With the UK having formally activated Article 50, Investment Manager Robin Kyle considers the longer-term implications.
If Brexit negotiations were a boxing match, it’s unlikely there would be a spare seat in the MGM Grand. A heavyweight contest set to go the distance, the result will have pronounced consequences for the future prosperity of both participants. The opening bell rang on the 29th March, as Theresa May formally activated Article 50 in a letter to the European Union.
The early exchanges have been very much as anticipated. May’s letter warned that if the UK is to co-operate on issues such as security, the remaining 27 member states must play their part on trade. The EU immediately countered, noting that trade discussions will only be brought to the table once “sufficient progress” has been made on a separation settlement. It won’t be until the later rounds that the contest will be determined but in the meantime, we’ve set out 5 thoughts on negotiations and their likely progression.
1. Market reaction to the announcement was muted, highlighting that investors have been doing a better job of tuning out the noise (at least until meaningful information is revealed). May’s letter, together with her accompanying remarks, ultimately offered little by way of further clarification on the UK’s approach. Particularly notable was the reaction of sterling, which ended the week stronger against the dollar and the euro, highlighting the level of bad news priced in. We expect that sterling will remain range bound in the medium term as negotiations progress but we continue to see the potential for longer-term upside.
2. Volatility is still anticipated to pick-up once formal negotiations get underway in early July. However, any real progress before the end of the year is unlikely, with Chancellor Merkel – undoubtedly a key figure for Europe – pre-occupied by domestic elections in November. Self-preservation ought to trump pragmatism as any early concessions to the UK could damage her popularity with the electorate.
3. Key early milestones from an investor’s standpoint include the agreement of an interim solution or an extension to discussions. As the parable of Iceland’s protracted membership negotiations illustrates, the intricacies of multi-state mediations are complex and a full resolution to the Brexit question within 2 years seems optimistic. An interim agreement, dictating that the 2019 end date is no longer viewed as a precipice, would have a significant impact in assuaging the markets.
4. We wrote about it in our latest Financial Market Overview but discussions behind the scenes are likely to be more amicable than portrayed in the press. Whilst on a longer-term view, this increases the chances of a pragmatic settlement, in the interim, partisan press reporting risks unsettling the markets. It also highlights that political considerations will firmly be at play alongside economic ones, with the former presenting the biggest risk to investors. Our view remains that pragmatism ought to prevail in light of mutual trade interests but prolonged political posturing is unlikely to be healthy for the UK economy in particular.
As a sidebar, it’s worth noting that less amicable will be Theresa May’s approach to Nicola Sturgeon, with the SNP this week passing legislation to enable a 2nd Independence Referendum. May has made clear that “now is not the time” and there is a growing view that any vote is unlikely before the mid-2020s at the earliest, with Sturgeon’s standing compromised by a disappointing domestic track record. Other EU states have also weighed in on the debate and while Spain – under pressure on the question of Catalonian independence – has insisted it won’t veto a Scottish attempt to join the EU, it has made clear there will be no special treatment. Scotland will be forced to join the line of candidates and enter into negotiations in the same way as any other state.
5. Finally, much has been written about the “purgatory” of acceding to WTO trade rules in the event that discussions with the EU break down and 2019 marks a full stop in the Brexit process. By the terms of the single market, the average tariff on goods is 2.5%. Under the WTO regime, the UK’s basket of traded goods would incur tariffs of 4.5% (as a result of higher charges on cars and agricultural products). Although more expensive, the difference is far less dramatic than has been publicised. Additionally, in the event that sterling weakness persists, the translation effect of the stronger euro would more than offset the difference. Of course, the WTO approach would undoubtedly introduce more “red-tape”, however, we remain of the view that the more likely outcome is that the UK negotiates some form of middle ground with the EU.