Brexit: deal or no deal?

Investors brace for uncertainty

When people in the U.K. woke up on June 24, 2016, to the news that the country had voted to leave the E.U. (or “Brexit” as it is now commonly known), little did they know that 2½ years later, the future of the U.K.’s relationship with Europe would still be unclear. As debate and negotiation continue, what should investors do?

The narrowly won vote to leave the E.U. after 46 years of membership was mainly motivated by concerns about unrestricted immigration of E.U. citizens into the U.K., the relative lack of sovereignty over decision-making that E.U. membership entailed and the ongoing financial cost of being a member. The broader economic consequences of this change were perhaps less well understood. Most economists agree that the economic impact is likely to be negative, with GDP falling due to the less advantageous terms on which the U.K. will be able to trade with its nearest neighbours. The U.K.’s terms of trade will also likely deteriorate (as they have already with the fall in sterling since 2016), meaning imported goods and services will tend to be more expensive. There may also be long-term costs once the U.K. becomes relatively less open to the flow of people and ideas that can stimulate growth.

So far, there is some evidence that the uncertainty surrounding Brexit has caused firms and households to defer spending plans until the situation is clarified, while overall U.K. growth seems to have fallen behind G7 peers over the last two years. But looking forward, the seriousness of Brexit’s impact on the U.K. economy will depend on the terms of the eventual deal between the U.K. and the E.U. This is what the negotiations have been about since the government triggered Article 50 in March 2017.

Almost certainly, the worst outcome all around would be for the U.K. to leave the E.U. without any deal at all, though we believe this is relatively unlikely. This might occur if the current lack of agreement in Parliament on how to proceed continues. No Deal would be the “hardest” type of Brexit on offer, involving the U.K. moving on to World Trade Organisation trading arrangements with higher tariffs and more restrictive movements on goods across borders, as well as the lapsing of other U.K.-E.U. arrangements.

We believe it is more likely that some kind of deal with the E.U. will be reached, probably involving a type of free trade arrangement with minimal tariffs on trade in goods with the E.U. but no harmonization of standards as occurs in the European Single Market. This would probably be costly for the U.K. economy and still constitute a moderately “hard” Brexit. Less costly would be some variant of a so-called “soft” Brexit. This could be achieved by staying in the customs union with the E.U., though this prevents signing trade treaties with non-E.U. countries, or joining some variant of the European Economic Area (sometimes called the Norway option). Either of these options would be much less costly in terms of economic impact but neither would realize many of the possible benefits of leaving the E.U., since the U.K. would not be able to curb E.U. immigration and would need to continue to pay into the E.U. For now, so long as No Deal is avoided, as we expect, no new trading arrangements would come into force until after they had been agreed during a transition period lasting until the end of 2020.

The reality is, however, that no political consensus has been reached within the U.K. nor between the U.K. and E.U. on what rules should apply. One particular stumbling block has proved to be the treatment of the border between Northern Ireland and the Republic of Ireland, which post-Brexit will form a land border between the U.K. and the E.U. Indeed, the inability to reach agreement has increased the possibility that the March 29 deadline will be extended and even that a new referendum might be called, which could potentially reverse the original decision and lead to the U.K. staying in the E.U. after all.

So how should investors respond to all of this Brexit uncertainty? So far, the exchange rate has borne the brunt, falling around 10% since the referendum; U.K. equities have probably been slightly weaker than would have been expected, while U.K. fixed income has probably been more robust as the Bank of England policymakers have held off raising interest rates. If No Deal is taken off the table, it seems likely that sterling assets would rally slightly, even more so if Brexit were reversed altogether. But the threat of a hard Brexit or even No Deal still means there are downside risks to U.K. assets. In the absence of a crystal ball, the case for a well-balanced globally diversified portfolio of stocks and bonds is as strong today as ever. Far better to watch the news as an interested citizen than as a trigger-happy investor!

Peter Westaway is chief economist and head of Vanguard Investment Strategy Group, Europe.

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