When should the Brexit take place in full?
What is the 'no deal' and what would it mean for the UK economy and markets?
The European Union (EU) is a community of countries whose members can trade with one another with minimal barriers because all countries apply common regulatory norms and product standards. Goods that are imported into the EU from countries that are not members of the Community are subject to a common customs duty. The EU also concludes trade agreements with other countries or blocs on behalf of all of its members. There are 40 such agreements covering around 90 countries.
When the UK leaves the EU, it will remain in a broader community of 164 countries called the World Trade Organization (WTO). The terms of trade agreed in the WTO are much more general, which is why a return to the level of WTO terms would mean
- that British exports to the EU would be cleared and vice versa. The WTO prohibits discrimination between its members, which is why the duty rate for a product must be offered to all WTO members (which is known as the most-favored-nation clause). That would correspond to a weighted average rate of around 3.2% on UK exports to the EU.
- Customs controls should be carried out at all border crossings, including the border between Northern Ireland and the Republic of Ireland.
- There would be no mutual recognition of product standards, which is why regulatory reviews would have to be carried out for new and existing product lines.
- The UK financial services sector would lose its passporting rights (i.e. the right to provide services to EU customers from all EU countries). Broadcasting rights and claims for transport services would also be lost.
- The UK would have to replicate all trade agreements negotiated by the EU on its behalf (so far, 12 of the 40 agreements have succeeded in doing so), but it would also have the option of signing new trade deals on its own.
While that would be the starting position on November 1st if the UK leaves without a deal, there would actually likely be a number of emergency arrangements in place to ease the transition process, even if the negotiations ended in a really hostile way. For example, each side could decide to update certain agreements for a fixed period of time to give companies the opportunity to make adjustments during a transition period.
The extent to which such arrangements are made is just one of the factors that make any forecast of this unprecedented process uncertain. In our opinion, the most detailed and rigorous attempt at analyzing the short-term effects of an exit without a deal has come from the Bank of England (BoE) at the request of the Treasury Select Committee. The table below is taken from this report1 and depicts the impact of a "disorderly" no-deal scenario on the economy and pound sterling versus a "disruptive" no-deal scenario in which both sides take precautions to facilitate the transition.
Figure 1: Modeling of no-deal Brexit scenarios by the Bank of England
Source: Bank of England, J.P. Morgan Asset Management. For GDP and real estate prices, the maximum decreases from the starting point are given. The unemployment rate and inflation are peak values. Data as of August 6, 2019.
After analyzing the assumptions, the “disruptive” scenario is, in our opinion, more plausible than the “disordered” one. The most immediate impact on an economic level would be the disruption of supply chains. Companies would have to deal with customs clearance and EU manufacturers would try to source components from EU companies that officially comply with EU regulations. It is worth mentioning that, according to a survey by the BoE in July 2019, only a fifth of respondents said that their company was prepared for a no-deal Brexit. The sectors most likely to be affected are food and agriculture, chemicals and pharmaceuticals, and transportation and transportation services.
The depreciation of the British pound and subsequent inflation would tighten real incomes and lower consumer spending. This effect would be compounded if the business climate deteriorated and companies started shedding jobs. The current slowdown in global economic activity would be anything but helpful in this situation.
One of the main uncertainties is the EU's treatment of the UK financial sector. While the UK will lose its passporting rights, an agreement could be reached that UK companies can continue to provide financial services through some sort of "equivalency" arrangement (basically allowing them to continue providing some services while it is proven that the UK regulators issue regulations that are at least equivalent to EU regulations). It really helps that the BoE has such a good reputation internationally for its oversight skills.
In the absence of an agreement on financial services, a no-deal Brexit carries the risk of a general European financial bottleneck that would exacerbate the downturn on both sides of the channel. It could also be a serious problem for the UK if international investors questioned the current dominance of UK financial services providers, not least in terms of the sustainability of the UK budget (given that 28% of all tax revenues come from the top 1% of the UK Taxpayers originate).
The one element of the BoE analysis in the table that we question is the policy rate. The BoE had argued that a no-deal scenario would cause more damage on the supply side of the economy than on the demand side, resulting in sustained upward pressure on inflation as a net effect. Recently, the BoE has admitted that it is more likely to cut rates. We would therefore expect the BoE to cut the key rate at its November meeting, possibly by 50 basis points to 0.25%. In the months that followed, she would very likely begin again with systematic bond purchases. That could help the bond market absorb the additional issues of government bonds (the Office for Budget Responsibility2 stated that a no-deal Brexit would require the government to borrow £ 30bn annually).
