17 Jul 2020
Karen Ward, chief market strategist for EMEA at JP Morgan Asset Management
An American colleague joined me on a call recently and was perplexed by the fact that I was talking about Brexit. “Isn’t Brexit done?”, he asked me. Alas, no. While the UK did officially leave the EU on 31 January, for the economy nothing actually changed since the UK entered into an 11-month period of transition. During this period, the UK and EU were supposed to agree on a future trade arrangement to commence on 1 January 2021.
The terms of the UK’s departure from the EU were legally enshrined in the Withdrawal Agreement. Included was a specification that if the UK felt more time was needed for the negotiations it could request an extension to the transition period. But that request had to be made by 30 June. Hence people are talking about Brexit again now.
Negotiations do not appear to have proceeded well. It’s not just because Covid-19 has created physical and capacity constraints. At the root of the problem is the same issue that has plagued the discussion for the last four years. The UK wants to regain control – to become fully sovereign – setting its own rules and regulations overseen by British courts. However, the EU is not willing to grant significant access to the single market without guarantees that standards will not be undercut to gain competitive advantage.
So what happens next? The UK government appears resolute in not requesting an extension. Seemingly, this will create a crunch point towards the end of the year: either the next six months will see a breakthrough and a free trade agreement (FTA) will be established or the UK will leave and trade on World Trade Organisation (WTO) terms.
Trading on WTO terms has been used synonymously with ‘hard Brexit’. What exactly does that mean? The short answer is potential tariffs, more customs paperwork for businesses that trade with the EU and potentially the need for the UK to be removed from EU supply chains if regulatory conformity cannot be guaranteed. It is these non-tariff barriers that we would expect to have the most economic impact. There could also be significant ramifications for financial firms since the UK would lose its passporting rights – its ability to serve EU clients from the UK. Advocates for a hard Brexit argue that a clean break would allow the UK more flexibility in negotiating future trade deals with other trading partners, although any benefit from these agreements would still only be seen once these trade deals had been implemented, which is often a lengthy process.
What will happen and what will be the implications for markets? In our view, the announcement of a comprehensive FTA might see sterling rise to 1.45 against the US dollar. By contrast, in a no-trade deal scenario we see sterling closer to 1.10 against the dollar. Much weaker sterling would partially help the UK to cope with new trade frictions.
The markets are unlikely to react negatively to the 30 June deadline passing unless both sides make it clear that further negotiations are pointless and attention should turn to preparing for no deal. At present, the EU has stated that negotiations should proceed, alongside what it terms ‘readiness’ preparations in case no deal can be agreed.
If negotiations are proceeding, then the market may not pay close attention until the autumn, when crunch time approaches. Our central expectation is that by the start of the fourth quarter both sides will be in full sabre-rattling mode in order to extract the most concessions. It will appear that no deal is on the cards. But, as the end of the year approaches, pragmatism will prevail and some solution will be found. When ‘Brexit’ was added to the English dictionary, the word ‘fudgery’ should also have been included. We expect a significant amount of ‘fudgery’ in order to get a partial trade agreement done. This may, in fact, involve high-level agreements that disguise what is essentially a transition to iron out the finer details.
While this outcome is our central expectation, there are significant risks around it that investors should be mindful of. Sterling may be particularly volatile and, with almost 80% of revenues coming from abroad for the FTSE 100, this will also have implications for the stock market, since higher sterling could put downward pressure on earnings and vice versa should sterling fall, all other things being equal. However, we caution against relying too heavily on the FTSE rallying in the event of a hard Brexit as a disorderly Brexit would be likely to impact both UK and EU activity negatively, depressing some of the overseas earnings that matter to UK companies.
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