As expected, Boris Johnson won the UK Conservative Party leadership race and with it the keys to 10 Downing Street.
But as he looks to establish his administration and set out a policy agenda over the coming weeks, Johnson faces profound challenges and scrutiny both at home and abroad.
He enters Downing Street at a time of heightened international tensions between the United Kingdom and Europe over Brexit, but also in the Middle East, where the UK relationship with Iran has deteriorated dramatically in recent days. All of these considerations are likely to have significant implications for markets.
Markets Respond to Johnson’s Victory
We’ve already seen some market movement in response to news of Johnson’s leadership victory, and we expect volatility to continue for several weeks as he builds his government.
Yields on 10-year Gilts are around 70 basis points (bps), or 0.70%,1 reflecting an overall decline in yields globally but also weaker UK growth numbers.
While 0.70% 10-year Gilts may not sound attractive to investors, we’d expect to see that number go much lower in the event of a no-deal Brexit.
The pound has also come under pressure against the US dollar and euro, again reflecting concern about the possibility of a no-deal Brexit.
Sterling weakness has prompted some interest from investors outside the United Kingdom who consider it cheap. So, we think any sterling selloff in the event of a no-deal Brexit might not be as much as people think, and/or it could be a quick selloff followed by a swift rebound.
Uncertainty over Brexit is continuing to weigh on UK corporate credit valuations. That is probably going to persist for the foreseeable future until we have some resolution of Brexit.
Still, we see those valuations as an opportunity to own names that are internationally focused (those whose exposure to the UK is minimal), or companies that are focused on the UK domestically. We recognize the UK economy will not disappear completely post-Brexit.
Brexit Countdown Continues
Meanwhile, time is ticking away. Johnson has less than 100 days to find a solution to Brexit, a problem which persists despite three years of negotiation between the United Kingdom and the European Union (EU).
We think no-deal is now a much more likely scenario because it will be one of Johnson’s negotiating points. But just as the United Kingdom is entrenching its position, so the EU could take a tougher line under European Commission President-elect Ursula von der Leyen.
Europe has a reputation for taking an “extend-and-pretend” approach of kicking the can down the road, but could force a no-deal exit, simply by refusing to extend Brexit further.
Holding the Party Together
Johnson inherits a government with a razor-thin majority and will need to ensure he can maintain the unity of the Conservative Party if his administration is to survive. If only a handful of Conservative members of parliament (MPs) were to withdraw their support or even switch party, he’d lose that majority, potentially sparking a general election.
We expect to see a radical overhaul of his cabinet. Quite a few prominent Conservative politicians who seem implacably opposed to Johnson’s agenda are moving from front bench positions to the backbenches where they can more freely articulate their views.
As a result, the new cabinet will likely be dominated by Brexiteers. Johnson cannot have as politically diversified cabinet as Theresa May did because he cannot afford to have waves of resignations every time a disagreement over Europe occurs.
The tenets Johnson set out in his leadership campaign are very much the sort of business-friendly, tax-reduction ideas that we’d expect from a center-right party.
However, with other considerations to address in short order, we expect a period of extreme uncertainty over policy from the UK government.
Johnson’s cabinet will be working hard over August to bring a plan to parliament when it returns from summer recess in September.
But in the meantime, we expect volatility to remain the central theme for European markets.
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1. A basis point is a unit of measurement. One basis point is equal to 0.01%.