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Breaking up is so very hard to do...

Guy Foster, Brewin Dolphin’s Head of Research, looks at the status of the Brexit negotiations and what it might mean for investing.

The pound has been weak as Brexit concerns linger on and policymakers seem to be making little progress in negotiations. Most commentators point to the Irish border question as the key problem, but suggest policymakers are likely to reach a compromise on that sticking point. But, is that really likely? And if so, what impact will this have on the economy and investments?

As we get closer to the deadline for withdrawal from the European Union, expectations are being tempered. The EU and UK are currently negotiating the withdrawal agreement. Originally it was hoped that the agreement would involve considerable detail on the ongoing relationship with the EU. However, as time elapses the opportunity to do so reduces.

This is a problem for the UK. It makes it increasingly likely that during a transition phase, when UK negotiating leverage will have declined, some of the details will still need to be negotiated.

The art of the deal

The UK desires and warrants a bespoke deal, but it is useful to consider what such a deal might look like in the context of other countries’ existing trading relationships with the EU.

Norway, like Lichtenstein and Iceland, is outside the customs union, enabling it to strike free trade deals with other countries. It is a member of the single market, which allows frictionless trade across a wide range of products and services. This also requires Norway to abide by European regulations, about which it has no say, and means it is within the jurisdiction of the European Court of Justice.

Canada, by contrast, has reached a comprehensive free trade deal with the EU and is free to evolve its own regulations as it wants, whilst recognising that it could  at some stage violate the rules for sale within the EU.  It enjoys tariff-free trade, but not frictionless trade, as it is still subject to customs checks, the cost of which  may dwarf the equivalent cost in tariffs1.

The difference between the Norway and Canada options illustrates the difference between a soft and hard Brexit.

Comparing the options

A hard Brexit would be expected to result in the UK being outside the customs union (as Canada is). Administrative checks would make it harder for companies to trade with peers in the EU, notwithstanding ambitions to reduce tariffs to nil. Based upon existing arrangements it is likely that service-based industries, like the City, would lose jobs as institutions relocate some of their functions to be within  the EU. These factors would weaken growth, however the UK would have greater control over immigration and domestic laws.

A soft Brexit would mean the Norway option. This offers much less economic disruption but diminishes sovereignty, in some ways, and doesn’t materially improve the UK’s ability to control immigration.

Barriers to agreement

Unsurprisingly, the soft Brexit option is popular with those who wished to remain within the EU and who form a majority in parliament. Technically it would mean leaving the EU, and would have a relatively low impact on economic prospects.

However, even though it is assumed to have a parliamentary majority behind it, the soft Brexit option would be unlikely to pass for two reasons. First, it is unlikely to get the chance as the government is not trying to negotiate such a deal. Second, it will be opposed. Both major parties might experience rebellion within their own ranks. It is likely that the hard Brexit rebels within the Conservative Party would outnumber soft Brexit rebels within the Labour party. This makes it very difficult to see how soft Brexit will progress.

Finally, we have the Chequers deal, which prime minister May negotiated with her cabinet to try and achieve the best of all worlds. Unfortunately, it has arguably achieved the opposite. Leavers believe it is almost as constrictive as the EU, whilst Remainers believe it will reflect the disadvantages of leaving the single market.

A major additional source of concern for leavers is that mutual EU membership has been a useful support to the historic Good Friday (or Belfast) Agreement. Twenty years after the historic agreement it was already in trouble as deadlock in the Northern Ireland Assembly has left Westminster reluctantly having to impose a budget on the region. Should Brexit require the introduction of a more visible border between Ireland and Northern Ireland, many worry about the long-term consequences.

These are the challenges which need to be overcome to get a deal agreed with the EU and then passed by parliament.

In addition, the Chequers deal has failed to win over the EU. Its position on Brexit has always been fairly clear – if the UK steps out, the EU will not allow it to cherry pick the benefits of membership without meeting the costs. Recent polls suggest that the UK electorate too remains unconvinced. The prime minister continues to promote the Chequers deal but is coming under increasing pressure to pivot towards a Canada-style relationship.

Investment implications

How does this impact investments? A harder Brexit is likely to have more negative near-term implications for UK economic growth which will impact the revenues of some companies. However, most listed companies in the UK are quite international in nature which would cushion the impact. In fact, the greatest impact would be felt through the pound which would likely weaken considerably under a hard Brexit scenario. Under those circumstances many UK shares would offer some protection against sterling’s devaluation.

To some extent it would be a repeat of the referendum, when the weak pound was bad news for retailers (who buy goods from overseas and sell them in the UK), while weaker UK growth prospects weighed upon housebuilders and property companies, which are highly sensitive to the UK economy. This created opportunities which we were able to take advantage of, as some of these shares overreacted. At the same time, the likes of food, beverage and pharmaceutical companies, that generate their revenues in foreign currencies, were worth more in sterling terms after the referendum vote.

