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UK Brexit scenarios and their investment implications

Jon Cunliffe, Charles Stanley's Chief Investment Officer, looks at the market implications for each of the five potential Brexit outcomes

by
Jon Cunliffe

in Features

27.09.2018

The UK is scheduled to leave the EU on 29th March 2019.  This is enshrined in the Royal Assent to the EU (Notification of Withdrawal) Act, which was passed by the House of Commons by 494 votes to 122 and unopposed by the House of Lords.  The act fulfils all international and EU law requirements for the UK to leave on 29th March 2019, with or without additional agreements.   

The UK has petitioned the EU for a 21-month extension period from 29th March to smooth the transition involved in the UK’s EU withdrawal.  During this period, protocols around trade, migration rights and EU subsidies will remain broadly unchanged and the UK taxpayer will continue to make contributions to the EU budget.   

The current negotiations involve

  • A Draft Withdrawal Agreement relating to the 21-month transitional period.
  • A possible Political Agreement detailing the UK and EU’s intentions towards forming an Association Agreement.  This could include a free-trade agreement, data sharing and cooperation on criminal justice to name just three.

There is a clear link between these two agreements because, in return for making budget contributions for an additional 21 months, the UK will want the best possible agreement on future trade relations with the EU.  And this is going to be the sticking point.

The EU’s target date for a final UK Withdrawal Agreement and declaration on forming an Association Agreement is the 18th October, when the European Council meeting takes place.  It looks likely that more time may be needed.

As things stand, the European Council Meeting on 13-14th December may be the last chance for the UK and EU to agree on a Withdrawal Agreement. 

Assuming the UK and EU can agree it would then fall to Parliament to vote on the negotiated Brexit deal.  The risk here is that Parliament could vote against the Brexit deal, leading to a Conservative Party leadership challenge and potentially another general election.

Irish Border Question

The UK and the EU have pledged to avoid a so called “hard border” between the Republic and Northern Ireland.  In essence, any physical infrastructure could become a target for militants, contrary to the Good Friday Agreement.  Both the EU and UK are in agreement that a hard border is to be avoided but, at the time of writing this note, there has been little agreement regarding how this can be achieved – and this is important.  According to the EU’s sequencing, without an agreement on Ireland, there can be no Withdrawal Agreement and without a Withdrawal Agreement there can be no agreement on future trade relations with the EU.  The EU has proposed a backstop plan which makes Northern Ireland subject to the EU customs union and many single market rules comprising a common regulatory area where goods can move freely.  The UK government has rejected this, because it feels that for Northern Ireland to follow EU rules and be subject to EU restrictions would be unacceptable from a constitutional perspective and, in any event, the 10 Democratic Unionist MP’s, upon which Prime Minister May’s parliamentary majority relies, would also not agree.  One way round this issue is a customs plan based upon technology and trusted-trader status for small businesses conducting cross-border trade, known as “maximum facilitation”.  This has thus far been rejected by the EU.

What are the possible outcomes?

No Deal:  a few months ago many people felt that this was a very low probability scenario.  However, the attitude of many Brexiteers appears to have hardened following the release of May’s Chequers Agreement (see below) and the probability of this scenario may now be as high as 40%.

Under a “no deal” scenario the UK leaves the EU on 29th March 2019 and the UK will be governed by international (WTO) trading laws.  There will be a clear separation between UK and EU laws.  Tariffs and border checks will commence forthwith, and there has been much speculation about the likelihood of disruption to the flow of goods and services between the UK and EU.

UK companies which generate much of their earnings from the domestic market may benefit, as imported goods are likely to attract tariffs, companies reliant on imported goods may fare less well as they are likely to be affected by tariffs and border checks.

The issue of the Irish border is relevant here, because unless some form of workable “maximum facilitation” process can be implemented the UK government could be seen as failing to keep its side of the Good Friday Agreement.

Policymakers anticipate that a “no deal” scenario will create a negative shock to the UK economy, by causing business and consumer confidence to weaken.  In addition, in this scenario Sterling is expected to decline, causing a further unwelcome rise in inflation and squeezing real-income growth.

