Brexit: Political tail risks on the rise
The results of the European elections have set the UK’s major political parties in drastically different directions. After hemorrhaging support to the Brexit Party, the Conservatives look set to harden their stance on Brexit as the party searches for a new leader and prime minister.
The Labour Party, which suffered big losses to the pro-EU Liberal Democrats, looks set to fully back a second EU referendum shortly. Strong support for the Scottish National Party has renewed its drive for a second Scottish referendum. Altogether, this lowers the odds of a compromise semi-soft or soft Brexit while increasing the likelihood of the more extreme outcomes. The latest sterling selloff reflects heightened political uncertainty
and rising tail risks.
Recent opinion polls for the next general election suggest that frustrated Brexit voters are switching to the newly-formed Brexit Party led by eurosceptic Nigel Farage. This hurts the Conservatives the most, whose support has fallen from around 40 percent in March to 24 percent (last five polls), while support for the Brexit Party has risen to 17 percent. Despite economic risks, the next Conservative leader may benefit politically by taking a hard line on Europe.
According to the bookmakers’ implied odds, the next PM is likely to be a Brexiteer: Boris Johnson (38 percent chance), Michael Gove (18 percent), or Dominic Raab (18 percent). On its own, this would raise the hard Brexit risk. The impact of the Conservatives’ drubbing in the European elections and their slide in the opinion polls suggest the hard Brexit tail risk has risen significantly. We now put it at 35 percent, from 25 percent previously.
A genuine hardliner, Raab pushed for a harder stance when he headed the UK side of the UK-EU negotiations. The hard Brexit risk could rise further if he becomes PM. Johnson and Gove are more pragmatic. Instead of going head first for a hard Brexit, they will likely try to pass a deal. With luck, they might have the pro-Brexit credentials to unite their party and pass the Withdrawal Agreement. However, market participants see a 40 percent chance that the UK will pass the Withdrawal Agreement plus a compromise for future UK-EU trade eventually, down from 55 percent.
Even though a majority in parliament is against a hard Brexit, it remains the default option on October 31 unless the UK passes the Withdrawal Agreement or changes its mind on Brexit. The chance that the EU would agree to a third extension just to prevent a hard Brexit is low. However, for a snap election or second referendum that could be a different story.
Market watchers raise the probability of no Brexit to 25 percent from 20 percent, while nudging up the risk that Labour leader Jeremy Corbyn eventually becomes PM to 25 percent from 20 percent previously.