04 Jun 2019
Mark Burgess, Deputy Global CIO and CIO, EMEA
While the invocation of Article 50 in June 2016 was a straightforward process, the aftermath has been anything but. In its 45-year membership of the European Union, the UK has benefitted economically on several levels: the EU currently serves as the UK’s main trading partner (53% of its imports and 44% of exports1) and its “single market” characteristics have allowed for the free movement of goods and people. Brexit now threatens to fracture this set up.
Following the vote to leave the EU, 29 March 2019 was set as the date at which the UK would cease its membership. However, an inability to secure a deal has seen this deadline extended to 31 October 2019, with the potential to leave earlier or perhaps even to cancel leaving (the UK is free to revoke its notification to leave the EU without the unanimous consent of other EU member states, according to a landmark European Court of Justice decision).
If a withdrawal treaty is signed by the UK and ratified across EU members, and passes what has been termed a “meaningful vote” in the House of Commons, the UK will enter a 21-month transition period that was initially anticipated to last until 31 December 2020. During this period it will have the same contractual and regulatory relationship to the EU as it currently has, but will lose its voice in any decision making, such as in the European Parliament, the European Commission and any regulatory agencies. The transition period will be used to negotiate an as-yet-unknown relationship between the UK and the EU, and there is a myriad of possible outcomes.
Brexit means Brexit – but what form will it take?
Putting aside the uncertainty over whether the UK actually leaves the union or not, the consensus is that Brexit will result in either a “hard” or “soft” exit of the EU – although these terms are in themselves undefined.
A soft Brexit describes a situation where the UK maintains relatively close economic ties with the EU, continues to provide budgetary contributions and potentially allows for the free movement of people.
A hard Brexit, on the other hand, typically refers to arrangements involving a step-change in the UK’s formal ties with the EU. This would likely see it leaving the customs union and the single market, and would end the free movement of people. Under this scenario the UK would be bound by trading rules set out by the World Trade Organisation, which would be renegotiated with the UK as an individual body.
Existing formal arrangements between the EU and non-member countries such as Norway, Iceland, Liechtenstein and Switzerland are plenty, and adopting one of these (or similar) would typically be understood as a soft Brexit. The European Commission has aligned the UK government’s “red lines” on what it is prepared to consider with these existing arrangements (Figure 1). This appears to rule out any deal other than a hard Brexit (similar to a Canada-style free trade agreement with no deal whatsoever). However, the prime minister has initiated talks with the leader of the opposition to try and reach a compromise solution that would be acceptable to the House of Commons, likely to be some form of soft Brexit.
Figure 1: What next?
So, assuming the UK does leave the EU, it is seemingly heading for either a hard or soft exit – but what are the economic and social repercussions of each option?
Lower contributions to the EU
The economic impact of Brexit will vary hugely according to the type of deal that is finally secured. In the event of a soft Brexit, the UK would continue to provide contributions to the EU as well as receive subsidies. A hard Brexit, however, would see the immediate cessation of the UK’s contributions to the EU budget. After taking into account the €7 billion in subsidies that the UK receives,2 this would equate to a 5% shortfall in the EU’s finances. Other member countries would then be required to increase their contributions, most significantly the EU’s largest member Germany, with the Ifo Institute estimating this to cost €2.5 billion.3 With the country already experiencing a bout of softer economic growth, this would not be a welcome additional cost.
Trade disruption
The scale of the economic effect of Brexit on European regions will depend on the sectors that form the basis of a given local economy, their exposure to the UK, and the reallocation of exports between sectors which will result from trade flow disruptions. Consequently, regions with industries and sectors exporting to, or importing from, the UK would be particularly exposed to a disorderly Brexit. For example, Benelux countries import a high proportion of UK goods, while Ireland will be particularly susceptible due to its common land border.
In the UK, a hard Brexit would be especially disruptive to trade given that exports to the EU amounted to £274 billion (44% of all UK exports) in 2017.4 This is particularly significant given the difficulty the Department for International Trade has cited in trying to negotiate rollovers of free trade arrangements held through the UK’s EU membership.
It is this uncertainty that continues to hinder business confidence, with some manufacturers such as BMW stating that it could be forced to close its UK operations if Brexit makes trading more difficult.
