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With COVID-19 dominating 2020, one of the past few years’ biggest headline grabbers had taken a backseat eight months in. But now Brexit is back—and stealing headlines with a vengeance. Some financial commentators we follow are going so far as to claim the UK government has introduced legislation that violates the exit agreement it struck with the EU last year, rekindling the risk of a messy, de facto no-deal Brexit. However, whilst the specific twists that bring it back to the fore are new and lead many commentators to project potential damage to Britain’s economy, we think the takeaway remains the same: However it plays out, equity markets should gradually gain clarity as the year progresses, and even a no-deal Brexit shouldn’t bring disaster.
With free-trade negotiations between the UK and EU restarting, Prime Minister Boris Johnson introduced legislation called the Internal Market Bill. In related comments, his government portrayed it as a “legal safety net” for the UK in the event the country fails to ratify a free-trade agreement with the EU by year-end, when the post-Brexit transition period expires. Their stated aim was to set out the legal framework (including customs rules) for trade with the EU if Brexit happens without a trade deal in place—theoretically giving businesses and investors more clarity.
But, based on media reports we follow, things got thorny on Tuesday, when it emerged that the government’s plans differed from parts of the EU Withdrawal Agreement finalised last year. When questioned, the UK’s cabinet secretary for Northern Ireland stated the customs rules would “break international law in a very specific and limited way,” touching off a worldwide frenzy and resurrecting no-deal Brexit warnings from financial commentators.[i] To us, this super-charged bluster seems like politicking. With many members of Johnson’s Conservative Party speaking out against the bill this week, we would be a tad surprised if it were to pass without amendment. Moreover, that presumes the bill even needs to pass at all—this could just be a way of trying to nudge along free-trade negotiations.
In short, the Internal Market Bill is a fall-back position. The UK’s main goal, as stated repeatedly by top officials, is still to sign a free-trade agreement with the EU, but Johnson has stated he doesn’t want to surrender sovereignty over regulations and state-aid rules (including restrictions on industry-specific tax breaks and public investment) in order to do so—a red line for both sides, according to many financial press reports we have reviewed. Yet since Brexit talks began, ongoing news coverage shows both sides have drawn, erased and redrawn red lines, so this isn’t new. Setting out strongly worded policies explaining the or else in a standard accept our terms or else sparring match is also the norm. So we don’t think the risk of a no-deal Brexit got significantly higher this week.
The principal dispute is over customs on goods crossing the Irish Sea. When the UK and EU signed the Withdrawal Agreement late last year, many observers saw its protocol on Northern Ireland as something of a pipe dream. It kept the border between Ireland and Northern Ireland open and frictionless, in keeping with requirements under 1998’s Good Friday Accords that brought peace to the divided island. It also accepted customs checks for goods traveling between Great Britain (e.g., England, Wales and Scotland) and Northern Ireland, and it affirmed Northern Ireland’s unfettered access to the rest of the UK. This sounded like a win for all sides, but as policymakers hashed out the details, it became clear that it was an impossible trinity, with a high likelihood of Northern Ireland becoming economically isolated from the rest of the country. After all, how can Northern Ireland really have unfettered trade access to Great Britain if companies have to file export declarations every time goods cross the sea? What the government now proposes are effectively amendments to the agreement to ensure there isn’t a de facto border down the Irish Sea.
Observers we follow are divided over whether this is a treaty violation. A draft EU working paper circulating Wednesday says it is, warning the UK could be subject to EU sanctions if it passes.[ii] Johnson, for his part, claimed in a Wednesday press conference that the new bill seeks to insure against “extreme interpretations” of the Withdrawal Agreement and isn’t a bait and switch. Writing in Wednesday’s Telegraph, one UK legal expert stated the case for legality is “strengthened by section 38 of the 2020 [European Withdrawal] Act which expressly asserts the sovereignty of Parliament. This section specifically enables Parliament to introduce legislation to amend the Withdrawal Agreement.”[iii] Some commentators argue no country will sign a free-trade agreement with the UK—including a much-hyped US-UK deal—if it doesn’t keep its word on the Withdrawal Agreement, but there seems to be enough wiggle room here to mitigate that risk despite global politicians’ bluster now.
More broadly, there seems to be a disagreement over which approach endangers the Good Friday Accords. Some observers we read argue the new bill does, as it gives the UK government power to amend or waive export declaration requirements for shipments from Great Britain to Northern Ireland, raising the risk of border checks between Ireland and Northern Ireland to prevent British goods from entering the EU tariff-free. Yet Johnson argued the original Withdrawal Agreement stood a higher likelihood of jeopardizing peace by isolating Northern Ireland from the rest of the UK. In our view, it all just smacks of political disagreement, with all sides seemingly using unclear treaty snippets to make their case as they jockey for leverage in Brexit talks and domestic politics. In our experience, these matters typically end up being sound and fury for markets, with little substance.
We won’t hazard a guess on how this all plays out. The UK and EU are still pursuing a trade deal, and we think it is fair to say both sides have every incentive to get one done. If they don’t get one, we already know a great deal about what a no-deal Brexit looks like. We know the default tariffs on UK imports from the EU—and any other country with which the UK doesn’t sign a free-trade agreement. Those tariffs, which were officially unveiled in the Spring, are not high and, in many cases, amount to reductions from the current EU tariffs. We know regulators are already closing in on a number of side deals to preserve London’s status as Europe’s financial hub. We also know from news reporting that the Netherlands, France and other key export partners are lobbying Brussels to minimise restrictions and customs checks on goods coming from the UK. We even know, based on their repeated statements, that both sides are dedicated to avoiding a hard border on the island of Ireland, notwithstanding the present political disagreement on what that looks like.
We also know investors have been dealing with no-deal Brexit fears for more than four years now. In the more than 1,500 days since the Brexit vote, we have seen financial news headlines imagine every possible scenario up to armed conflict. We have seen warnings of blockades and a sudden stop in trade. We have seen fears of a protectionist, isolated UK. We have seen forecasts for deep economic recession, runaway inflation and a debt crisis in a post-Brexit UK. In our view, whatever reality emerges is likely to be better than these worst-case scenarios, especially as it becomes clear both sides are intent on keeping trade flowing. So whilst uncertainty may remain a headwind for UK shares as things go down to the wire, the risk of Brexit driving a market or economic disaster after 2020 ends seems exceedingly low to us.
[i] “Northern Ireland Secretary Admits New Bill Will ‘Break International Law’,” Staff, BBC, 8/9/2020.
[ii] “EU Sees Case for Legal Action Against UK Over Brexit Plan,” Alberto Nardelli, Bloomberg, 9/9/2020.
[iii] “The New Brexit Bill Is More a Political Than Legal Issue,” Clive Thorne, The Telegraph, 9/9/2020.
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