Brexit or ‘You can’t get there from here’

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Brexit or ‘You can’t get there from here’


Stéphane Monier

Chief Investment Officer
Lombard Odier Private Bank

The United Kingdom’s greatest economic challenge in generations has fragmented its political class and voters. Last week saw the British parliament reject the government’s terms for starting negotiations with the European Union. The country now lacks consensus on what it wants to achieve in its future relationship with its largest trading partner.

Markets, which for a long time have priced sterling, UK sovereign bonds and equities for a ‘soft Brexit’ through an orderly transition to life outside the bloc, must now decipher the rising risks. The choices, or accidental outcomes, range from the possibility of stumbling into a chaotic no-deal Brexit, to a series of alternative deals, or further political division over a second referendum. We begin by taking a step back and looking at recent events, which have led us to the current impasse.

Political miscalculations

In January 2013 the then UK Prime Minister David Cameron promised a referendum in an effort to end decades of Conservative Party infighting. "It is time to settle this European question in British politics” and give voters “a very simple in-or-out choice”, said Mr Cameron. The British electorate then voted, on 23 June 2016, to leave the EU by a majority of 51.9%. Mr Cameron resigned and was replaced by Theresa May who then unilaterally set a two-year deadline ticking for the UK to leave the EU at 11 p.m., London time, on 29 March 2019.

Mrs May also made the strategic miscalculation of calling a general election in an attempt to improve her majority in Parliament. That backfired in 2017, stripping the Conservatives of their majority and leaving her dependent on Northern Ireland’s Democratic Unionist Party (DUP). This turned the border with the Irish Republic into a key obstacle in negotiations.

Last week, on 15 January, after postponing a vote and certain defeat a month earlier, Theresa May put the government’s EU Withdrawal Agreement to legislators and suffered the worst rejection in British parliamentary history. The following day Mrs May’s government survived a vote of no confidence with the support of the DUP and Conservative Party ‘Brexiteers’ who voted against her deal one day earlier.

The Prime Minister is now committed to presenting a revised Withdrawal Agreement to parliament on 29 January. If the proposal is rejected again, there are four possible steps: the opposition Labour Party may call for a second vote of no confidence in the government; it may back calls for a second referendum; the UK may ask for an extension to the Article 50 deadline, or the Prime Minister may resign (or be forced to step down).

The British were sold a lie

Lies and delays

“The British were sold a lie,” French President Emmanuel Macron said at a speech in Normandy on 16 January. “The first losers are the British people….” Damping expectations that the UK might now get additional concessions from the EU, he added, “we already went as far as we could”.

As we write, Prime Minister May is reported to be against requesting a delay to the exit date. Any delay would only run into issues with European Parliamentary elections in May this year and questions of how to handle the election of British representatives. It would also raise questions about the purpose of a delay. Under the existing Withdrawal Bill, Mrs May can request an extension until the end of December this year.

She is also refusing to rule-out a ‘no-deal’ Brexit that would leave the UK on March 30 with no transition period in which to negotiate a relationship with the EU. As an illustration of the political chaos in which the UK now finds itself, Labour Party leader Jeremy Corbyn, whose goal is to topple the government and hold a general election, has refused to meet with Mrs May until a ‘no-deal’ is off the table. This, Mrs May cannot do, without splitting her own Party.

In the meantime, the UK government is spending an estimated GBP2 billion on ‘no deal’ plans for ‘stacking’ immobilised trucks on motorways, while stockpiling food and medicines. A worst-case no-deal Brexit may see annual tariffs rise by more than GBP6 billion, increase living costs, slowing cross-border shipments and the UK’s gross domestic product.

Other governments, including France and Germany, have also stepped up provisions for a ‘no-deal’ including additional customs officials. 

30 months later, the UK public is still largely in the dark about the consequences of their collective decision. And as a result, still largely in the dark about the implications for the available choices.

Obligations and issues

Ten weeks of debate ahead of 2016’s vote failed to explain the stakes of leaving the EU, and communicate the real choices involved to British voters. It can be argued that 30 months later, the UK public is still largely in the dark about the consequences of their collective decision. And as a result, still largely in the dark about the implications for the available choices.

The EU is the UK’s largest trading partner. Exports in goods and services to the EU were GBP274 billion or 44% of all UK exports in 2017 while 53% or GBP341 billion of the UK’s imports came from the EU.

As a member state, the UK is alone among the for-now 28-nation bloc in having a series of exemptions from EU legislation and institutions. The country has its own currency and monetary policy with no obligation to join the eurozone, retains supervision of UK banks and is not a member of Schengen border control agreement. It also enjoys a rebate from the EU’s common budget, chooses whether to participate in justice and home affairs measures and is allowed to avoid European Court of Justice scrutiny of UK labour law.

