Brexit – So what now?

 Brexit – So what now?

I recently gave a talk called Brexit – Phoney War. The historical parallels were that, in the UK, the declaration of the Second World War was followed by eight months of little action on the Western front. Similarly, the UK had voted for Brexit on the 24th June and despite the euphoria of the “Brexiteers”, little had happened materially up to that point. 

What has changed since I presented, is that Theresa May has now set a deadline of March 2017 for triggering Article 50. This action initiates the beginning of the formal negotiations for the UK’s exit of the European Union. The UK has two years to negotiate its exit unless all member states agree to extend these negotiations.

The effects of Brexit will be generational and profound. With the benefit of hindsight, fifty years hence, tomes and treaties will be written on the ramifications of Brexit and how it played out. Without the benefit of hindsight, I will be limiting myself to three questions. What is the most likely form of Brexit, hard or soft?  Answering this will enable the second question; what are the most obvious ramifications? And finally how long is this all likely to take?

So, the first conundrum: Will it be a hard or soft Brexit? 

A definition of terms is useful. Hard Brexit is where Britain and the EU fail to reach an agreement. Britain then falls back upon World Trade Organisation (WTO) rules in order to trade with the EU. This could be done quickly; would return border and immigration control to the UK but would leave the UK open to EU tariffs on goods and for the service sector, as well as potential barriers to trading in the European markets all together. For those on the Brexit side of the debate, “Brexit means Brexit” and that would seem to be the harder variety.

In its softest form, Brexit looks very similar to the UK in the EU today. The UK would continue to trade with the EU free of all tariffs and other barriers, both for services and goods. However, it would, like Norway and Switzerland, have to maintain open borders and pay into the EU budget, but without having any say about EU laws and regulations.

Under the softest of Brexits, the UK would probably retain the right to border and immigration control, without actually implementing it until deciding that it was needed. Freedom of movement is one of the key principles or red lines of the European Union and will be intrinsically linked to fully free access to the single market.

Whilst these two definitions are binary, the reality is that Brexit could end up being a mixture of both. This obviously makes predicting what is going to happen tricky and leads to the first, not so profound prediction. Things are going to be uncertain. As with this piece, there will be huge amounts of speculation and picking over the nuances of announcements, leaks and utterances from those involved in the negotiations.  Each one of these will be picked up by economic markets and interpreted. We will probably see an increase in price volatility over the negotiation period.

The outcome in relation to “soft” is easier to speculate upon as it effectively maintains the status quo. However, the soft exit does little to address the concerns in respect of immigration, the cost of the EU and sovereignty that many, including those in the Government, campaigned for. Given this and the stance of the EU, it would seem likely that Brexit is more likely to be hard rather than soft.

Conundrum two: What are the ramifications of this?

As I write, the head of the British Banking Association has stated that many UK and international banks are considering “relocation”. The most negative view, is that the banks and financial services companies move employees into the EU in order to get around perceived trade barriers in the future. Inevitably, this will come with the loss of jobs in the City. These lost jobs mean less money in the economy being spent on UK based goods and services and so on, leading to a leaner outlook for the UK as a whole.

Whilst this is likely to affect the banks immediately and other financial services, the wider loss of jobs and slower growth in the UK are more likely to affect the smaller, more domestically focused companies of the FTSE 250.

A less negative view would be that the loss will be marginal with banks setting up EU operations in addition to UK and global operations. The UK and particularly London will continue to be a major financial centre, due to its infrastructure, language and culture and will continue to grow in the years to come. 

So in conclusion, it seems clear that the UK will lose some jobs to Europe as businesses ensure that they have a foot in the EU, following on from a hard Brexit. The uncertainty is over the magnitude of these job losses, their effect on the wider British economy and whether the British Government can mitigate this through monetary and fiscal policy.

A hard Brexit, with controls on population flows may lead to further inflation in the UK.  As things stand, the UK is already likely to experience some inflation due to the falls in the value of the Pound Sterling. As Sterling decreases in value in relation to other currencies, exports become cheaper and any income received in non-Sterling assets, such as the US Dollar and the Euro, increase. It is for this reason, that the stock market has soared post the referendum. A majority of the income received from the top 100 companies in the UK is non Sterling. These companies have just had a massive boost to their profitability in Sterling terms and this has been reflected in their share price.

Whilst this is good for exporters, imports into the UK have now become more expensive and this will eventually feed through into inflation figures. This though is not as a direct result of Brexit but as a result of currency changes. The imposition of tariffs on EU goods in a “hard” Brexit would also push up inflation but the removal of some current tariffs imposed by the EU on non-EU goods (such as on food and wine) would lower consumer prices in the UK.

Hard Brexit will mean tighter controls on immigration, leading to less people in the country to put downward pressure on wages. Workers in the UK could be in a position then to demand higher wages leading to wage inflation. Since the financial crisis, the UK has seen subdued or limited wage inflation and this has helped to keep inflation under control. Tighter immigration controls are likely to restrict the flow of labour leading to increased wage inflation. This was identified through the campaign and could be mitigated if the Government is able to channel immigration into areas where there is high demand.