The Bank of England would probably look through the rise in inflation and focus instead on the downside risks to the UK economy, so Base Rates would be cut and Quantitative Easing (the purchase of government and corporate bonds to lower borrowing costs) would be reinitiated. We would expect Gilt yields to fall and Sterling to decline (at the time of writing, market consensus is for GBP/USD to reach 1.10 in this scenario).  In the immediate aftermath, large cap equities would benefit from a weaker Sterling, whilst domestically focused equities would be marked down, giving rise to buying opportunities, much in the same way that we saw in the aftermath of the EU Referendum in June 2016.

The decline in Sterling and weakness in domestic equities would be amplified in the event of a Corbyn government, which at the time of writing, proposes for up to 10% of all listed equities to be given to employees at a rate of 1% per annum, effectively diluting existing shareholders and is likely to prompt a number of UK listed companies to consider switching their listing to overseas exchanges. This is in addition to proposals to renationalise a number of utilities, the Royal Mail and rail firms.

Canada +: The UK makes a definitive split from all EU arrangements and institutions, including the single market, customs union and European Courts of Justice.  The UK is able to set its own rules and regulations and is able to strike bilateral trade deals with other countries.   Against this background, and with free movement ending after 2021, many argue that only this outcome is consistent with the vote to leave the EU in that it represents the genuine break with EU rules and institutions entailed by leaving the EU.

The Canada + arrangements envisage a comprehensive free trade agreement with the EU, supported by a “maximum facilitation” process.  Crucially, this will only apply to goods not services.  Thus far the EU have said that they will consider this only for Great Britain, and not Northern Ireland, a clear issue for the DUP and the stability of PM May’s government.

This proposal hinges on the Irish border question.  In this scenario the market will anticipate reasonable economic growth which should lend support to the Bank of England’s tightening bias.  Gilt yields are likely to rise, but not aggressively, and Sterling will be boosted by the prospects of more future interest-rate support.  In the round, UK equities should perform in line with global markets, but higher Sterling may be a relative headwind for large cap stocks and domestically defensive equities (so called “bond proxies”) may be a little vulnerable to higher bond yields.

Soft Brexit: The UK keeps a much closer alignment with the EU, potentially remaining in the single market and/or the customs union.  Supporters of this type of Brexit arrangement argue that it is likely to be less disruptive to the UK economy and it probably avoids the need for a hard border.  However, the UK could miss out on the ability to strike bilateral trade deals. 

In addition, those in favour of a harder Brexit argue that a soft Brexit is not consistent with the outcome of the EU Referendum in that the UK would still be bound by key EU institutions and protocols.

The Bank of England would view this as constructive for the UK economic outlook.  Given this, we would expect higher base rates, higher Gilt yields and a substantial rally in Sterling.  Large cap equities would underperform and, in general, domestic UK equities would outperform (however, bond proxies could be pressured by higher bond yields).

Chequers: In essence this arrangement was proposed to bridge the gap between “hard” and “soft” Brexit.  The idea was for the UK to remain close to the EU when it comes to trading goods.  The UK would sign up to a common rule book with the EU, which would avoid the need for tariffs and border checks.  Elsewhere, the UK would seek more freedom to strike trade deals with the rest of the world and Prime Minister May has expressed the hope that by using EU trade rules a hard border with Northern Ireland could be avoided.  Both the EU and many in the government are unhappy with this as they consider it a fudge. 

In this scenario the market will anticipate reasonable economic growth, which should lend support to the Bank of England’s tightening bias.  Gilt yields are likely to rise, but not aggressively, and Sterling will be boosted by the prospects of more future interest rate support.  In the round, UK equities should perform in line with global markets, but somewhat higher Sterling may be a relative headwind for large cap stocks and defensive domestic equities may be a little vulnerable to higher bond yields.

A “People’s Vote” on the terms of the UK’s departure from the EU, causing a Brexit reversal: At the time of writing there appears more appetite for this.  It would, however, require Parliament to overturn the EU (Notification of Withdrawal) Act, but were it to happen it could (just about conceivably) see the UK remain in the EU.  This is currently the least probable outcome.

The reversal of so called “Brexit uncertainty” will cause the Bank of England to anticipate a resurgence of positive “animal spirits”, which would boost business and consumer confidence.  Expect much tighter Bank of England Policy and a significant rise in Gilt yields; Sterling rallies aggressively versus the USD to $1.45-50.  Large-cap equities are marked down whilst domestic earners are likely to rally.  Bond proxies underperform, reflecting higher Gilt yields.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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