The Brexit negotiations have reached an important milestone with both sides agreeing to a period of transition between the UK formally leaving the EU in March 2019 and the new relationship coming in to force in January 2021. This has lifted sterling and UK interest rate expectations. Both could get a further boost if the next ambition is met - an agreement on the heads of terms of the final deal.

The impact of Brexit on the UK economy

Immediately following the UK referendum many forecasters cut dramatically their projections for UK GDP growth. The economy has exceeded many of these forecasts as growth has remained roughly constant in the region of 1.5%. The stability of growth in the UK however contrasts with the acceleration in activity that was seen in many other parts of the world. The UK thus slipped from joint top of the G7 league table in 2016 to second from bottom in 2017. The spike in sterling, the subsequent rise in inflation and the squeeze on real incomes was an important component of this underperformance. Lacklustre business spending, as firms postponed investment, also played a role.

The sharp fall in sterling immediately after the referendum led to a pickup in inflation that squeezed household incomes.

Guide to the Markets - UK, page 33

Progress made: Agreement on a period of transition to December 2020

The UK will formally leave the EU in less than a year, but the EU and UK have agreed upon a period of transition between 29 March 2019 and 31 December 2020. This will give businesses time to adapt to the new trading relationship.

Attention now turns to agreeing the heads of terms for the final trading relationship. The ambition is to have broad agreement by October in order for the Withdrawal Agreement to be legally ratified by March 2019. The finer details will then be worked out during the period of transition.

Challenge ahead: Future relationship

To reach a deal on the future relationship both sides will need to compromise from their current standing. The EU’s position is that there can be no 'cherry picking' and that the EU’s four freedoms – in goods, services, labour and capital - are indivisible. Broadly speaking the UK’s wish list includes an ambition to:

• continue trading freely in goods and services with the EU,
• have no physical border between Northern Ireland and the Republic of Ireland,
• be able to strike free trade deals with the rest of the world,
• be under the jurisdiction of British Courts rather than the European Court of Justice,
• control migration,
• and not contribute substantively to the EU budget.

Some of these ‘red lines’ will have to be either abandoned or seriously diluted which will bring challenges given strongly held views within the Conservative Party. Being able to strike trade deals with other parts of the world makes a customs arrangement with the EU very difficult because the EU would no longer have a clearly defined border on which to monitor the inflow of goods. If a customs arrangement is not in place then the Northern Ireland Border is difficult to solve (though the government believes that in time a technological solution can be found).

It is possible to envisage ‘mutually agreeable’ solutions on other issues. For example on the rule of law it has already been agreed that there will be a ‘joint committee’ of UK and EU representatives to oversee the implementation of the Withdrawal Agreement. This could form the basis of a more lasting arbitration panel. A compromise on migration might be that EU nationals have preferential treatment in a new migration system. And ultimately the UK may have to accept that if it wants access to the GBP 10 trillion EU ex-UK market it will have to contribute to its upkeep with budget contributions.

There are some reasons for optimism

There are reasons to believe that there will be a deal which means the UK and EU continue to trade in goods and services with limited frictions. It is in the EU’s interest to have a deal in goods given the EU’s large trade surplus in goods with the UK.

But it may also be in the EU’s interest to have a deal in services. The UK’s financial services industry, centred in London, is an important ecosystem that helps meet the financing requirements of businesses across the EU. The contingency plans which each bank established soon after the referendum showed that it was highly likely the financial sector would fragment to many different European countries. The loss of the ecosystem would very likely raise the cost of capital to business. In addition, many of the contingency plans identified Frankfurt as the preferred destination. In the past, Germany has not seen it as desirable to have a large financial sector given the potential need for public funds in the event of a financial crisis (demonstrated clearly in 2008). Keeping the financial centre in the UK may well be in the EU’s interests.

In our view the early agreement on transition signals a move in this direction, given the financial services industry was one of the key sectors requesting early agreement on transition.

At the start of the year our assessment was that there was still a significant ‘hard Brexit’ premium in UK markets. Sterling had risen against the dollar but that largely reflected a broad-based dollar decline. Against a basket of other currencies and the euro, sterling was still not far off the lows reached immediately after the recession.

Brexit has had a significant impact on UK markets.

Guide to the Markets - UK, page 35

Expectations about UK interest rates also remained depressed. Prior to the referendum the Bank of England was broadly expected to be tracking policy at the US Federal Reserve. As a result of the referendum, policy diverged as the Bank of England deployed more expansionary policies to support the economy through a period of real wage squeeze and weak business investment.

Investment implications

• The agreement on transition has already lifted the level of sterling against most currency pairs, as well as UK interest rate expectations. We now think the Bank of England will raise rates in May. If the coming months’ negotiations do see compromise and agreement on the heads of terms of the deal then we may see some further gains in sterling and UK interest rate expectations.
• The impact on UK equities is more complicated. 70% of the FTSE 100 earnings are from abroad. As a result rising sterling depresses repatriated earnings and would most likely put downward pressure on the price of these stocks. However, the price of domestically focused smaller cap stocks may move higher if there are signs of a deal emerging.
• There are reasons to be optimistic that a deal will be struck. However it may be some months before this emerges, and there could well be significant political and market volatility along the way. Indeed, the headlines could get considerably worse before they get better.

NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for institutional, wholesale, professional clients and qualified investors only, as defined by local laws and regulations.

The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield are not a reliable indicator of current and future results.

J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued in the United Kingdom by JPMorgan Asset Management (UK) Limited, which is authorized and regulated by the Financial Conduct Authority.