Leave perspective – if with more downside risk on trade. On the threefold questions, here are some salient points:
- Immigration. May’s position is contentious because she plans to use EU residents in the UK as a bargaining chip. And this has led to widespread alarm. But this is a natural outgrowth of her desire to remain within the EEA. Basically, the UK has no leverage in this negotiation unless it does one of two things. First, it can delay the invocation of Article 50 and second, it can use the EU nationals as a bargaining chip to get a better EEA deal. The reality is that the EU is already applying pressure to the Swiss over immigration controls and access to the single market. And this means that it is unlikely that the EU will bend its immigration position sufficiently to allow a PM May anything but a Brexit lite outcome unless she wields her two weapons to the max. Leadsom has no intention of staying within the single market. So her position on immigration will appeal to the Tory voters because she can credibly say that Britain will be able to “take back control”, meaning Tory voters for PM will know with 100% certainty that their immigration concerns will be addressed well by Leadsom. Moreover, I suspect that Leadsom will use the fact that Theresa May has been Home Secretary for six years while immigration has increased as a weapon against her over the coming two months. This is Theresa May’s Achilles’ Heel
- Article 50. Here May must delay invocation for two reasons. First, she needs to show that she is prepared because that is a big selling point regarding her candidacy for PM. She is the ‘responsible’ choice, if you will. And with that responsibility comes maximum preparation, which invariably means more preparation before Article 50 is invoked. Second, May needs to use this time to increase leverage with the EU because she has campaigned to stay within the EEA. And without delaying Article 50, the clock would be ticking – and that works decidedly against the UK. Leadsom can invoke Article 50 whenever she wants because her goal is to get the UK out of the EU and the only thing that therefore matters is preparing the UK for that eventuality. So the timing of invocation is less important. Overall, I would call this a slight win for May because of the preparation issue. Invoking Article 50 straight away is a risky strategy that opens the UK economy up to more uncertainty on trade and investment in my view.
- Single Market. May’s default position is to negotiate for single market access. But she has not definitively said she would do so. She has the fallback of being able to say that she will try and if the immigration guarantees the EU gives are insufficient, she would pull Britain out of the EU altogether. Leadsom has already said she wants out. And while this is simpler, it is also riskier. Because of the risk of this strategy to trade and investment, I would call this one for Theresa May.
In the end, Tory voters will have to decide how credible May is in her intention to deal with the immigration issue because her positions on trade are safer than Leadsom’s. Moreover, May is more likely to be a sell to Scottish voters because she campaigned for the Remain camp. In my view, this leads to a May victory in September. However, if she proves not credible on the immigration issue, Leadsom could steal the vote from her. And that would mean that Article 50 would be invoked sometime in 2016.
I continue to believe this scenario is bullish for gilts and for government bonds more generally. A 2016 invocation of Article 50 would mean market volatility and pressure on stocks and Sterling and a flight to bonds. In a worst case scenario, it would also mean a decline in investment and consumption that could not be offset by policy – with recession sometime in late 2016 or early 2017.
For my view on the market implications, take a look at this CBC video from a few days back