Boris Johnson has become the new leader of the Conservative party and Britain’s 77th prime minister. Brexit is the reason he is in office, and Brexit will dominate his agenda for his first three months in office. 
We have updated our 'decision tree' accordingly (figure 1). Of course, there are still many unknowns, but stopping at “we don’t know” is not good enough. And there can be quite a lot of information in “we don’t know” if we break down the overarching conundrum into a sequence of smaller questions. When we work our way down the tree to the possible outcomes in red and calculate their conditional probability, we find that they are not all equally likely, even if we have expressed “we don’t know” mathematically at a number of nodal points.
Johnson takes on many of the same challenges faced previously by Theresa May. He will have to contend with a dwindling government majority that makes it very difficult for Johnson to get Parliament to stand by and allow his threat of a 'no deal', 'do or die' Brexit to come to pass. April’s Cooper-Letwin Bill, whereby Parliament took control of Commons business, has set a profound precedent and its implications are likely to be repeated if leaving the EU without a deal – the default option – looks likely. The vote on 18 July to make proroguing parliament extremely difficult established another legal barrier to 'no deal'.
Source: Rathbones
To be sure, it is not off the table, but as we work through our decision tree, it becomes clear to us that 'no deal' is not as likely as some commentators contend. To be clear, this analysis is designed to take us no further than 31 October, hence “delay” being an outcome. The probability of 'no deal' occurring eventually is therefore higher.
Johnson has said that leaving without a deal is not his preferred option and that it has a million-to-one chance of occurring. This makes it rather clear that the embrace of “no deal” is a negotiating tactic - and you don’t have to be an expert in game theory to see that this weakens its ability to function as one.
From past interviews, it is clear Johnson wants existing arrangements to continue until a trade deal is made. He has added that the time it would take to negotiate a trade deal would also be used to solve the questions of the Northern Irish border. We wonder if the UK might push for a formal link between achieving a future trade deal and the payment of the UK’s financial settlement – the so-called 'divorce bill'. This might also be something the EU would likely agree to. But it is not clear that the hardest Brexiters within the Conservative party feel the same way. As such we estimate a 23 per cent chance of the new government passing a withdrawal agreement.
We think it is unlikely that the EU will agree to any more substantive changes, and far more likely that it grants an extension. Our recent research trip to Brussels revealed a willingness from the EU Council to grant an extension of the current deadline to March 2020.
Johnson has said that the UK will definitely leave on 31 October. Certainly, there is very little time for Johnson to resolve Brexit as it stands. The leadership contest has finished just before Parliament’s summer recess, which lasts until early September. The new government will therefore have just seven weeks before the October deadline once it reconvenes. An extension would be expedient. It is possible that the most staunchly pro-Brexit MPs will call a vote of no confidence if he doesn’t deliver, but we think this risk is negligible – what would they have to gain?
If 'no deal' looked likely and a no confidence motion was indeed tabled, the loss of the vote will lead to a general election, if a repeat vote is not won within 14 calendar days. There must be at least 25 working days between the dissolution of parliament and polling day, which means that a vote of no confidence must be tabled before 9 September – the fifth working day after parliament returns from the summer recess – if a new government is to be established before 31 October. This seems unlikely. To our knowledge, there is no precedent for what might happen if the government loses a confidence vote, but remains in charge on the day the UK is set to exit the EU. The route to a second referendum before a general election is harder to envisage now compared with a year ago.
Investment implications
Brexit is not a globally systemic event and non-UK markets are unlikely to move much in response. Only 3 per cent of the revenues earned by US companies originate in the UK; just 6 per cent for non-UK European companies. Even FTSE 350 firms make just 25-30 per cent of their revenue in the UK. Figure 2 assesses the impact of each outcome on five key asset classes. We use a nine-point scale, where ‘1’ represents an extremely positive impact on the asset class, ‘5’ no impact and ‘9’ an extremely negative impact. On the right of figure 2, the orientation of the arrows represents the probability-weighted average outcome.
Source: Rathbones
The exercise shows that exposing portfolios to considerable currency risk by over-weighting overseas assets is perhaps not the best strategy given the current political outlook. “We don’t know” doesn’t lead us to “sell the UK”.
We believe that financial markets are pricing in a much higher chance of a 'no deal' Brexit than our decision tree suggests. On a long-run basis – the only timeframe over which we believe currency forecasts can be made with any certainty – sterling appears very undervalued. This holds even when we hypothesise a highly adverse scenario for the UK economy. If Brexit were abandoned, we expect the pound would go up by more than it would fall should a hard Brexit be confirmed.
A stronger exchange rate would normally weaken shares of multinational companies listed in the UK, holding all other things equal. Remember how the FTSE 100 outperformed immediately after the referendum and indeed for the rest of 2016, before underperforming dramatically for the next 12 months or so as foreign investors sold UK companies indiscriminately, regardless of their exposure to UK revenues. But there is a good case for a softer Brexit resulting in both a stronger pound and a stronger FTSE. That’s because the FTSE is so under-owned by global investors. The equity risk premium applied to the FTSE 100 – the compensation investors demand for assuming the risks associated with future earnings – is as high today as it was during the financial crisis, unlike elsewhere in the world. A number of key UK sectors are trading at discounts to international peers. 
The market in interest rate derivatives perhaps offers the clearest indication that markets are over-weighting “no deal”. Throughout June and July, several members of the Monetary Policy Committee emphasised that while rates would likely be cut in the event of 'no deal' they would gradually rise in any other scenario. Yet the derivatives market still does not price a single rate rise until 2022!
The economic backdrop
Since the referendum, the UK economy has grown at an historically weak rate, weak, also, by international comparison.
Business investment has been particularly hard hit. The Bank of England’s investment intentions survey indicates a contraction of business investment for the first time since the immediate aftermath of the referendum. This is consistent with a swathe of leading indicators of broader economic activity that point to extremely weak growth or contraction. Of course, the rest of the world is also undergoing something of a slowdown, but the UK looks weaker than most western economies.
One of the biggest risks facing the economy is household behaviour. A fall in consumer confidence, coupled with a potential increase in the household saving rate, could result in a slowdown in retail spending. This is despite the lowest unemployment rate since 1974, relatively high wage growth and inflation hitting its 2 per cent target set by the Bank of England despite the weakness of the pound.
The historically close relationship between unemployment and savings behaviour means that the outlook for employment is key. The unemployment rate 3.8 per cent, the lowest since 1974, but job creation has slowed. Were it not for continued growth in self-employment, the economy would have shed jobs between March and May with the number of employee jobs fell by the largest amount since 2011. Job vacancies have also declined to a 13-month low. The Bank of England’s employment intentions survey has fallen to the weakest level since referendum, but this may, in part, reflect recruitment difficulties, and so it should support wage growth.
Of course, there are still many unknowns. The constraints and trade-offs in the contest to win the votes of Conservative party members – essentially currying favour with staunch leave voters – are very different to the constraints and trade-offs that face Johnson as the new prime minister. The emphases in his leadership campaign may shift as a result.
Ed Smith is head of asset allocation research at Rathbones. The views expressed above are his own and should not be taken as investment advice.