This deal or no Brexit?

Ahead of the referendum on UK membership of the EU on 23rd June 2016 we took a proactive approach over the holding of UK and European equity in our portfolios. At the time, we recommended selling these holdings ahead of the vote and then reinvest once the outcome was known. This strategy avoided the initial falls but then participated in the subsequent gains to the significant advantage of investors.

We are now entering the end game over our decision to leave the EU and how this may pan out as far as investment markets are concerned. The FTSE 100 stood at 6138 on Referendum day in June 16, hit a high of 7778 in May 18 and now stands at 7028. Brexit has meant corporate investment has been delayed which has held back the economy.

After 29 months of negotiations that at times looked weakened by indecision, infighting and incompetence, we now see the full implications of leaving the EU, something that many of us would now say we did not fully comprehend at the time of the referendum.

Theresa May now has a withdrawal agreement and a declaration over the framework of the future relationship with the EU signed off by her Cabinet, the EU commission and the Heads of State of the 27-member states.

It is quite clear that there is no appetite for a no deal Brexit to occur from UK politicians and business leaders. This position is shared by our European partners as well. The parliamentary support for a hard Brexit is very small as witnessed by the limited support the European Research Group obtained in challenging the Prime Minister. The City, CBI and most business leaders are seeking as soft a Brexit as possible.

In the very unlikely event of a no deal Brexit, we would see sterling fall significantly. The Bank of England would cut interest rates back to 0.25% to reduce borrowing costs. The government would initiate a £5bn spending programme on infrastructure and house building as well as supporting adversely effected industries such as motor trade and aerospace. Supply chains would be affected or even broken and would need rebuilding within the UK. This may create a boost to indigenous business. The Treasury would likely cut corporation tax to 10% to increase Britain’s attractiveness and competitiveness to international business.

If we leave on a no deal, the initial disruption would be massive. The current delays for exporting goods through British ports is up to 2 hours. This is projected to increase to 72 hours at ports on both sides of the channel. The impact on supply chains, imported goods such as food, medicines and materials for industry and construction would hit the economies of the UK and of Europe. The government and industry would need to stock pile while farmers will need to increase food production. Just in time delivery supply chains would come to an end in their current form and workers hours would be reduced or they could be made redundant. We remain wholly unprepared for this outcome.

The implications are clearly very painful but there are many economists, some business leaders, hard Brexit Conservatives and UKIP members who advocate such a move with the UK trading on World Trade Organisation (WTO) rules post Brexit.

One of the heralded dividends of Brexit is the self-control of borders, money, laws and trade. Having been through the torturous negotiations, it is clear to all that bilateral trade agreements take years not weeks to conclude. If we did leave on WTO rules and were free to enter into trade negotiations, it could be years before we conclude these deals.

The withdrawal agreement allows for a period of transition up until the 31st December 2020 or longer if agreed by both parties. During this period, the UK has to abide by EU rules but will lose our representation in EU institutions. The level playing field clauses lock the UK into EU law on labour, environmental protection, taxation, competition rules and state aid. The European Court of Justice will have the final say on matters of law. The withdrawal agreement does end the free movement of peoples so Britain can regain full control over immigration.

The withdrawal agreement sets out the legal framework for the divorce payment, thought to be around £39bn paid over several years, the rights of UK and EU citizens in each other’s territories and the avoidance of a hard boarder between the Republic of Ireland and Ulster.

During this period, the UK and EU will negotiate a future trade agreement, the principles of which are laid out in the framework document. The so-called Irish backstop agreement only comes into play after a mutually extended transition period has failed to produce a trade agreement. In the transition, Britain will remain a member of the EU customs union so allowing smooth and free transfer of goods and services between the UK and EU.

During the transition, the UK can start trade negotiations with other countries that can then be implemented from the time we leave the customs union and start our new trade relationship with the EU. The withdrawal agreement leaves open the option for a Canada-style free trade agreement and allows the UK the time to get its act together and prepare for self-government.

Critics of the withdrawal agreement see the UK becoming a rule-taker and adopting the status of a ‘colony’ of the EU while in the transition period. Britain will still operate under EU trade rules which we will have no input over, having lost our MEP’s and commissionaires. We will still be paying into the EU for our membership of the customs union. Full membership cost £10.8bn this year. The withdrawal agreement does not offer the UK a unilateral exit mechanism over when the transitional period ends as this is determined by mutual agreement. This arrangement is disliked by many advocates of Brexit as this position could allow our rivals to undermine our competitive advantage in certain sectors or industries and hold us in the customs union longer than the UK government may want.

Several independent political commentators have stated that while the agreement does not satisfy everyone and is imperfect in many ways, it is an agreement that should have been expected given the EU position and its red lines of free movement of goods, services, capital and people. Many of the Prime Ministers critics and opponents have said that they would have done a better job of the negotiations but the outcome, whoever represented the UK would be little changed if the key parts of the referendum result was to be honoured.

The Labour opposition to the withdrawal agreement focuses upon the UK staying a permanent member of the customs union in order to maintain our existing trade with the EU. The UK imports £95bn more goods and services from Europe than exports to Europe. This permanent position of rule-taker while still paying into the EU is no more beneficial than staying a full member of the EU.

At the last general election both Labour and Conservative parties campaigned on manifestos to leave the EU single market and customs union.

