In June 2016 citizens of the United Kingdom voted to leave the European Union. Proponents of the split had promised a smooth exit that would return to the UK greater control of its laws, budget and borders. But nearly three years after the referendum, UK and EU officials are still struggling to agree on the terms of the divorce.
With a March 29, 2019, deadline looming and negotiations at an impasse, the UK faced a worst-case scenario—crashing out of the EU’s single market into a state of uncertainty. A last-minute reprieve from the EU postponed the separation date to at least April 12, but difficult questions remain regarding how to break the deadlock and whether Brexit will even happen at all. What appears clear is that the negotiation process is far from over, and the nature of the UK’s future relationship with the EU could remain undecided for some time.
If and when the UK does leave the EU, both sides are likely to face negative economic consequences, with most estimates suggesting that the UK will bear the brunt of the blow. Still, the departure of its second-largest economy will exacerbate the EU’s current economic weakness and further test the seams of a union already straining against increased Euroscepticism. Further, Brexit stands as a testament to the ongoing embrace of anti-establishment doctrine worldwide, with consequences for the stability of the traditional global order and the capital markets.
Key Takeaways
- The Brexit referendum in 2016 was a high-profile entry in what has become a long list of populist movements that emerged following the financial crisis.
- After nearly two years of negotiations failed to produce a mutually acceptable compromise, the UK and EU agreed to postpone the original March 29 Brexit separation date to at least April 12.
- The new deadline offers little time to resolve serious disagreements between the UK and EU as well as within the UK Parliament itself. The situation is fluid, and several outcomes—including crashing out, general elections, a second referendum or no Brexit at all—are still in play.
- The timing and conditions of Brexit remain unclear, but most estimates suggest that both the UK and EU econo-mies will suffer as frictions are introduced into their economic connection. The magnitude of the costs likely will depend on the relative closeness of the future UK/EU relationship.
- We think companies with strong balance sheets, sustain-able earnings and conservative managements are most likely to weather the impact of Brexit regardless of its outcome, to the potential benefit of their investors. In fact, near-term market volatility may provide opportunities to build on or to acquire positions in such companies at attractive valuations.
Brexit Is Part of a Broader, Disruptive Trend Toward Populism
Populist movements worldwide have continued to attract supporters disillusioned by the weak economic growth and rising inequality that followed the global financial crisis. Despite historical levels of intervention by governments and major central banks, the post-crisis recovery has been uneven, and voters of many nations continue to struggle with the losses and dislocations that manufacturing automation and globalized labor markets have fostered.
Brexit has been discussed in the UK as early as the 1970s. Anti-EU sentiment reached a fever pitch after the financial crisis, however, as frustration with these losses—perceived to be driven by the trade and immigration requirements of the EU1 alliance—pushed more UK voters to reject the status quo. In addition to the June 2016 Brexit referendum, we have seen populist, anti-establishment change across a number of advanced and developing economies. In the US, Donald Trump ascended to the presidency. To the south, left-wing Andrés Manuel López Obrador was elected in Mexico while right-wing Jair Bolsonaro was elected in Brazil, each defeating the traditional political parties with campaigns focused on reducing corruption and improving security. In the euro area, Emmanuel Macron overthrew the French political establishment only to be confronted by ongoing populist discontent embodied in the “yellow vest” movement, while an anti-establishment coalition of the far-left Five Star Movement and the right-wing League took control in Italy. Prime Minister Viktor Orbán in Hungary, in power since elected in 2010, implemented popular spending programs financed by taxes on foreign companies and served as an inspiration for leader Jaroslaw Kaczynski in neighboring Poland. The list goes on.
This swell of political left-tail events has us questioning society’s bandwidth to absorb structural economic change and the unorthodox fiscal and monetary policies employed to address it. As such, we believe we have transitioned to a more uncertain socioeconomic equilibrium in which unexpected political outcomes—such as Brexit—can dominate the ordinary vicissitudes of the business cycle. This vulnerability is exacerbated by the growth in debt, which renders the global economy more sensitive to changes in risk perception. To the extent that the Brexit referendum was a high-profile example of this trend, we think it’s worth reviewing the situation as the UK and EU sit at the intersection of a number of uncertain paths.
Markets Appear Calm for Now, but Volatility May Emerge
UK markets were surprisingly resilient in the months leading up to the original March 29 Brexit separation date, as parliamentary developments dampening the outlook for a deal were seemingly offset by signals that an extension would forestall a no-deal “crash-out.” The pound, though about 12% weaker than its pre-referendum level, has appreciated modestly against both the US dollar and the euro since the end of 2018, by roughly 5%. UK stocks (as represented by the FTSE 100) also have rebounded from the global equity declines observed in December 2018, though to a lesser degree than US and European indexes. The yield on 10-year gilts has bounced around a bit, though mostly in line with other sovereigns.2
While a Brexit deal’s impact on equities is not straightforward, some generalizations can be made. For example, export-focused companies that produce significant revenue outside the UK—which includes much of the large-cap FTSE 100—have benefited significantly from the pound’s post-referendum weakness. These names would enjoy unchanged trading rules during the Brexit transition period,3 but their foreign earnings may take a bit of a hit from a stronger pound due both to currency translation effects as well as some loss of relative price competitiveness in international markets. In contrast, more domestically focused companies—which tend to populate the FTSE 250 and FTSE SmallCap indexes—may find that a less-downbeat near-term economic outlook encourages more spending by their customers, though now-cheaper imported goods may compete for those incremental pounds.
