OCBC OneWealth App– Brexit: Happy endings are for fairy tales

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Brexit: Happy endings are for fairy tales

14 December 2020

Irreconcilable differences

The journey that began in 2016 is about to meet its scheduled end, although not with an ending that many had hoped for. Chances of a trade deal between the UK and the European Union appears increasingly slim. There are intractable differences on both sides that seemingly cannot be resolved. Both are unwilling to compromise, at least at this point in the game.

Access to British fishing waters seems to be a bone of contention. It is a politically sensitive issue and hence courts plenty of attention. However, compromise already seems likely in this area.

Less discussed is the more significant disagreement surrounding the issue of a “level playing field.” Concerned that a post-Brexit UK will undercut social, environmental, labour and state-aid rules that underpin the single market to get a leg up on the region, the EU has demanded for a mechanism that would make access to the single market contingent on both sides, maintaining a regulatory “level playing field.”

Essentially, through this mechanism, the EU will have the right to promptly retaliate by levying trade penalties on the UK should it attempt to undercut EU rules. The inconvenient reality is that this is bound to happen anyway because a post-Brexit UK will be independent of the single market and therefore should have the right to determine their own rules and diverge from EU regulations without fear of reprisals from the EU. The threat of retaliation is seen by Brexiters as another way for the EU to ensure the UK remains tethered to its rules. Yet, this demand is not unique to the UK. In fact, Norway has had to operate within these terms to gain access to the single market.

In view of these almost intractable differences, both UK Prime Minister Boris Johnson and European Commission President Ursula von der Leyen have sounded increasingly pessimistic over the prospects of a deal and have alerted their respective governments to prepare for a possible no-deal outcome.

Initially, both sides had until Sunday to secure a deal. Yet, overnight, both leaders agreed to go the “extra mile” and keep working on a post-Brexit accord. Does this mean a deal is within reach? Who knows? All we can do is prepare for the worst, although we think chances are talks will go down to the wire and a skinny deal may finally emerge.

Suppose we get a “no-deal” outcome

The transition period ends on 31 December. Failing to secure a deal by this hard deadline means the UK will fall out of the single market without a new set of trading rules and regulations in place. Customs and regulatory controls will apply immediately as the UK becomes a third country in relation to the EU. Trade between the UK and the EU will be conducted under the terms of the World Trade Organisation (WTO) with the applicable tariffs being the most-favoured nation (MFN) duties. This has serious implications, not least because exports to the EU accounts for 46% of all UK goods exports. The effects of tariffs on these goods naturally have key implications for growth.

Non-tariff barriers may be a more potent cause of disruption in the near-term. Custom procedures, additional administrative paperwork and further checks to ensure compliance with different regulatory standards will create a more onerous process for trade and may incur high logistical and administrative costs.

As it stands, certain main points of entry into the UK for lorries reportedly do not have the capacity to introduce custom controls without adversely impacting the current volume of traffic that passes through these points on a daily basis.

Other reports suggest that lamb, beef and poultry exports originating from the UK might be denied entry into the EU in view that these individual exporters have not been approved by the European Commission’s Food and Veterinary Office, particularly because they hadn’t needed to in first place due to the UK’s membership in the EU.

Impact on financial markets

For the most part, financial markets have priced-in an eventual trade deal. Only recently had the Pound reacted to the potential risks of a no-deal outcome. A no-deal scenario will likely shock global markets and push the GBP lower against the US Dollar, as markets price in a near-term disruption to trade and lower growth potential.

As can be gleaned from Chart 2, the GBP tends to react strongly to Brexit developments and the threat of trade between the UK and EU – by far Britain’s largest trading partner – being disrupted. The GBP plunged 12% from 1.50 to 1.32 against the greenback in June 2016 following the Brexit referendum and fell close to 1.20 in the weeks and months after. It may well test these levels again, should a no-deal outcome emerge.

As it stands, the UK economy is already in a weak spot. Its GDP is projected to contract by more than 11% this year owing to the pandemic and the multiple lockdowns that the government had to implement to contain the spread of the virus. This is a far worse outcome than the Eurozone, US and Japan.

Monetary and fiscal policies are already stretched, with fiscal deficit expected to balloon to about 19% of GDP – its highest level since 1944 during World War II – while monetary policy remains very accommodative with the benchmark interest rate pinned at crisis lows of 0.10%. Despite this, a no-deal shock will spur the government to act with more fiscal stimulus. Meanwhile, the Bank of England could increase the pace of asset purchases and potentially push interest rates into negative territory to stabilise the economy. The confluence of these factors, both the economic shock and the resulting policy responses, will only dampen the Pound further.

Risk aversion would be the most immediate reaction to a no-deal shock. Demand for haven currencies like gold, Yen, US Dollar and the Swiss Franc will likely rise in the near term. Global stocks might be impacted from the risk-off mood, although the effect will likely be more pronounced in the UK and European markets. This is broadly a European problem after all.

As it stands, European stocks have underperformed other regional markets year-to-date, with the MSCI Europe Index and FTSE 100 UK benchmark down 7% and 13% respectively. A no-deal shock only compounds the problem. Susceptible stocks would be export names with a high exposure to UK trade. We can expect Germany’s auto players to be hit from a chaotic exit as the UK remains a key export market for its products.

Perhaps there is still hope

Four years into this Brexit saga, we’ve observed that a deal somehow emerges right at the 11th hour. Of course, the past is not necessary prologue and it shouldn’t lull us into a false sense of confidence that a deal would somehow emerge amid these intractable differences.

While UK Prime Minister Boris Johnson and European Commission President Ursula von der Leyen had earlier called for a firm decision by Sunday, the hard deadline is still 31 December. It’s little wonder therefore that they allowed talks to continue past the Sunday deadline. Even if a no-deal outcome is the end destination, they would still want to show that they expended every possible effort to avoid it. Giving up just a couple of weeks before the hard deadline would not help their political image. We could still see talks going into the last weeks of December as they seek to avert a chaotic exit.

While we should always prepare for the worst, compromises tend to happen when the stakes are the highest. Until then, the lack of indication that a deal is forthcoming will cause financial markets to start pricing in a chaotic exit from the EU and UK’s current trading arrangements on 31 December.

For regional markets outside Europe, a no-deal Brexit is a shock that can undermine risk assets. But over time, this might appear more of a sideshow than a fundamental focus.

Think of Brexit as the bridesmaid who chooses to wear a white dress to a wedding. Sure, she will elicit some audible gasps from the audience for her sheer audacity, but soon enough focus will return to the bride. It’s her day after all. To avoid ambiguity, Covid-19 is the bride in this analogy and 2020 rightly belongs to her. Brexit be damned.

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