We see five main options for Brexit in the coming months; three result in a near-term resolution while two options result in a further delay or “no deal” Brexit.
A resolution would likely sustain the recent rally in U.K. assets and resolve some near-term uncertainty weighing on the global economy.
No deal would likely result in a recession and bear market for the U.K. and varying degrees of negative impact for other countries proportional to their exposure to the U.K.
What is the latest on Brexit?
A new British law passed by Parliament this month requires Prime Minister Boris Johnson to ask the European Union (EU) to postpone the U.K.’s exit from the EU beyond the October 31 deadline should the EU leaders’ summit in Brussels on October 17-18 result in no agreement.
The EU is currently unwilling to alter the terms on Brexit. If no new deal is reached, Johnson has said he will ignore the law and take the U.K. out of the EU on the October 31 Brexit deadline, in an attempt to gain leverage for a new Brexit agreement. Currently, talks are stalled with the EU over the so-called Irish border backstop, a policy intended to ensure there are no checkpoints crossing the U.K.’s land border with Ireland.
What happens next?
For the moment, it appears a damaging “no deal” Brexit may be avoided should Parliament succeed in taking back control of Brexit from the Prime Minister (PM). However, there are still a number of potential outcomes. In our view, the main options, in order of their likelihood, are:
- Further delay – Another extension of the Brexit date to January 31, 2020 is what Parliament intended by passing the new law, with the intention of passing PM May’s Brexit deal (or possibly an election and new Parliament if necessary). This delay could be followed by yet another delay or one of the other options.
- Pass PM May’s Brexit deal – While this deal fell just short of a majority when voted on three separate times, there is a chance this bill (with or without minor changes) could pass if put to another vote, if it seems no new deal with the EU can be achieved.
- Exit without a deal – While it would face many challenges, Johnson may take the U.K. out of the EU on October 31 without a deal. Alternatively, Parliament may still fail to pass an agreement after securing yet another delay (option 1).
- Craft a new deal – The EU has little incentive or inclination to change the deal it crafted with former PM May, despite Johnson’s threat to withdraw from the EU without an agreement if he doesn’t get a new deal over the coming month. However, a minor change to the May deal is a possibility being signaled by some EU leaders.
- Revoke Brexit - Parliament may pass new laws that revoke the Article 50 notification, which triggered the U.K.’s legal divorce proceedings and EU exit timeline.
Is Brexit resolved if a deal is passed (option 2 and 4)?
No, simply because the deal isn’t a comprehensive outline for Brexit. There is no provision for a post-“customs arrangement” trading relationship between the U.K. and EU. Also, the U.K. would still be constrained from entering free trade agreements with non-EU countries such as the United States. So another series of potentially contentious negotiations would need to begin.
While these longer-term trade agreements are negotiated, there would be little immediate economic impact on the U.K. or the rest of the world. The U.K. will remain in a customs arrangement with the EU until December 2020 (which could be extended) or until a better solution is found to keep the Irish border open. As a result, there will be no need for tariffs, quotas, or land border checks between the U.K. and the EU. Importantly, most U.K. financial services companies will be able to access the EU market, as long as the U.K. maintains similar regulations to the EU.
How does a deal impact the markets and economy?
While markets may not be able to breathe a total sigh of relief that business won’t be disrupted in the event a deal is passed, much of the near-term uncertainty would be resolved and likely sustain the rebound in the British pound and U.K. stock market from near the lows seen since the July 2016 Brexit referendum.
Recent partial rebound from near post-referendum lows
Source: Charles Schwab, Bloomberg data as of 9/15/2019.
The U.K. economy contracted slightly in the second quarter, following a build-up in the first quarter in anticipation of the original Brexit deadline of March 31 and a Brexit-related shutdown of auto production. However, third quarter growth is expected to rebound. Under options 1, 2, 4 and 5, the U.K. may avoid the start of a recession in the fourth quarter, with GDP continuing to increase at around a 1% pace into next year. As in most of the world, U.K. manufacturing is weak and economic support is coming primarily from consumer spending as rising wages and slowing inflation have supported consumer purchasing power.
