The Specter of a Hard Brexit

Wed, Oct 12, 2016 - 9:31am

The decline in the British pound sterling that began in June when the UK voted to leave the European Union (EU) accelerated last week, culminating in a “flash crash” on Friday October 7th that wiped out a tenth of sterling’s value, briefly dropping the currency to its lowest level since 1985. While the market subsequently calmed down, sterling eased further on Monday and Tuesday, reaching $1.2122. (This morning sterling recovered to around $1.230 in London following the development given in the news update at the end of this note.)The steep decline in the nation’s currency does not reflect current weakness in the economy, which to the contrary has held up surprisingly well since the Brexit vote. Rather, the apparent cause is the increasing likelihood that the UK’s exit from the EU will be what is termed a “hard” Brexit – that is, a clean break, with Britain leaving both the single market and the EU’s custom union, and ending EU obligations regarding contributions to the EU budget, the free movement of workers, wide-ranging EU regulations in areas such as product standards and labeling, and the jurisdiction of the European Court of Justice.

In an October 2 speech to a Conservative Party conference, Prime Minister Theresa May signaled her intention to take Britain out of Europe’s single market and to become “a fully independent sovereign country.” She announced that she will invoke Article 50 of the EU treaty before the end of the first quarter of 2017, which will initiate a two-stage process of leaving the European Union. The tumbling currency indicates that global market participants consider the UK’s completely leaving the EU to be a less attractive alternative than a “soft” Brexit.

Read Bianco: Brexit Probably Most Bullish Thing That Happened This Summer

The announcement to invoke Article 50 was probably unavoidable in view of the referendum vote, but many had wished and expected that Britain would seek a “soft” Brexit that would maintain access to the single market, recognizing that this would involve making some concessions with respect to border controls, EU regulations, and budget contributions. Mrs. May appears to reject such an outcome, which would be similar to the current situations of Norway and Switzerland. She proposed instead to replace Britain’s participation in the single market with sector-by-sector trade accords that would provide similar market access without the loss of national sovereignty required for access to the single market. It is highly uncertain whether such a deal is attainable, and how many years of negotiation would be required.

UK firms in a letter from the Confederation of Business and three other business lobbies have expressed their concerns with Mrs. May’s position. The letter calls for consultations with “firms of all sizes” and urges the government to “deliver barrier free access to the EU’s single market which is vital to the health of the UK economy”.

It is possible that the hard stance signaled by Mrs. May is an initial negotiating position that may later evolve. Certainly, EU leaders including French President François Hollande, German Chancellor Angela Merkel, and Jean-Claude Junker, head of the EU’s executive, have made clear their hardline position that continued access to the EU’s single market requires, inter alia, freedom of movement.

We will not describe here the lengthy and very complex negotiations that lie ahead for the UK, both with the EU and, following exit from the European Union in 2019, with all 53 other countries with which the UK’s current trade relations are carried out through membership in the European Union. Britain will also have to renegotiate its membership in the World Trade Organization (WTO). The October 8th edition of the Economist features a good discussion of the challenging negotiations facing Britain. What is inescapable is that markets and business face a very lengthy period of uncertainty that, when added to the increased likelihood of a complete break from the single market, has serious adverse implications for the British economy, further weakness in sterling, and increased market volatility, not only for Britain but for European and global markets as well.

Read also UK: Prime Minister Lays Out Her Brexit Plans

The eventual economic effects of a hard Brexit would not occur until after 2019 when access to the single market would be lost. But the effects of uncertainty leading up to that date and the prospect of loss of market access in two years are already affecting market attitudes and are soon likely to affect business decisions.

The UK’s financial services sector, which is the UK’s strongest industry, accounting for 7% of UK output, would be on the front line in a hard-Brexit scenario. Some 40% of the UK’s financial services exports go to the EU. Even were the UK to seek a “soft” Brexit outcome such as gaining membership in the European Economic Area of which Norway is a part, financial services would not be covered. Nor are financial services included in the still-unratified free-trade agreement between the EU and Canada.

The UK looks highly likely to lose the “passporting rights’’ that allow financial firms to conduct business out of London freely across the EU. EU financial centers have indicated their desire to attract London’s euro clearing and settlement business. UK banks are already said to be developing contingency plans such as establishing subsidiaries within the EU and moving staff. Not only are banks concerned about the passporting issue; they also worry that UK immigration restrictions will impact their international workforces, which are estimated to consist of over one million workers. Estimates have been published that 75,000 to 100,000 financial-sector jobs could be moved to the EU.

The UK economy grew at 2.2% last year and likely will register a 1.8% advance this year, slightly better than the 1.9% and 1.5% rates, respectively, for the EU. The UK economy’s growth is projected by both the IMF and the OECD to slow to 1% in 2017 due to uncertainty about the future path of policy and the reaction of the economy to weaker confidence. Firms, in particular, are likely to postpone capital spending and hiring, and the resulting weaker job market will impact consumer spending.

The effects of Brexit on trade flows and restrictions on labor mobility will come after formal exit from the EU in 2019. Exports to the EU countries account for 45% of total UK exports and about 12% of UK GDP. The OECD has estimated that by 2020 the UK’s GDP may be over 3% lower and by 2030 over 5% lower than it would have been had the UK remained in the EU. Along with the impact of higher trade barriers, labor productivity would be reduced by lower foreign direct investment and more limited access to skilled labor. Not well appreciated by many in the UK is the contribution of migration, which has accounted for half of GDP growth since 2005, according to the OECD.

See Is the UK Economy Doing Better Post-Brexit?

A further uncertainty following from the vote for Brexit is the future structure of the United Kingdom. Sentiment in both Scotland and Northern Ireland is heavily against leaving the EU. Suggestions that these parts of the UK could negotiate continued access to the single market have been rebuffed by the EU. There is consequently a considerable risk that one or both will seek to break away from the UK. And in the EU there are concerns that other members of the EU may seek to follow the UK’s lead out of the Union. The latter concerns are likely to strengthen EU negotiators’ resolve to resist offering concessions to the UK that could make exit appear to be an attractive option. This anticipated tough stance increases expectations that the UK’s exit from the EU will indeed be “hard.”

Going forward, the outlook for UK assets does not appear attractive. While the domestic UK equity market, like the UK economy, has done well this year, including during the period since the June Brexit vote, investors in the main UK ETF used by US investors, the iShares MSCI United Kingdom ETF, EWU, have lost money this year. EWU is down 1.41% year-to-date October 10th. This trend is due to the decline in sterling versus the US dollar. US investors could have avoided this currency effect by investing in the iShares Currency Hedged MSCI United Kingdom ETF, HEWU, which is up 17.08% year-to-date. While there could be some near-term consolidation in sterling, we think further declines in the currency are more likely than a significant recovery is. This outlook suggests that hedging any UK positions will continue to be wise. A weaker Japanese yen is positive for UK multinational firms as long as single-market access continues, but the prospect of a weaker domestic economy and heightened policy uncertainty lead us to maintain our maximum underweight of the UK in our International, Global, and Tactical Trend ETF Portfolios.

NEWS UPDATE: Markets reacted positively this morning, Wednesday, October 12th, to the news that Prime Minister May has agreed that Parliament should vote on her plan for exiting the European Union. Conservatives have only a slim majority and views on Brexit differ within the party. The Labour party has called for this Parliament scrutiny. This development is seen as increasing the probability Britain will seek to find a way to maintain access to the single market. But May is still insisting limiting immigration is more important. The outcome in Parliament will be critical for Britain’s future.

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Chief Global Economist
bill [dot] witherell [at] cumber [dot] com ()