The clock has started, and it’s time for the UK government to roll up its sleeves because the heavy lifting begins now. How it splits assets and liabilities with the EU and whether it can negotiate a trade deal to replace the current relationship with its most important trading partner within two years will be key. And while it’s been so far, so good for the UK economy since the Brexit vote, will the consumer continue to drive growth? As this new era dawns, we look at how the negotiations are likely to play out and what this means for UK financial markets.
Breaking up is hard to do
Prime Minister Theresa May’s Brexit negotiation strategy is now clear. The UK will leave the EU’s single market, the territory with more than 500 million people with free movement of goods and services. By doing so, the UK will escape the restraints of EU regulations and reclaim control of immigration.
The UK will also have to withdraw from the EU customs union in order to form new trade links outside the continent. No trade agreements with non-EU countries can be negotiated so long as the UK is a member of the customs union.
Having triggered Article 50, May will initiate the Brexit negotiations, which have a strict two-year deadline — whether or not an agreement has been reached, the UK will be out of the EU two years from the trigger date. Much like a divorce settlement, the negotiations will focus on winding up the current relationship and discussing how to separate assets and liabilities, such as property and pensions.
Separately, the terms of a new relationship with the EU also need to be agreed. This process will be difficult as the EU will seek to preserve the cohesion of its remaining members. Indeed, negotiations may not start until the divorce has been settled. Even so, they will likely start slowly as Europe remains preoccupied by the French presidential elections in the spring and the German federal elections in September, where a real challenger to Chancellor Angela Merkel – Social Democratic Party leader Martin Shulz – has emerged.
Furthermore, Scotland’s first minister, Nicola Sturgeon, plans to call a second independence referendum within the next two years on the basis that more than 60 percent of Scots voted to remain in the EU. The UK government will do all it can to delay a second Scottish referendum as it could weaken the UK’s bargaining position with the EU. Trying to preserve the British union at the same time as complex negotiations with the EU take place would be a significant challenge.
There is no deadline for agreeing to the new terms of the relationship with the EU, so if an agreement is not struck before Brexit’s completion, by default the UK-EU relationship will be governed by the regulations of the World Trade Organization (WTO). UK exports would not only face tariffs going into Europe, but also non-tariff barriers, such as product standards and regulations, would be erected. Imports could be held up at customs due to lengthy debates about rules of origin, disrupting supply chains.
Falling under the auspices of the WTO could be painful, as UK exports to the EU are worth 12 percent of GDP (EU exports to the UK are a lesser 3 percent). We would rate the probability of this as low but not negligible. Certainly, the government seems to be bracing itself for this possibility, and May has stated she would rather have no deal than a bad deal. An interim or transitional trade agreement until the final relationship with European countries is agreed upon would be useful so as to avoid a “cliff edge” for businesses.
To replace the UK’s trade relationship with the EU, May plans to establish free trade agreements with other regions around the world. But with the EU receiving roughly half of UK exports, this is no small task. While it would be remiss to underestimate the resilience and ingenuity of the UK, replicating the EU’s trade deal with more than 50 third-party countries will likely be daunting.
So far, so good?
Despite the challenges ahead, the UK economy has held up well since the Brexit vote. Swift action by the Bank of England and a weaker pound underpinning exports are often cited as reasons for this. But the main driver has been consumption as households not only dipped into savings, but also increased debt levels, taking advantage of the availability of cheap credit.
Indeed, 85 percent of new loans were made at a low rate of 3 percent or lower. Net consumer credit grew at a rate of more than 10 percent year on year, a level which may prove difficult to sustain. With most loans on a variable rate basis, any increases in interest rates in the years ahead would pinch households’ pockets.
And even though no interest rate increase is likely in the medium term, it may become more difficult for the consumer to prop up the economy going forward. Disposable incomes are already losing momentum just as consumer confidence has plateaued.
Inflation is picking up and could surpass economists’ 3 percent consensus expectation in the next year, as the weak pound feeds through, squeezing disposable incomes. Moreover, overall house prices, which have underpinned the consumer for years, are rising more slowly and are actually coming down in London as heavier property taxes take their toll. Brexit uncertainty will likely deter buyers, though, at some point, the weaker pound may start to attract foreign buyers back to the London prime market.
Overall, while it would seem the 1.6 percent GDP growth that RBC Capital Markets has forecast for 2017 is benign, the risk is skewed to the downside.
The barometer for this Brexit uncertainty has been the currency. The pound is down 16 percent since the referendum and more than 20 percent since the vote was first promised in the run-up to the 2015 election. We expect the pound could fall further against the U.S. dollar from here, as factors that enabled it to hold steady in recent months are likely to be challenged going forward. For instance, rising growth expectations will likely eventually sow the seeds of their own demise and become unattainable. Meanwhile, export volumes are failing to respond to the pound’s weakness.
While the UK stock market is facing greater uncertainty than other regions, we still believe that it will be reasonably underpinned by various factors. For one, the UK has the highest exposure to non-domestic sales in Europe, at some 70 percent. These revenues are likely to benefit from a weak pound and from the improved global economic environment.
The stock market is also likely to be supported by merger and acquisition activity. With the pound now 25 percent cheaper than at its peak in U.S. dollar terms, British companies are more attractively priced for foreign buyers. Moreover, given that the UK equity market’s exposure to financial companies should also help to underpin performance. The financial sector tends to perform well when interest rates move higher at this stage in the economic cycle, therefore firms exposed to U.S. interest rates should benefit the most.
In fixed income, we expect the EU divorce negotiations to feature heavily over the coming months. This, and the belief that the Bank of England may cut interest rates to support markets, will likely bring added volatility to the short end of the UK bond market.
Overall, there is little visibility at the moment as to what the shape of the UK economy will be in two years’ time. While investors should approach UK investing with caution, there continue to be compelling selective opportunities in the region.