Sunday’s agreement between European Commission president Ursula von der Leyen and UK prime minister Boris Johnson to continue UK-EU trade talks reminded us that there still is political will to reach an agreement.
Despite that more than four years have passed since the June 2016 Brexit vote, not much has changed so far. In fact, while the UK officially left the EU on January 31st, 2020, the 11-month transition period has allowed UK-EU trade relations to continue as usual with EU law still applicable in the UK. Nonetheless, the transition period comes to an end on December 31st, 2020, as set in the Withdrawal Agreement. The pressing timeframe was further confirmed last June when the UK formally denied the option to extend the transition period beyond the end of this year. This locked the Brexit negotiations to a six-month limited period with the UK set to exit the EU with or without a deal.
Key recent developments point to some progress on critical issues of fair competition but both sides remain at a gridlock over fishing rights, the key dispute blocking the trade agreement. The EU wishes to retain access to UK waters and in return would grant UK fishermen favourable terms on fish exports to the EU. While the UK is motivated to regain more control, UK fishermen export most of the fish caught, with the majority sold within the EU. Needless to say, the dependency is obvious, but so is the determination for one side not to concede.
Unless a Free Trade Agreement (FTA) is reached over the next three weeks, the UK is set for a hard Brexit. This would trigger an exit from the Single Market and EU Customs Union and shift its trade relationship with the EU to one that is based on the World Trade Organisation terms. As a consequence, a no deal scenario would introduce more tariffs, differences in regulatory regimes and ‘non-tariff barriers’ that would disrupt trade between the regions.
In August, the IHS Markit warned that a failure to reach an EU-UK trade deal could have broad negative implications to the UK economy, which is already struggling from the covid-19 pandemic downturn. In the event of failed negotiations, the IHS forecasts a contraction in the UK economy of 1.4% and 0.4% in 2021 and 2022, respectively. This contrasts with the baseline forecasts of an expansion of 4.9% in 2021 and 2.7% in 2022 if a disorderly Brexit is avoided. The divergence in expectations highlights the uncertainty to the outlook, which is closely tied to the Brexit negotiations outcome. More importantly, the economic contraction as a result of a hard Brexit reflects the broad-based implications of a disruption in the highly integrated supply chains and services.
The event driven market return implications of the Brexit negotiation, for the short term, are also asset class dependent. A comprehensive FTA is expected to strengthen the sterling and decrease the likelihood of further rate cuts by the Bank of England. On the back of a breakthrough in negotiations, yields and UK domestic stocks should move upwards as the recent rise in risk premium, driven by a higher probability of a no deal Brexit, unwinds. Meanwhile, the negative impact of a no deal scenario is expected to be largely felt across domestic companies, as lower GDP growth forecasts get priced in. The already depressed yield levels present relatively more limited downside risks but are also more likely to be driven by the Bank of England’s monetary decisions.
With or without an agreement, the UK is set to exit the Single Market at the end of this year. As the time window continues to narrow, the risk of a no deal outcome continues to tick higher. Nevertheless, political will remains, as agreement between European Commission president and UK prime minister to “go the extra mile” ignites hopes for a trade deal between the regions.
This article was written by Rachel Meilak, CFA, Equity Analyst at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.
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