The impact of Brexit on investments
The continuing EU and UK government negotiations on their post-Brexit relationship will sternly test whether politics really is the art of the possible. While it appears that the negotiating positions of London and Brussels are so stubbornly entrenched as to make any agreement unrealistic, we believe a deal by year-end remains possible. However, it appears likely that any deal will be a ‘bare-bones’ agreement and many areas will take years to ultimately settle.
Boris Johnson has stated that, if a deal is not reached by 15 October, both sides would need to cut their losses and ‘move on’ without agreement. Given the seemingly perilous state of the negotiations and the controversial plan to breach international law by re-writing the Brexit withdrawal agreement, undermining the previous deals on state aid and Northern Ireland, what conclusions can we draw? How will this affect UK markets, and what will it mean for investors?
The Brexit negotiations must deal with the fact that the philosophical views of the UK and EU are at polar opposites.
On the one hand, the UK government wants to ensure that Brexit really does mean Brexit, and that it can escape the EU’s regulatory constraints and become master of its own destiny. The UK government has stated it is willing to discuss all issues except sovereignty over laws, courts and fishing.
On the other side, the EU's position is that if the UK government wants to retain access to the EU marketplace, it needs to play by the EU’s rules. In return for tariff and quota free trade in goods, the UK must remain closely aligned with the EU in terms of labour and environmental regulations, state aid, tax and social standards. However, the UK government is increasingly insistent on securing freedom from EU rules on state aid. So we can expect to hear lots of talk about equivalence, level playing fields and lines in the sand.
So long, and thanks for all the fish
There are other areas of strong disagreement or, as Michel Barnier, the EU’s chief negotiator has warned, topics that will be “very, very difficult to reconcile”. One of the most emotive issues will be fishing rights, and the success or failure of the wider negotiations may rest on reaching an acceptable compromise on the access of the EU’s fishing fleet to British territorial waters.
Despite the fact that the fishing industry represents a tiny fraction of the EU’s and UK’s GDP (0.04% in the case of the UK), the EU remains adamant that it must retain its existing right to fish in British waters and that this right must be guaranteed for the long term. The UK government, in contrast, has insisted that such access is reviewed, and agreed, annually. A deal is implicit, given 75% of UK-caught fish is exported to the EU and the UK does not have the capacity to process or consume all that is caught. However, it will be used as a key bargaining chip; probably up until the very last minute.
The City of London
Of far more importance to the UK is the access of the UK financial services industry to the European market. Brussels’ standpoint is that it will unilaterally judge whether British regulations and financial supervision are sufficiently robust to allow UK firms to operate within the EU. Even if granted, this access may be withdrawn with 30 days’ notice; a time period which is far too short as far as the UK government is concerned.
What does a no-deal Brexit mean?
There may well be a no-deal outcome at the end of 2020. It seems that, if the 15 October deadline is missed, the UK will have to trade with the EU under World Trade Organisation (WTO) rules from the beginning of 2021. Extensive tariffs would be applied and, in many cases, export and import licenses would be necessary. Time is running out and the UK government is now openly ramping up its contingency planning for a 1 January no-deal.
What is a soft Brexit?
The EU’s version of a soft Brexit, which offers tariff-free trade on agricultural and industrial goods, requires a level playing field on labour, social, and environmental standards, together with future 'dynamic alignment'. This means that, should the EU tighten its rules in the years ahead, the UK must follow suit. The more access the UK requires, the greater the regulatory alignment.
The UK government’s version envisages a free trade agreement (FTA) similar to the EU's deals with Canada and Japan. This suggests the UK government would accept tariffs and restrictions on trade in certain sectors, but would align regulations with the EU in areas where cross-border value chains are important (such as autos) or the UK has a strong export presence (including pharmaceuticals).
The most likely outcome
The problem with brokering a Canada-style FTA is that it would normally take several years of negotiation. The EU also believes the UK should be treated differently to Canada given its geographical proximity. Meanwhile, regulatory alignment is wholly unpalatable to Boris Johnson.
There are fundamental differences between the UK government’s and EU’s positions which won’t be resolved in just a few months. So, what compromise could be reached before year-end? The likeliest seems to be a very basic deal which covers certain critical provisions, including travel and transport arrangements, and limited agreement on certain vital industries. Thereafter, sectoral trade negotiations would be conducted on a case-by-case basis, but these could take many years to resolve. Until then, trade would be conducted either under WTO rules, or broadly as it is now.
The impact of Brexit on UK assets
Given the uncertainty engendered by the Brexit negotiations, it is no surprise that the UK equity market has underperformed this year, even when allowing for its significant exposure to sectors which have been hardest hit by the coronavirus pandemic. We have maintained our long-standing underweight to the UK in our clients’ discretionary portfolios and have benefited from a more global focus; much as the UK government hopes to capitalise on a more global perspective in its dealings with the outside world.
It is also important to monitor the sterling/euro exchange rate. While a ‘hard Brexit’ may already be priced in to an extent, the ultimate failure of any negotiations could well exacerbate sterling’s decline.
Irrespective of this, it is important to stress that the UK will continue to present investment opportunities, and there are many world-class companies, institutions and cultural bastions of which the UK can continue to be proud. Certainly, the underperformance of UK equities is presenting many intriguing stock opportunities which we will continue to identify.
COVID-19 may force the UK government to maintain high levels of spending. If this spending is focused on the right areas, the UK economy may ultimately benefit. For now, and from a top-down perspective, we are in no rush to increase our exposure to UK equities for discretionary portfolios. However, a breakthrough in the negotiations, or increased hopes of a soft and orderly Brexit, may yet prompt us to reappraise this position.
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If you have any questions about the issues raised in this article or would like to find out more please get in touch with us or email email@example.com. Please remember, if you hold an account with Canaccord, you can check your portfolio value at any time, through Wealth Online or by getting in touch with your Investment Manager.
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IMPORTANT: Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.