Still, all EU member states have four key obligations to the bloc. These are commitments to the free movement of goods, services, capital and people, which cannot be ‘cherry-picked’ without undermining the value of membership for the remaining states. 

The Irish backstop

Touching on all four obligations is the question of the ‘Irish backstop.’ Thanks to the Conservative government’s dependence on the DUP for a parliamentary majority, the question of how to manage the UK’s only land border with the EU has become key. The EU and UK signed up to a backstop in December 2017. Neither side wants to install the infrastructure of an international border between Northern Ireland and the Irish Republic once the UK leaves the EU. The question is both practical and historically sensitive.

The backstop would leave the UK as a member of the European customs union beyond December 2020, during which the UK could sign, but not implement, new trade deals with other countries. The legal problem is that the EU cannot guarantee when this transition would end, because it depends on future negotiations, but nor does it want the UK to enjoy the benefits of the single market without any of the EU’s membership obligations. 

The free movement of people dominated debate in the run-up to the 2016 vote and was, from the start of Mrs May’s premiership, and before she even opened talks with the European Commission, a negotiating red line. May, a UK former home secretary, has often been characterised as obsessed by containing immigration to the UK, even before the Brexit vote. In many ways, the interests of controlling immigration in the UK’s domestic debate have overridden the interests of moving goods and providing cross-border services in a future relationship.

The UK’s supporters of the leave vote promised that, Irish backstop notwithstanding, a cornucopia of free trade deals await the UK once it is free of its EU trade commitments. They have forgotten that trade deals have become harder, not simpler, to negotiate over the last two decades as populations have noticed that true free trade has implications, bad and good, for domestic industries, job markets and national sovereignties because they limit the ability of governments to legislate and regulate their economy.

It is no coincidence that the last global trade agreement now dates back to the creation of the World Trade Organisation in 1995. The WTO has been negotiating a successor agreement since 2001 and in the meantime, the EU has signed a series of free trade agreements with other nations, including Japan, Singapore, Canada and South Korea.

United Europe

Since the UK’s 2016 referendum, political division and chaos have deepened in the UK. Looking on, the European Union’s remaining 27 member states have rarely proven so united. While many EU governments expected to face UK negotiators to test their solidarity, in the event, the UK has proven isolated. That isolation is only likely to intensify as and when the substance of negotiations over, for example, fishing rights or financial services begin.

It's also worth remembering that the UK’s biggest trade partners, Germany and France, each have other international priorities, including managing domestic populist movements of their own as well as challenges with neighbours on their own borders. They have no incentive to offer the UK, soon to be a trade rival, anything that undermines the EU’s own rules, nor anything that makes Brexit look attractive to their own domestic populist parties.


Investment implications

The first point to note is that if the UK were to crash out of the EU on 30 March without a transition period in place, the Bank of England has said it may have to raise interest rates, inflation may reach 6.5% and house prices fall 30%. The UK’s current account deficit, the largest for any major economy, is dependent on foreign investment.

Nevertheless, much of the bad news is already priced into UK assets. Therefore, sterling rallied after the UK’s parliamentary votes, reflecting a view that a general election, and all the uncertainty of a possible Labour government, is now less likely. Markets are also putting their faith in Mrs May’s government finding support for a revised deal, and at worst, parliament’s determination to avoid a no-deal.

As far as currencies are concerned, we are forced to make an assessment based on probabilities. On balance, while for now the political default option remains a no-deal Brexit, its likelihood has diminished and we believe that a soft, or no-Brexit scenario, would be GBP positive. 

The yield on the UK’s benchmark 10-year gilt rose last week to 1.35%, from a low of 1.19% at the start of the year.

Turning to equities, short interest is 2.5 times higher on domestic-focused UK stocks than exporters who have benefitted from the weaker GBP. Domestic investors have been mostly overweight exporting companies since the referendum, and may reverse their positioning in case of soft Brexit. This explains why, since the 2016 vote, the FTSE100 index, which is largely composed of exporters, has fallen 2% in EUR terms and gained 12% in GBP terms. This also indicates that conversely, a soft Brexit would be most beneficial to domestic companies in GBP.

“I wouldn’t put much weight on these very short term moves,” BoE Governor Mark Carney told parliament 16 January. “The market is waiting.”

In the face of such uncertainty, we can only encourage investors to look hard at their exposure to UK and European assets, and watch developments closely as they unfold.

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