Brexit Is Back: The Endgame For Investors
The risk of a “no deal” Brexit and the potential economic harm that accompanies it increased last week.
Uncertainty may continue until a potential last-minute compromise in mid-to-late October.
Avoiding a “no deal” Brexit could benefit U.K. financials and the pound.
The risk of a hard “no-deal” Brexit at the end of this year rose last week, weighing on U.K stocks and the British pound, and pushing U.K. monetary policy rate expectations into negative territory. But, as the Brexit battle moves to the endgame, there may be potential opportunity for investors.
UK equities lagging European peer
Total return measured by MSCI country indexes.
Source: Charles Schwab, Macrobond, MSCI data as of 9/11/2020.
What’s the latest?
The current flare up is fueled by U.K. legislation that would change key elements of the Brexit Withdrawal Agreement including subsidies and Northern Ireland trade that apply if a free trade deal is not reached. This is threatening to derail trade talks that must be finalized within a month. The complex issues at stake are illustrated by the diagram below.
The three scenarios are illustrated by areas where the circles overlap:
- The Brexit Withdrawal Agreement. If the U.K. leaves the EU’s Single Market and Customs Union and does not want a border between Northern Ireland (part of the U.K.) and Ireland (part of the EU), then there must be border between Great Britain and Northern Ireland (within the UK’s internal market). This was a key part of the Brexit Withdrawal Agreement.
- Violation of the Good Friday Agreement. If the U.K. leaves the EU’s Single Market and Customs Union, and does not want a border between Great Britain and Northern Ireland, then there must be a border between Northern Ireland and Ireland, violating the Good Friday Agreement, which specified that the island not be divided.
- No Brexit. If the U.K. cannot decide on a border between itself and the EU, either between Northern Ireland and Ireland or a border between Great Britain and Northern Ireland, then the UK cannot leave the EU’s Single Market and Customs Union.
The first scenario was agreed to in the Withdrawal Agreement (Brexit) between the U.K. and EU less than a year ago. But this week, the U.K. proposed eliminating the border between Great Britain and Northern Ireland. This new fourth scenario (the center of our diagram) that seeks to combine all three through this new U.K. legislation is the problem. The U.K. acknowledges that this breaks international law.
Last week, the EU gave the U.K. an ultimatum to amend or pull the legislation by the end of September. If the U.K. does not respond, there is a significant risk that, the EU could suspend talks on their future trading relationship, making a hard “no deal” Brexit a reality, ruining more than four years of negotiations seeking to avoid it.
What happens next?
If the U.K. and EU arrive at a trade agreement, the U.K. legislation, and the backstop issue it created, doesn’t apply. We believe there is enough room for compromise on the main issues dividing the U.K. and EU to develop a trade deal. The U.K. agreeing to a trade deal with Japan last week provides some encouraging momentum
Did the U.K. bank on introducing this legislation giving it more bargaining power to drive a deal with the EU? It seems unlikely that the EU will be willing to make any compromises, until the U.K. ends its threatened breach of the Withdrawal Agreement. Although the U.K. legislation is likely to stall in the House of Lords, be defeated or pulled, it is still delaying Brexit negotiations. As it has in the past, we expect a resolution at the last minute which may be mid-to-late October. At that time, after having pursued all other options, legal or otherwise, Johnson may accept a deal close to the present EU proposals, as he did when he signed the Withdrawal Agreement in October of last year that he and Theresa May had both rejected only a few months before.
At the Bank of England (BOE) meeting this week, policymakers are put in a tough spot. Despite better than expected economic data, the BOE is facing increased risks of a “no deal” Brexit, a sharp rise in new daily COVID-19 cases, and the October 31 expiration of the worker furlough program (which replaces 80% of pay for those who aren’t working due to the pandemic). Markets have moved to price in a cut to policy rates in the coming months, putting the reference rate in negative territory from the current BOE rate of +10 basis points,
Source: Charles Schwab, Bloomberg data as of 9/11/2020.
What does this mean for investors?
U.K. stocks have declined over 20% this year, sharply underperforming other European markets and reflecting the heightened risks. The British pound has fallen relative to the U.S. dollar this year as well, even as the euro has posted gains. Failure to agree on a deal would deliver a major blow to the U.K. economic recovery. However, a portion of these risks seem to have already been priced in to these markets, including the expectation that the Bank of England will have to a shift to negative interest rates prior to year-end to respond to the added economic shock.
With some of the risks already reflected in performance, a last minute deal may give a significant boost to markets and to confidence in the U.K. recovery. A deal could also motivate the EU to broaden the agreement over time, perhaps permitting the U.K. financial sector to be able to continue to provide financial services to EU customers. This could result in:
- A rally in U.K. stocks, and to a lesser extent EU stocks.
- Gains in U.K. financial stocks due to a lower risk of a reduced marketplace and negative yields.
- A rise in the British pound as the prospects for negative yields fade.
The Brexit endgame may finally be here after more than four years. That means risks for investors have mounted, but also offers potential opportunities.
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