|Last week was a critical one in the ongoing Brexit odyssey. As the UK hurtles towards the end of 2020 (which will mark its exit from the European Union), it has been negotiating with the EU on the terms of their future trading relationship. However, the UK had announced that if no deal were reached by Oct. 15, it would walk away from negotiations. EU leaders clearly believed they had the upper hand, and called on the UK to acquiesce on some key outstanding issues that had been in dispute. However, the UK refused to give in on those issues, and last Friday British Prime Minister Boris Johnson announced it was now time to prepare for a Brexit with no EU trade deal. He lamented that the EU refused to give the UK the same trade terms as Canada, and stated that the UK would now be preparing for a “no-deal” Brexit. |
How long might the negotiations be stalled? Talks are expected to resume this week, as the EU is hoping for “intensive” discussions until a “fair deal” is reached. And while Johnson seems perfectly comfortable with a “crash out,” some members of the British cabinet are likely feeling desperate and fearful of the implications of such a result, which may hopefully make the UK more flexible.
So what are the possible outcomes from here?
A no-deal Brexit
Let’s start with what is becoming the most likely scenario, in our view. There is certainly a growing probability of a no-deal Brexit, as evidenced by EU leaders stepping up contingency plans for this outcome. But what exactly does “no deal” mean? Presumably, the UK and EU would have a trade relationship based upon terms laid out by the World Trade Organization (implying tariffs that run from 0% on fuel and pharmaceuticals, through 9% on vehicles, to 45%-50% on cereals and meat).1
We would expect to see a significant negative impact on trade; in 2019, the EU accounted for 43% of UK exports and approximately half of imports.2 A no-deal Brexit would likely spread chaos through the supply chains that stretch across Britain, the EU and beyond — at a time when the economy remains fragile because of the pandemic. Furthermore, the virus is resurgent in both the UK and EU, targeted lockdowns are already in place, and the risk of new national lockdowns has resurfaced. Much economic activity including UK-EU trade is likely to remain well below normal in this environment. Even so, we expect disruption in goods or agricultural trade in the event of a hard Brexit to further damage the economy, as well as cause political problems on both sides of the Channel. Put all this together, and we believe there could be a greater double-dip recession risk for the UK than for most other major Western economies.
This scenario may lead to additional risks, most notably the growing possibility of a breakup of the United Kingdom. Political pressures are rising for not only Scottish independence but also the eventual reunification of Ireland. Recall that in 2014, Scotland had a referendum on independence and was persuaded to stay part of the UK on the belief that the UK would remain in the European Union. While Prime Minister Johnson has indicated that he won’t allow a second Scottish independence referendum, we expect Scottish fervor to abandon the UK to continue to grow, especially if the Nationalists hurtle to victory in the Scottish Parliamentary elections in May. One silver lining in this scenario is that the risk of a UK breakup may temper the speed and extent of divergence and separation from the EU — as should the fact that EU members and other partners are pulling together to manage both Brexit and COVID; indeed, Switzerland has just voted in a referendum to maintain freedom of movement with the EU, as part of their relationship and trading arrangements.3
We believe financial markets have already rendered their verdict on the impact of Brexit, and it is not positive. British sterling weakened after the referendum of 2016 and has remained weak. We think this decline in the currency could be viewed as a judgement that the UK economy has been rendered less competitive. And UK equities, which we would expect to outperform global equities given their inverse historical relationship with sterling, have underperformed in the last several years, again indicating pessimism about the impact of Brexit on the UK economy.4
We believe this situation may continue or worsen in the wake of a no-deal Brexit. Tensions in EU trade negotiations are reflected in English nationalism, Scottish nationalism and Irish republicanism — and all suggest that economic growth and investment in particular may be low, high financial market volatility may continue, UK risk assets and sterling may remain at depressed valuations, and bond yields may remain low. All these issues pose a bit of a “value trap” in the short term, as politics may discourage investors who might normally look for opportunities in depressed UK valuations relative to other major markets.
In the longer term, however, we would expect the UK government to gradually find its way through fits and starts to decent policy choices, unlocking some of that value and restoring a bit of lift to growth. We believe this backdrop calls for keeping a watchful eye on the UK and being diversified across countries and asset classes. Diverging and shifting policies could potentially favor a more diversified strategy. That would stand in contrast with the generalized, macro shifts of repeated opposite moves of sterling versus gilts and UK versus global equities that have dominated the Brexit era and have pointed to significantly weaker UK trend growth ahead.
Is a deal still possible?
Now there is a very small chance that a trade deal could still happen, even though we have passed the informal Oct. 15 deadline — likely something akin to Canada’s trade deal with the EU. This would come as a great relief, and we believe it would allow sterling to gain some of the ground lost since the referendum (though perhaps not all of it, given the poor pandemic performance of the UK and the weakening of commodities since 2016, which play a big role in the UK stock market, if less so in the economy). We wouldn’t be surprised to see a meaningful gain in sterling under such a scenario, as well as some outperformance in UK equities. There is also a moderate possibility (likelier than a comprehensive Brexit deal) that the EU and UK could forge a “skinny” Free Trade Agreement as well as a number of sector-specific deals, including for the UK’s large financial and professional services sectors. This outcome could help avert severe disruption but would not resolve key challenges. We believe it would temper the underperformance of sterling and UK equities, but certainly not achieve the strong rebound in sterling that we would expect if a comprehensive Brexit deal were arrived at.
In the week ahead, we will of course need to follow closely any developments in the Brexit negotiations as well as any developments in the US regarding fiscal stimulus. And we will want to follow closely the rising COVID infection rates in the US, UK and Eurozone, which are concerning.
Is a Brexit deal still possible?
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1 Source: World Trade Organization
2 Source: House of Commons Library, “Statistics on UK-EU trade,” June 17, 2020
3 Source: BBC, “Switzerland referendum: Voters reject end to free movement with EU,” Sept. 27, 2020
4 Source: Refinitiv Datastream, based on the MSCI UK Index and MSCI World Index, both in local currency format. The MSCI World Index is an unmanaged index considered representative of stocks of developed countries. The MSCI UK Index is designed to measure the performance of the large- and mid-cap segments of the UK market.
Blog header image: Daniel Limpi/ EyeEm/ Getty
All investing involves risk, including the risk of loss.
Diversification does not guarantee a profit or eliminate the risk of loss.
The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Brexit refers to the scheduled exit of the UK from the European Union.
The opinions referenced above are those of the authors as of Oct. 19, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.