As for the stock markets, there are many international companies listed on the London Stock Exchange with significant foreign sources of income and little exposure to the UK economy. If a no-deal Brexit is to come about, the devaluation of the British pound would noticeably drive up the earnings of these companies, which means that larger companies with significant foreign business are likely to outstrip the smaller, more domestically active companies. For comparison: in the ten trading days after the referendum in 2016, the British pound lost 13% against the US dollar. Over the same period, the FTSE 100 index rose 3.1%, while the FTSE 250 fell just over 8%. So while it can be foreseen that large caps should beat small caps if the pound fell again after an exit without a deal, it is less clear whether British large caps would generate a positive return as in the period after the Brexit referendum. If investors believe that UK-listed companies should be revalued and revalued lower following a disorderly Brexit in light of political uncertainties, this devaluation could partially offset the positive effect of higher earnings on prices. The ratings in the FTSE have already declined significantly since the referendum compared to the other markets of the industrialized countries, such asFigure 2 made clear. This suggests limiting the further risk of loss, but we would not rule out the possibility that the valuations investors are willing to pay for companies listed in the UK would fall to the next lower level in a no-deal scenario.
Figure 2: Difference in the PER in the FTSE 100 and MSCI World forward P / E ratios
x, difference as a factor
Source: MSCI, Refinitiv Datastream, J.P. Morgan Asset Management. The graph shows the 12-month P / E for the FTSE minus the 12-month P / E for the MSCI World. A value of zero means that both indices are trading at the same level; a negative value means that the FTSE is trading at lower valuations than the MSCI World. Data as of August 6, 2019.
The impact is not limited to the economy and markets. Without a solution to the Irish border, questions about the reunification of Ireland could arise. And a no-deal Brexit would give the Scottish independence debate a major boost, especially given that 62% of the Scottish population voted to remain in the EU.
Will parliament accept a no-deal Brexit and are we facing a new election, shouldn't that be the case?
We have seen on several occasions over the past year that there is no majority in the UK Parliament in favor of a no-deal Brexit. Will Parliament try again to block a no-deal scenario? And can it do that?
The current legal situation provides that Great Britain will leave the EU on October 31st. In order for Parliament to be able to block a no-deal Brexit, a change in the law would be necessary. That could happen if MPs linked changes to other government bills that the government wants to pass. A recent example is the amendment preventing the government from suspending Parliament, which has been linked to a law on the decentralization of Northern Ireland. The government can avert this risk if it decides not to come forward with new laws before October 31st.
So what options does Parliament have to intervene? At this point, Parliament's rules and regulations become vague and opaque. We know that the Speaker of the House plays an important role and he is known to have said that bypassing Parliament is unthinkable. While it is unclear exactly what legislative tool could be used to change the law, we can hardly imagine a scenario in which the Brexit outcome is in stark contradiction to what a majority in the UK Parliament wants.
Johnson could even use this opposition as a justification for calling new elections. His goal would be both to increase his majority (from the current marginal majority of just one seat) and to buy a little more time for the economy to recover after a no deal before he has to face the electorate again. Under the Fixed-Term Parliaments Act, Johnson would need a two-thirds majority to call new elections. We assume that one condition for gaining the appropriate support would be an extension of the October 31 deadline, which could be sold as a technical postponement due to the election. We would also expect the EU to agree to such an extension.
It is also possible that the Prime Minister will be forced into a general election if the Labor Party brings things to a halt by asking the vote of confidence.
As a reminder, the Fixed-Term Parliaments Act provides that the government has 14 days to regain the confidence of parliament - by changing its policy, the prime minister or the cabinet. If it fails to restore confidence, the other parties are given the opportunity to form a government.
In order for the vote of confidence and the elections to take place before October 31, the vote of confidence would have to be asked very early after parliamentary activity resumed.
The vote of confidence could also be initiated later, but then there is a risk that Britain will leave the EU on October 31 without a government of its own. However, to change the exit date to facilitate parliamentary elections, a government of national unity could be formed.
One thing is certain: the first few days of the coming parliamentary term will be very busy.