Growth and investment
Analysis by the UK government predicts that under a hard Brexit scenario, UK economic growth compared to current forecasts would be reduced by 8% over the next 15 years.5 The National Institute of Economic and Social Research echoes this, with research showing that in comparison with a soft Brexit scenario, a hard Brexit would cause annual input to be 5.3% smaller over 10 years. UK economic growth would only be 0.3% in both 2019 and 2020, compared with 1.9% and 1.6% in a soft Brexit scenario.6
Investment is a key component of economic growth and would come under pressure, particularly in the form of foreign direct investment (FDI). FDI is an investment made by countries into overseas countries. It raises national productivity, and therefore output and wages, as multinational firms bring in better technological and managerial know-how. It also stimulates improvement among domestic firms as a result of stronger supply chains and tougher competition. The UK’s FDI stock of more than £1 trillion sees approximately half of this come from EU countries, with the prospect of easy access to the EU a key attraction for foreign investors. A soft Brexit would see a continuation of investment from abroad, while a hard Brexit could see a reduction in FDI inflows by 22%.7
Market impacts
Market watchers believe many larger UK stocks are better sheltered from a hard Brexit than their smaller competitors as they generate more of their earnings globally – and outside the EU. More domestically focused UK shares, which have underperformed since the referendum, are expected to be harder hit, and investors should expect UK stock markets to remain volatile.
Turning to the UK government bond market, a hard Brexit scenario would see base rates cut to 0.25% (and potentially even lower), which would prompt a significant rally in gilts. However, if sterling was to slide further, as is expected from its already low position, this would not leave the central bank with much room to manoeuvre. It is also important to note that a weakness in sterling could actually benefit those UK companies that derive their sales overseas. In fact, more than 70% of the revenue earned from the FTSE 100 comes from outside the UK.8
Irish border
A hard Brexit would have a particularly negative impact on the Irish border regions. There are currently 110 million border crossings a year between the Republic of Ireland and Northern Ireland, with 30,000 people commuting daily across the border for work. These crossings require no checks due to EU customs union arrangements that align both nations.
There are fears that Brexit could see an increase in delays and checks at crossing points. This gave rise to the most contentious issue of Theresa May’s deal, the Northern Irish “backstop”. The backstop acts as a safety net policy to maintain cross-border cooperation and protect the Good Friday Peace Agreement. Given that the Republic of Ireland is still a part of Europe, a hard Brexit would require some sort of border to prevent goods and people crossing without being checked. There is a fear that this would be unacceptable to those who currently travel freely between the two countries and that it could lead to anger and, potentially, violence.
While broad consensus across the UK and EU is that the Irish crossing points must remain open without any form of border, hardline Brexit supporters are deeply concerned that the proposed backstop would result in the UK being indefinitely tied to EU customs union laws. Likewise, a softer deal would continue to see the free movement of people and goods between the regions, at least for the duration of the transition period.
Conclusion
Regardless of the type of deal that is eventually secured, Brexit has had, and will continue to have, a far and wide-ranging impact economically and socially – both in and outside of the UK. With a soft Brexit we would expect a relatively positive outcome in terms of the impact on the economy as existing ties remain relatively unaltered. In the case of a hard Brexit, we expect to see a more drastic change from the current situation with disruption to trade, reduced FDI and a loss of subsidies. The difficulties with bureaucratic checks at borders will slow the movement of goods and people, incurring additional costs.
While the scale of the effect of the UK’s withdrawal will depend on individual countries’ exposure to the UK, the general consensus is that a hard Brexit would result in far more disruption to the economic environment than a soft variant.
1 Statistics on UK-EU trade, November 2018. https://researchbriefings.parliament.uk/ResearchBriefing/Summary/CBP-7851
2 The EU budget at a glance, European Parliament. December 2016. http://www.europarl.europa.eu/external/html/budgetataglance/default_en.html#united_kingdom
3 From trade to migration: how Brexit may hit the EU economy. June 2016. https://uk.reuters.com/article/uk-britain-eu-economy-europe/from-trade-to-migration-how-brexit-may-hit-the-eu-economy-idUKKCN0ZA0KE
4 Statistics on UK-EU trade. November 2018. https://researchbriefings.parliament.uk/ResearchBriefing/Summary/CBP-7851
5 EU Exit: Long-term economic analysis, November 2018. https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/760484/28_November_EU_Exit_-_Long-term_economic_ analysis__1_.pdf
6 Prospects for the UK economy, November 2018. https://www.niesr.ac.uk/media/press-release-prospects-uk-economy-13523
7 The impact of Brexit on foreign investment in the UK. March 2018. https://cep.lse.ac.uk/pubs/download/brexit03.pdf
8 FactSet, FTSE 100 geographical revenue exposure, March 2019.
Important information: For internal use by Professional and/or Qualified Investors only (not to be used with or passed on to retail clients). Past performance is not a guide to future performance. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. Your capital is at Risk. The analysis included in this document has been produced by Columbia Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice and should not be seen as investment advice. Information obtained from external sources is believed to be reliable, but its accuracy or completeness cannot be guaranteed. The mention of any specific shares or bonds should not be taken as a recommendation to deal. Issued by Threadneedle Asset Management Limited. Registered in England and Wales, Registered No. 573204, Cannon Place, 78 Cannon Street, London EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.