- Market Commentary
- By Jack Ablin
- October 21, 2019
Bracing for Brexit
Britain’s departure from the European Union (EU), aka “Brexit”, is set to take place on November 1. UK Prime Minister Boris Johnson’s last-minute compromise with EU officials was tabled by Parliament over the weekend, forcing him to ask the EU for an extension against his wishes. Without a formal divorce agreement, the UK and the EU face a “no-deal” Brexit, the most draconian outcome from a political and economic perspective.
Should Britain leave the EU under such circumstances, the free flow of goods, services and people across the border between the two territories would stop, creating friction that will cost time and money to resolve. Britain would lose duty-free access to the world’s largest trading bloc. Last year the UK imported $353 billion of goods and services from the EU, with $91 billion of imports from Germany alone. Britain exported $232 billion to the EU, with Germany accounting for nearly $50 billion.
Without an approved trade deal, the UK’s trade relationship with the EU would revert to World Trade Organization rules negotiated in 1995. Trade in food would be the category most affected, with tariffs in the teens on agricultural and animal products, and a 35 per cent duty on dairy. Carmakers would be slapped with a 10 per cent tariff on autos; other goods, like clothing and linen, would be hit with a 12 per cent fee.
UK service industries, like finance, law and accounting, will lose preferential access to the European single market. This means red tape for Britain’s service providers, who collectively make up 79 per cent of the UK economy and 45 per cent of exports, according to Bloomberg. UK-based financial companies are planning to shift some of their London-based operations to Europe.
Complicating matters, data protection and data sharing between UK and EU companies would be affected, from bank records to Uber receipts. A no-deal Brexit threatens to leave companies exposed to lawsuits under the EU’s strict data-protection rules. As an EU member the UK doesn’t have to prove data adequacy, but Brexit would force a disentanglement process in which companies would scramble to ready themselves to continue data transfer arrangements. We anticipate the costs and efforts of compliance would be tantamount to a mini-Y2K effort.
Border crossings between the UK and the EU would no longer be unobstructed, and nowhere would the impact be felt more keenly than in Ireland: the Republic of Ireland would remain part of the EU but Northern Ireland would not. Without a last-minute compromise, a 310-mile border would in effect partition the two territories. Burdensome customs red tape and security checks would not only hurt economies on both sides of the border; splitting Ireland would likely rekindle latent political resentment. The Irish Prime Minister warned that a no-deal Brexit could eventually stir sentiment for a united Ireland. Ireland’s central bank asserted that a no-deal Brexit could cost 73,000 Irish jobs over the next two years.
The Channel Tunnel, running beneath the English Channel, is a vital conduit between Britain and the European continent that in 2018 was the conduit for £120 billion ($150 billion) of goods. Starting November 1, expect long delays at border crossings as truckers wait in line to pass through checkpoints. The UK government warned that 50-85 per cent of freight truckers won’t have the proper paperwork to enter the EU through France.
A no-deal Brexit would have a dramatic impact on economies on both sides of the border, but the pain would be most acute in the UK, according to a study by the OECD. Their paper, titled “The Economic Consequences of Brexit: A Taxing Decision,” projects a 2 per cent decline in UK GDP by 2020, or about £1,500 per household. They project EU GDP would shrink by about one percentage point. If the OECD forecast is correct, Brexit would undoubtedly push Britain into recession: year-over-year GDP rose at a scant 1.3 per cent through Q2/19, with the last three months contacting by 0.2 per cent. Meanwhile, the EU economies collectively could potentially skirt recession since they grew by 1.4 per cent through Q2/19.
The OECD also warns about capital flight threatening the UK’s record current account deficit of 7 per cent of GDP. Refinancing of Britain’s government debt could come under stress. Public debt is close to 90 per cent of GDP with about one quarter of it held by foreigners. The UK accounts for the largest share of foreign direct investment (FDI) inflows into the European Union, but this could reverse if investors no longer view the UK as an attractive home for their capital. With access to the single market lost, lower FDI would seem unavoidable. The consequence would stunt innovation, export capacity and productivity.
The potential impact of a no-deal Brexit has been largely considered by global investors. The British pound has lost about 10 per cent of its value since the original Brexit vote in June 2016. The FT100, Britain’s stock index, as well as the EURO STOXX 50, Europe’s stock index, have trailed the S&P 500 by about 15 percentage points since the infamous vote. London housing prices are off 4.4 per cent over the last 12 months, their worst showing since August 2009 amidst the global housing bust.
Brexit risks undoubtedly have been at the top of Bank of England (BoE) and European Central Bank (ECB) agendas. The BoE) has kept overnight rates unchanged at 0.75 per cent since 2018, while policymakers warn that a no-deal Brexit would lead to weaker growth, higher inflation and a further drop in the value of the pound. The BoE concluded that the UK’s tenuous relationship with the EU risked a further period of “entrenched uncertainty” leading to weaker growth as confidence sags and business investment follows. The ECB recently cut interest rates further into negative territory and continues to buy bonds indefinitely to stimulate investment and growth. Both central banks are poised to respond, if necessary, to the economic blowback that a hard Brexit would inflict.
What does this mean for investors? “Sell the rumor and buy the news” could be premature in the event of a no-deal Brexit, since the complex interconnection of trade, finance and culture between these two trading partners is so involved and could lead to unpredictable outcomes. We will be watching the value of the pound and UK equities for buying opportunities. For now, we suggest investors stay tuned in to the news to follow the unfolding drama. Every crisis presents buying opportunities for those investors with eyes on the long term and strong stomachs in the short term.