Increasing inflation will put the Bank of England into a bind. On the one hand the Bank is pursuing a looser monetary policy, keeping rates historically low and ensuring that money supply is high through Quantitative Easing. However, inflationary pressure will mean that the Bank will need to increase interest rates, making lending and mortgages more expensive at some point. This is likely to be held off for as long as possible in order to provide stability through the uncertainty. However, the sharp spike in inflation, that the fall in Sterling will produce, will mean that the pressure to do something will now come in the next 12 months.

Hard Brexit is likely to mean tariffs of on average 4-5% and the prevention of certain services being marketed into the EU by British companies. Whether this is likely or not will remain to be seen, as barriers trade tend to hurt both parties, but it is as well to define what this could look like.

Conundrum 3: How long is this all likely to take?

It is uncertain just how long the uncertainty will last. The reason for believing that the timescale of negotiation and hence clarity may be longer than just the two years lies in the nature of the EU itself. 

The timescale for extricating the UK in two years and agreeing a softer trade deal seems ambitious. The Canada trade deal (CETA) deal took seven years to negotiate and still hasn’t been signed. Re-negotiating forty years’ of law and regulations in two years to each side’s satisfaction seems unlikely at this point.  Theresa May has, however, suggested that the UK will repeal the European Communities Act 1972, which is the origin of EU power in the UK, and at the same time transfer all EU law into UK law pending review and amendment.

The two years can be extended if all of the EU member countries agree to an extension. If consensus cannot be reached, then regardless of where the negotiation is by 2019, the UK will be out and again Brexit is likely to be hard.

Recent news highlights that a hard Brexit is a more likely outcome. This is typified by the recent problems experienced with the CETA deal. Canada, a western democracy, which has very similar values to the European Union as a whole, took seven years to negotiate this deal.  It has not been ratified as all member states have to, and Belgium currently cannot. 

Belgium is a federal state requiring all regional legislatures to ratify. The Walloons, a left of centre region of 3.6 million people, have rejected the treaty and as a result Belgium cannot ratify and subsequently neither can the whole EU.

This fragmented EU decision making could be exacerbated by the exit of the UK and it could be that consensus now will be the exception rather than the norm in EU negotiations. This might not just be from those wishing to preserve the EU and wanting to “punish” the UK for leaving. This could actually arise from those inside of Europe who wish to see its demise. For example, I have recently seen talk of Frexit (France), Nexit (the Netherlands) and probably best named Fixit (Finland). Whilst none of these movements as yet has anything like the momentum of Brexit, you could envisage decisions being taken by this camp to bog down the EU, at key times, in order to show its political impotency and further their own agendas.

All of these reasons lead to the following conclusions. Brexit is likely to be of the harder variety. It is likely to occur at the end of the two year period of negotiation due to a lack of agreement. However, the reasons for this are as likely to be a lack of European consensus as much as they are due to hard Brexiteers wanting a swift, clean break.

As a result of hard Brexit, negotiations in relation to UK services will not have concluded and this is where Britain has most to lose. In order to mitigate this, service providers based in the UK, predominantly banks and financial services companies will look to get around these barriers by boosting their EU operations. Therefore, some jobs in the UK will be lost to the Europe as service providers endeavour to mitigate any the effects of any trade barrier.

However, it should be noted that despite all the current gloom over the UK’s future trade prospects post Brexit, the 20% fall in Sterling since last year means that UK goods and services are now much more competitive (even if the EU imposes their common external tariffs. Judging from business surveys and looking at previous episodes (like 1993-94, after Sterling fell out of the ERM), a UK export boom is quite likely in the next two years.

Finally, inflationary pressures, brought about by the falling exchange rate in the short term and possible wage price inflation in the medium term, mean that the bank of England will need to raise interest rates, probably within the next 12 months, contrary to current market expectations which suggest no rate increases until 2018.

Some economic and market conclusions

Brexit is likely to mean that the UK will cease to be a member of the EU “single market” but will still have access to it, at least on as good terms as other countries such as the USA and China do now.  The UK’s exports to the EU are only around 12.5% of UK GDP. In a worst case scenario, with our exports subject to a 4% common external tariff, UK GDP growth might then be around 0.5% or so lower than it would have been. The greater likelihood is that a free trade deal will be negotiated with the EU over the next 2 years or so, with not much changing during the negotiation period.

In the year ahead, the UK economy is likely to perform reasonably well, given the stimulus from lower interest rates, more “QE” and the much lower value of the Pound.  UK Gilt yields and Sterling are likely to rise from current levels. UK equities will probably make modest gains in the year ahead, although perhaps in the short term a period of consolidation is likely.

In the longer term, the growth of the UK economy and the valuation of Sterling and Sterling assets will be determined by other factors than whether or not the UK is in the EU, in particular UK tax and regulatory policy. The new UK government may be able to show they have policies to boost potential GDP growth (e.g. airport expansion, lower taxes, cheap UK-sourced energy). The Chancellor’s Autumn Statement would be an obvious opportunity to start to do this.

Matthew Phillips
Managing Director

Opinions, interpretations and conclusions expressed in this document represent our judgement as of this date and are subject to change. Furthermore, the content is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or a solicitation to buy or sell any securities or to adopt any investment strategy.