While Brexit hasn’t been a major worry for global markets this year, the lessened risk of a shock to global economic growth and the financial system may support a modest relief rally for the world’s stock markets.
What if there is a “no deal” Brexit (option 3)?
A “no deal” Brexit would likely push the U.K. into a recession, with GDP dropping sharply by early 2020. The Bank of England’s latest updated analysis of the economic impact of a no-deal Brexit includes an initial plunge of 5.5% in GDP, a sharp rise in unemployment to 7% (from the current 3.8%), and a jump in inflation to 5.25% (from around 2%) as the pound falls and import prices rise. The loss of jobs and erosion of spending power from the rise in inflation may crush consumer spending, which makes up two-thirds of the U.K. economy. With U.K. stocks up around 10% this year, there is substantial downside risk in the form of a bear market in the event of severe recession and business disruptions. The hit to confidence and the outlook to earnings could be severe.
However, a “no deal” Brexit may be far less impactful on the rest of the world, looking at relative exports. U.K. exports to the EU have accounted for a substantial 12-15% of U.K. GDP over the past decade, with about half of all U.K. exports go to the EU. But EU exports to the U.K. are just 3-4% of GDP for the remaining EU countries with only about 10% of the EU’s exports go to the U.K.
However, this trade relationship varies by country, as you can see in the chart below. Belgium and the Netherlands have a high trade exposure relative to the size of their countries (the numbers for the Netherlands may be inflated from goods flowing through their ports) and Germany’s auto industry exposure is significant, since it exports 14% of the cars it makes to the U.K. In contrast, total exports to the U.K. account for only 2% of German GDP. Ireland has the opposite problem, relying on imports from the U.K. rather than exports. Other EU countries have marginal exposure relative to their economy, most notably France which has very little exposure. This may be a reason why Germany seems more willing to find a compromise with the U.K. than France, which has taken a hard line on any changes to the May Brexit deal. Over the past three years, there have been preparations for any potential business disruptions, with many businesses moving staff and operations to the EU from the U.K.
U.K. trade balance with other EU countries in 2018
Source: Charles Schwab, Data from U.K. Office for National Statistics’ Pink Book 2018 Table 9.3
Looking outside the EU, the U.K. is one of the top five trading partners of the U.S., but this relationship makes up less than 1% of U.S. GDP. Japan has similar-sized exposure to the U.K. on a percentage of GDP basis.
While the direct impacts may be generally relatively minor outside the U.K. and there has been more than three years for businesses to prepare for the possibility, the impact of a “no deal” Brexit—including a recession in the sixth largest economy in the world—would act as an additional drag in a global economic environment already growing at a below average pace and vulnerable to shocks.
Stock markets around the world would likely suffer some losses with a “no deal” Brexit, proportional to their exposure to the U.K.. These potential losses are unlikely to be nearly as severe as those in U.K. equities. However, there may be an offset if fear of fallout from a “no deal” Brexit were to help drive a compromise on a U.S.-China trade deal and invite fiscal stimulus in Europe.
How did we get here?
The U.K. has never been fully comfortable linking itself to continental Europe. Britain dragged its feet for 17 years before joining the European Economic Community, the EU’s predecessor, after it was formed in 1957. The same euro-skepticism kept the U.K. from joining the Eurozone and the euro currency when it began 20 years ago in 1999.
EU membership has not been a negative for the U.K. The U.K. economy trailed well behind the world’s third and fourth largest economies of Germany and France in 1973 when it joined the EU. By 2007, it had surpassed France and narrowed the gap with Germany. Growth slowed in the U.K. as it did elsewhere following the 2008 global financial crisis. By 2016, nationalist sentiment had taken root with the belief that the U.K. may grow more quickly if unencumbered by EU bureaucracy, policies and trade agreements.
While the long-term benefits of an exit from the EU can be debated, over the past two years the U.K. has been losing ground as growth lagged behind the rest of Europe with an uncertain future clouding the outlook for business investment. The series of Brexit delays with no obvious resolution continue to take their toll.
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