Should a deal before the April 12 deadline remain elusive and the UK be forced to request an extended Brexit delay, the market implications are harder to gauge; while it raises the probability of no Brexit at all, it does so at the cost of a protracted period of uncertainty. In the less likely but worst-case scenario of a no-deal/crash-out Brexit, the potential market impact seems unambiguously negative. We would expect risk aversion to take hold worldwide, as a crash-out would disrupt not only what previously was intra-EU trade but also other trade agreements the UK was party to as a member of the EU, including its trade with the US.4 The reaction of markets to the results of the Brexit referendum may provide a good framework for what to expect. After the surprising victory of “Leave” in June 2016, the exchange rate on the British pound plunged 11% against the dollar almost overnight, global equity markets fell sharply, and investors flocked to historical safe havens like US Treasuries, German Bunds, Swiss francs, Japanese yen and gold.
A Brexit deal or an extended delay would appear preferable to a crash-out from an investment perspective, but they do little to provide long-term certainty to businesses or investors. The UK and EU will need to return to the negotiating table to establish terms of their future relationship. It’s likely that headline risk around the progress of these negotiations could combine with other fears facing the global economy—slowing global growth, trade battles, growing isolationism/protectionism—to create higher levels of volatility across currencies, sovereign yields, credit and equities, accompanied by bouts of risk-off investor sentiment.
Though such pronounced market gyrations can be disconcerting, we believe companies with strong balance sheets, sustainable earnings and conservative managements are more likely to weather the impact of Brexit no matter the outcome, to the potential benefit of their current investors. In fact, near-term market volatility may provide opportunities to build on or to acquire positions in such companies at attractive valuations, especially for patient investors with cash on hand. Currency-risk hedges, meanwhile, may help mitigate return volatility during periods of tumult, as may other traditional hedges like gold.
A Long and Bumpy Road to Brexit
Through its membership in the EU single market, the UK is able to trade goods and services with all other members without tariffs, quotas or non-tariff barriers.5 These benefits, however, come in exchange for some loss of independent policymaking power and an acceptance of the “four freedoms” of the EU—the unrestricted movement of goods, services, capital and people within the bloc. For many Leave voters, separation from the EU was not so much an economic imperative as it was an urgent attempt to regain what they characterized as a loss of national sovereignty. (See the timeline that begins below for a condensed history of UK/EU relations over the past 45 years.)
The Brexit referendum was fiercely contested. Though betting markets and pollsters depicted a close race, most observers expected “Remain” to pull out the victory. In hind-sight, confidence that reason would prevail seems misplaced. So, too, was the belief that negotiations would be swift and straightforward.
UK and EU leaders have struggled to settle on terms for their separation, with the “red lines” established by each side at the onset of negotiations making mutually satisfactory compromise near impossible. UK Brexiteers were intent on breaking free from the rules and restrictions seen as incompatible with self-determination, but compulsory for mem-bership in the EU customs union and access to its single market. These included allowing the free movement of people, paying into the EU budget, regulatory coordination, a prohibition on extra-EU trade arrangements and subjugation to the authority of EU institutions. For the EU, preserving the inseverability of the four freedoms was paramount; the union would not allow the UK to pick the parts of the single market it liked (free movement of capital, goods and services) while scrapping the parts it didn’t (free movement of people and budget contributions). To discourage other EU member states from exiting the EU, Brussels has been keen to limit the benefits the UK might derive from separation.
After two years of difficult talks—along with a number of political miscalculations that compromised her negotiating position—UK Prime Minister May and representatives of the other 27 EU member states agreed in November 2018 on a set of departure terms, including a legally binding withdrawal agreement dictating conditions for the immediate aftermath of the separation.6 Members of PM May’s pro-Brexit Conservative party viewed the deal—which included a £39 billion divorce payment by the UK and the “Irish backstop” provision (see text box on page 6) —as a betrayal of the Leave mandate, and it was defeated three times in Parliament over the course of several months.
Without a deal in place before the March 29 deadline, the UK faced immediate expulsion from the EU trade and services bloc, giving citizens and businesses no transition period and little certainty about future access. Absent ad hoc continuity agreements, the country’s goods exports worldwide would be subject to the World Trade Organization’s less-accommodating tariff regime. The residency status of EU nationals in the UK (and vice versa) would be unclear, as would the reliability of such cross-border necessities as banking, commercial haulage, passenger transport and the delivery of medicines.
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