The Treasury has now published its economic forecasts that compares staying in the EU to the various Brexit options. The forecast compares the likely impact of the proposals agreed by the Cabinet at Chequers in July with the alternative scenarios of Norway-style membership of the European Economic Area, a Canada-style free trade agreement with the EU and a no-deal Brexit. It finds that GDP will be lower in 15 years under all Brexit scenarios than it would be with EU membership.

The official figures indicate that while the UK economy is expected to grow, there was no version of leaving the EU that increased UK prosperity. The sought-after post Brexit free trade agreements only added a small addition to national growth. The forecasts suggest that the UK economy could be up to 3.9% smaller after 15 years under the PM’s Brexit plan, compared with staying in the EU and that a no-deal Brexit could deliver a 9.3% reduction in GDP. The Treasury estimates do not put a cash figure on the potential impact on the economy, but independent experts have said that 3.9% of GDP would equate to around £100bn a year by the 2030s. Capital Economics expects GDP growth of 2% if the Withdrawal Agreement is ratified, compared to a 2% fall if a no deal exit occurs.

The Withdrawal Agreement Bill will come before MP’s from the 5th to 11th December. It is expected to be voted down as opposition parties and Brexiters join forces for different reasons to defeat the bill. The 100 Conservative MP’s who are publicly opposed to the withdrawal agreement could with Labour support defeat the Bill and with no opportunity for success press Mrs May to change her policy or stand down so a new leader can take over.

We can expect markets to react negatively to the Bill being defeated. Sterling is likely to fall as would the FTSE 100 as it reacts to political events.

As it stands the only real option on the table to achieve Brexit is through the withdrawal agreement. A hard Brexit is not wanted and at this stage there is no second referendum on offer. MP’s who want Brexit or wish at least to honour the referendum result and the opinions of their constituents will have on 11th December a stark and binary choice. It is this deal or no Brexit. Teresa May knows this as she has been through the negotiations.

The Bill is unlikely to get through on first attempt and may take a number of amendments to appease back benchers looking for a reason to support the bill such as a technological solution to import checks on the Irish boarder or a clearer and more UK focused exit agreement for the transitional period. If the Prime Minister loses the first vote, she may gain some additional traction with the EU for some concession over the framework agreement.

Without doubt this process will generate UK market volatility but this in itself will concentrate minds.

The choice in Parliament is either support an amended withdrawal agreement as a route to a soft Brexit or no Brexit at all. Even if Brexiteers do not like the deal, they run the risk of losing Brexit through a second referendum or a general election.

Another option is membership of the European Free Trade Area (EFTA) and European Economic Area (EEA) for a temporary period. This area includes countries such as Iceland, Norway, Lichtenstein and Switzerland. The so called ‘Norway For Now’ option is an existing ‘off the shelf’ alternative and is being discussed between Democratic Unionists and Conservative Brexiteers as an alternative to a voted down withdrawal agreement. The EEA option does have a unilateral exit mechanism and no backstop but does mean accepting during membership EU rules of freedom of movement of workers, labour and capital while also paying the EU about £2bn per year for single market access. Teresa May has avoided the option of EEA membership as it does not end freedom of movement.

If an amended version of the withdrawal agreement is defeated twice, which is quite possible, we will move into unchartered waters over Brexit. The country will need leadership at this time and in order to unite the Conservative Party and the DUP to create a majority in the House of Commons, Teresa May could signal a change of policy to seek temporary membership of the EEA. We think it unlikely that the Prime Minister will countenance the option of a second referendum and a delay to the Article 50 deadline or to call a snap general election on the basis she takes her withdrawal agreement directly to the people. But a week is a long time in politics. The Dominic Grieve amendment giving Parliament a greater say in the direction the country takes in the event of the failure of the withdrawal agreement increases the chances of a second referendum.

If we did end up holding a second referendum the choice will again need to be binary. The ballot should ask voters to either support leaving the EU or remain. With opinion polls showing the nation still divided over the issue of Brexit we may get the same result as last time and Teresa May will secure her withdrawal agreement, see it through and then step down or Britain could seek to remain an EU member state hopefully retaining our veto’s and Margaret Thatcher’s hard won £5.6bn annual rebate.

The main UK stock markets are offering good value to investors. Yields and PE ratios are internationally attractive. The FTSE 100 and FTSE 250 could certainly be hit by no agreement but could equally be boosted by any agreement to proceed with a soft Brexit in the form of the withdrawal agreement or EEA membership or even no Brexit at all. The passage of the Withdrawal Agreement Bill is likely to see sterling rally which may hit UK exporting manufacturers but generally there should be a relief lift, including greater investment that had been delayed and improved consumer confidence now that the cloud of Brexit is at last lifted. UK interest rates may rise in 2019 and sterling could strengthen further.

The pound jumped in value on the news that the EU and UK had agreed the draft text of the framework for the future relationship. The text does strike an ambitious tone stating that the EU and UK will aim to deliver trade in goods and services that goes well beyond WTO commitments and ensures an economic partnership without tariffs, fees and charges. The text confirms that UK financial services will obtain EU equivalence and therefore avoid disruption.

We have on this occasion not recommended the move out of UK equity to cash over the Brexit decision period as we are unsure of its time duration. While markets will be affected short term, we do not want to miss out on the likely relief lift when it occurs.

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