Karen Ward: Why are people talking about Brexit risks again?

People often stop me in my tracks when discussing Brexit to ask, “Isn’t it done?” Alas no. While the UK did officially leave the EU on 31 January, for the economy nothing actually changed since the UK entered into an 11-month period of transition. During this time the UK and EU were supposed to agree on a future trade arrangement to commence on 1 January 2021.

The terms of the UK’s departure from the EU were legally enshrined in the Withdrawal Agreement. Included was a specification that if the UK felt more time was needed for the negotiations the UK could request an extension to the transition period. But that request had to be made by 30 June. Hence people are talking about Brexit again now.

Negotiations do not appear to have proceeded well. It’s not just because Covid-19 has created physical and capacity constraints. At the root of the problem is the same issue that has plagued the discussion for the last four years. The UK wants to regain control – to become fully sovereign – setting its own rules and regulations overseen by British Courts. However, the EU is not willing to grant significant access to the single market without guarantees that standards will not be undercut to gain competitive advantage. One can see the point of both.

What does it mean to trade on WTO terms?

So what happens next? The UK government appears resolute in not requesting an extension. Seemingly this will create a crunch point towards the end of the year – either the next six months will see a breakthrough and a free trade agreement (FTA) will be established, or the UK will leave and trade on the World Trade Organisation’s (WTO) terms.

Trading on WTO terms has been used synonymously with ‘hard Brexit’. What exactly does it mean? The short answer is potential tariffs, more customs paperwork for businesses that trade with the EU and potentially the need for the UK to be removed from EU supply chains if regulatory conformity cannot be guaranteed. It is these non-tariffs barriers that we would expect to have the most economic impact. There could also be significant ramifications for financial firms since the UK would lose its passporting rights – its ability to serve EU clients from the UK.

Advocates for a hard Brexit argue that a clean break would allow the UK more flexibility in negotiating future trade deals with other trading partners, although any benefit from these agreements would still only be seen once these trade deals have been implemented, which is often a lengthy process.

The fortunes of sterling and markets on a trade agreement versus no deal

What will happen and what will be the implications for markets? In our view, the announcement of a comprehensive FTA might see sterling rise to 1.45 against the US dollar. By contrast, in a no-trade deal scenario we see sterling closer to 1.10 against the dollar. Much weaker sterling would partially help the UK to cope with new trade frictions.

The markets are unlikely to react negatively to the 30 June deadline passing unless both sides make it clear that further negotiations are pointless and attention should turn to preparing for no deal. At present the EU has stated that negotiations should proceed, alongside what it terms ‘readiness’ preparations in case no deal can be agreed.

If negotiations are proceeding, then the market may not pay close attention until the autumn when crunch time approaches. Our central expectation is that by the start of the fourth quarter both sides will be in full sabre-rattling mode in order to extract the most concessions. It will appear that no deal is on the cards. But as the end of the year approaches pragmatism will prevail and some solution will be found.

While this is our central expectation there are significant risks around this that investors should be mindful of. Sterling may be particularly volatile and with almost 80% of revenues coming from abroad for the FTSE this will also have implications for the stock market since higher sterling could put downward pressure on earnings and vice versa should sterling fall, all things equal.

However, we caution against relying too heavily on the FTSE rallying in the event of a hard Brexit as a disorderly Brexit would be likely to negatively impact both UK and EU activity and depress some of the foreign earnings which matter to UK companies.

Karen Ward is chief market strategist for EMEA at JP Morgan Asset Management

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