Where the current situation differs from the referendum is the number of possible outcomes. The markets, being dispassionate over issues such as national sovereignty, are quite happy with the Norway option and, for that matter, even the Chequers agreement. They would be less keen on a Canada-style relationship but are most concerned about the prospect of no deal being reached. No deal would result in significant increases in tariff and non-tariff barriers to trade between the UK and EU, without adequate facilities to process them. For a large open economy with globally-integrated supply chains the delays and costs this would cause would be very significant.

A no-deal Brexit might seem like a realistic option, given the challenges to getting any deal through the EU and parliament. However, if it does look likely then the UK government can request more time to negotiate. It would be a somewhat humiliating step, but still likely to be preferable to severe economic disruption. However, it is important to remember that both the EU and parliament would have to agree to such a request.

Advancing negotiations

We believe that the ambition to reach an agreement is huge on all sides. For the UK the economic costs of no deal are now quite widely accepted to be significant. For the EU a no-deal scenario would raise a question over some of the £39bn of outstanding obligations the UK has agreed to pay. Both will be keen to resolve the issue.

It seems very likely that Chequers cannot be accepted by the EU and that, even if it were, it would face a significant hurdle to get through the UK parliament. We therefore expect the government to eventually pivot towards a harder Canada-style Brexit. The prime minister’s principle justification in ruling out such an approach has been that it would require a hard border either across Ireland or between Northern Ireland and the United Kingdom. There really isn’t any perfect mechanism to resolve this. Any Brexit deal will have to be a compromise.

The Irish border Most of the details of the UK’s ongoing relationship with Europe will only be referred to vaguely in the withdrawal agreement, with major details deferred to be negotiated during the transition period. The opportunity to create something more binding has simply elapsed while the two parties have been talking past each other. What cannot be deferred though, is a resolution of the Irish border issue.

The importance of this is that it forms the “backstop”. This is what the arrangements will be at the end of the transition period if no better solution has been reached. The UK’s position is that there can be no division of the Union, no border between Northern Ireland and the rest of the United Kingdom. The EU’s perspective is that there can be no border between Northern Ireland and the Republic of Ireland.

This issue is very difficult to resolve but for a Brexit deal to be agreed a compromise between these two seemingly intractable positions is needed. The Republic of Ireland and Northern Ireland have existed in a common travel area since before the EU existed, with checks made on travel between Northern Ireland and the mainland UK to prevent non-EU migrants from entering illegally. The fact that this has historically taken place away from the actual border between the two countries helps to de-emphasise the border, making it seem less hard. Extending these checks to identify non-Irish migrants, rather than just non-EU migrants, would seem possible.

A border for goods would be necessary, but how hard or soft it would be depends upon your definition. A border need not be permanently manned. Goods vehicles passing through might be randomly stopped or asked to proceed to another location where they can be checked. That need not take place at the border, but there does need to be a border. Albeit, in the fullness of time, it can be a relatively unobtrusive one.

The most likely outcomes

The contentious border arrangements would have to satisfy the EU and parliament, both of whom might be reluctant to agree to them. However, their reluctance would be balanced against the alternative scenarios, most of which are worse. Added to which, EU negotiator Michel Barnier has suggested that a Canada-style arrangement is available.

Conservative rebels would be faced with voting this deal down and thereby potentially leading to a no-deal Brexit or a general election which could see the Conservatives lose power. Given the opposition’s enigmatic stance on Brexit, it would be unclear what type of Brexit a change of government might lead to.

The upshot of these deliberations is that we can estimate the chances of each outcome based upon the likelihood of them being pursued by the UK government, the likelihood of them being agreed by the EU and parliament and the likelihood of a fall back request to extend negotiations.

The conclusion is that, despite the compelling reasons for most actors to pursue a deal, the chances of achieving one remains just over 40%, the vast majority of which represents a deal bearing similarities to a Canada-style relationship (i.e. a hard Brexit).

Very slightly more probable (but within the margin of error) is that the government ends up requesting more time to negotiate. Quite where those negotiations might lead becomes another question that depends on factors such as whether there is a resulting general election or change in Conservative Party leadership. We haven’t modelled these odds because they are so small at this stage. Finally, and most importantly, there is a residual 16% probability of a no-deal Brexit which would be treated as a very adverse outcome by the market.

There is therefore only a relatively small chance of a sharply adverse outcome for sterling which would be felt through domestically orientated stocks and particularly smaller companies. While a reasonably likely hard Brexit might initially be treated negatively by investors, they would balance that against the avoidance of a no-deal Brexit. With such a delicate balance between outcomes, positioning portfolios on the basis that a particular scenario will play out is risky. The better approach is to be ready to react to the turbulence the eventual decision may create.

The value of investments can fall and you may get back less than you invested. Past performance is not a guide to future performance. The information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. No investment is suitable in all cases and if you have any doubts as to an investment’s suitability then you should contact us. If you invest in currencies other than your own, fluctuations in currency value will mean that the value of your investment will move independently of the underlying asset. The opinions expressed in this document are not necessarily the views held throughout Brewin Dolphin Ltd.

1http://real.mtak.hu/34087/1/Hornok_Koren_Administrative...JIE_u.pdf

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