Brexit Alarm’s Return Looks Unlikely to Unsettle Equities

Editors’ Note: MarketMinder Europe is politically agnostic. We favour no politician nor any political party and aren’t inherently for or against political developments like Brexit. We assess events for their potential economic and market impact only.

Just in time for Halloween, the Brexit monster appears reanimated, as illustrated by financial commentators we follow warning of trade wars and economic calamity haunting both sides of the English Channel. At issue: the Northern Ireland Protocol aspect of the Brexit agreement, which established customs checks on goods travelling from Great Britain to Northern Ireland in order to prevent a hard border between it and the Republic of Ireland, an EU member.^[i] Neither side has argued the present system is working well, with the recent so-called sausage war over the protocol’s ban on British meat entering Northern Ireland but one high-profile example.^[ii] UK Brexit Minister David Frost officially announced his intent to renegotiate the agreement on Tuesday, and EU Vice President Maros Sefcovic outlined the EU’s position Wednesday.^[iii] We won’t hazard a guess at how this plays out, but we still don’t think this is likely to be a wallop in waiting for the UK, European or global markets.

Two years ago, when UK and EU officials were racing against time to strike a Brexit deal before the deadline, Northern Ireland was amongst the biggest sticking points. UK leaders wanted trade across the Irish Sea to remain unfettered, but the Good Friday Accords, which cemented the peace agreement between paramilitary groups in Ireland and Northern Ireland, required an open border between the two with no checkpoints.^[iv] To preserve that, the UK and EU agreed Northern Ireland would remain in the EU’s customs union, also known as the single market. Hence, goods crossing the Irish Sea were subject to checks.

At the time, a host of observers we followed determined that this agreement looked good on paper but would likely be unworkable in the real world. Thus far, we think reality has largely borne that out. Being in the EU’s customs union requires Northern Ireland to abide by all EU trade restrictions.^[v] In addition to imposing customs checks on milk, dairy and a host of other goods, that also includes a ban on importing chilled meats from non-EU nations—which meant no meat or sausages from Great Britain could enter the country and be sold in Northern Irish shops.^[vi] Faced with the prospect of no bangers in Belfast, officials agreed a temporary grace period for this and several other rules, ostensibly to give negotiators more time to find a permanent solution.^[vii]

As of last week, they had one for sausages: The EU offered a full exemption for all “national identity goods,” including British bangers.^[viii] This is one solution to one pocket of trouble, but no one we follow appears to think a patchwork approach like that is workable for all goods. More serious issues also loom large, including potential medicine shortages in Northern Ireland once other temporary exemptions expire.^[ix] If each industry or agricultural category has its own special carve out, the resulting complexity for businesses and border officials on both sides would likely be off the charts, in our view. Thus, the Northern Ireland Protocol itself is now up for a rewrite or replacement.^[x]

Which brings us to Lord Frost’s speech Tuesday, in which he called for replacing the Protocol with a new agreement that removes all customs checks and puts the border under the legal jurisdiction of an international arbitration panel rather than the European Court of Justice (ECJ).^[xi] In what we think is an apparent negotiating tactic, he warned that if the EU didn’t compromise on both fronts, the UK was ready to invoke Article 16 of the Brexit agreement, which allows the UK to abandon the protocol unilaterally.^[xii] But that article also allows the EU to erect retaliatory trade barriers, including higher tariffs, hence the trade war chatter.^[xiii]

In our view, there appears to be a lot of daylight between the two sides. The EU has offered to cut the number of goods subject to customs checks when crossing from Great Britain into Northern Ireland if the UK grants EU customs officials access to the UK’s trade databases—so that it can beef up surveillance on which products are entering the Republic of Ireland.^[xiv] EU officials have also discussed removing all checks on goods intended to stay in Northern Ireland, rather than cross into the EU.^[xv] So on this front, we think compromise appears workable. In a turn that surprised some observers, Sefcovic also signalled that pharmaceutical firms in Great Britain will be able to continue shipping generic drugs into Northern Ireland without going through EU regulatory processes.^[xvi] However, it offered no compromise on the ECJ. EU officials’ statements indicate the ECJ has long been a red line for the EU, and we don’t think officials would likely bend easily—especially whilst they are separately sparring with Poland over a court’s ruling there that the ECJ doesn’t have sovereignty over Polish laws and courts.^[xvii]

If our past experience is a reasonable guide, the next few months will likely feature a lot of tough talk, threats, leaks, stalemates, deadline extensions, breakthroughs, setbacks, new red lines, summits and pre-summits. To us, this is basically your typical Brexit-related negotiation—or more broadly, your typical EU negotiation, judging by the many debates over Greece’s debt crisis last decade. We think the heightened rhetoric could hit sentiment at times and might trigger some volatility if trade war talk runs hot. But we also think this public, drawn-out process lets markets price in potential changes well before they actually occur, likely sapping surprise power if new tariffs and other barriers do arise. We aren’t saying that outcome is likely, as both sides have high incentive to compromise and preserve free trade, in our view. Yet if a full breakdown does happen, we think markets will probably see it coming from a mile away, likely blunting its impact on returns.

Still, uncertainty may be a market headwind whilst this plays out, in our view, just as we think it was throughout the Brexit negotiations. We don’t think that is a reason to avoid UK equities, but it probably does favour large firms whose revenues depend on global demand rather than Europe alone—companies that can capitalise on the UK’s increased trade ties with Asia.