What are the risks to the markets in the event of an election?
The magnitude and magnitude of recent promises of tax cuts and spending increases suggest that the Prime Minister is preparing for a general election.
However, at this point in time, it is far from certain that the Conservatives will claim a landslide victory. Let's take a look at thatFigures 3 and4. Figure 3 shows that three years after the referendum the people of Great Britain are still deeply divided. This survey - from May of this year - shows that 30% of the population are against a deal. But 35% of the population would prefer to stay in the EU. This is causing a shift in the UK political landscape - seeFigure 4. For the people who don't want a deal, the newly formed Brexit party is tempting. In contrast, those who wish to stay lean towards the Liberal Democrats, who believe that the British people should have a new vote. These two parties are draining the electoral base of Conservatives and Labor alike.
Figure 3: Which outcome would you prefer for Brexit if you had a choice?
% of respondents
Source: YouGov, J.P. Morgan Asset Management. The survey was conducted on April 10th and 11th, 2019.
Figure 4: Intention to vote in a parliamentary election
% of respondents
Source: YouGov, J.P. Morgan Asset Management. The May 2018 survey was conducted on May 20 and 21, 2018. The July 2019 survey was conducted on July 29 and 30, 2019.
Johnson faces the difficult balancing act of remaining attractive to the Brexit hardliners ensnared by the Brexit Party, but not losing the Conservatives who want to stay in the EU and are tempted to vote for the Liberal Democrats. While no-deal supporters clearly predominate among Conservative members, support for a no-deal is less strong among their broader electorate. In fact, in May of this year, an election poll showed that of those who voted Conservatives in the 2017 election, 42% wanted to leave the EU without a deal, 32% were in favor of a Brexit with an agreement and 23% wanted to stay in the EU.
To make the situation even less predictable, the UK has a relative majority voting system with one-person constituencies which is very beneficial for the two leading parties. As a result, a voter who has usually voted conservatively but rejects a no-deal Brexit and lives in a constituency where one vote would be a wasted vote for the Liberal Democrats could vote for Labor solely on the basis of their Brexit preference. The potential for higher voter turnout by younger voters also adds to the uncertainty.
Overall, the outcome of a parliamentary election is difficult to predict, which entails several risks for the markets. It could happen that neither party gets a majority and / or the Liberal Democrats get significantly more votes, giving them a much more influential role in the formation of a new government. Such a development would most likely be perceived as positive by the markets.
Alternatively, the Conservatives could get a strong majority and have the mandate and parliamentary capacity to push Brexit through without a deal. Though unlikely according to recent polls, the Labor Party could win more votes if it can find a clear anti-Brexit stance and win the votes of Liberal Democrat-leaning voters. In this scenario, while the market would welcome Labor's pro-European stance, it would be likely to be concerned about the less-market-friendly initiatives included in the current Labor election manifesto, such as large-scale renationalization.
Has hope of a deal died?
It cannot be ruled out that the UK and the EU will reach an agreement in the coming weeks that the UK Parliament will accept.As a reminder, the deal negotiated by Theresa May consisted of two parts - a political statement on the future partnership, which was not legally binding, and an exit agreement, which was legally binding and included a financial settlement. This deal failed because of the backstop regulation in the exit agreement, which provided for a customs union with the EU in the event that the two sides could not agree on a future partnership. While this was a clear solution to dealing with the Northern Irish border and solved some economic problems, it did not give Great Britain back full sovereignty and restricted the country's ability to conclude its own trade agreements (Figure 5 contains a list of the different deals negotiated and their effects).
Figure 5: Brexit options for Great Britain
Source: J.P. Morgan Asset Management. Data as of August 6, 2019.
In order to improve the likelihood of the British Parliament passing the deal, a time limit on the backstop could be envisaged. Alternatively, the political declaration included a workaround that included a commitment to work on a technical solution for the Irish border that would not require a customs infrastructure and that the UK would be free to pass its own laws and trade agreements.
If the EU agrees to align the wording of the backstop with the text in the political declaration, the deal could win a majority in the UK Parliament. At this point in time, the EU is not showing any readiness to reopen the exit agreement, but a no-deal Brexit would be detrimental to the economies on both sides. Should the current political inclination to play with fire subside and a new deal is agreed, there could be a significant appreciation of the British pound towards the 1.40 mark against the US dollar.
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