A Case Study in Gridlock’s Greatness, Brought to You by Brexit

Two years ago, the UK and EU signed a landmark trade agreement that determined what trade between the two would look like post-Brexit. It stipulated tariff-free goods trade, wide-ranging market access and—crucially—enabled the UK to enjoy strong trade with the EU while gaining the ability to sign new free-trade deals elsewhere. It wasn’t perfect (see: the clunky Northern Ireland agreement and some customs headaches), but at least it set ground rules and let everyone know what they would be dealing with. Logically, you might think everyone then moved on. But the real world often isn’t logical, and Brexit is no exception: We have now had two years of every … little … thing … getting cast through a Brexit lens. A Guardian series published this week is but the latest example showing how this landmark change still weighs on sentiment—and serves as a case study in why, in a roundabout way, stocks prefer gridlock to active governments.

When investors think about policy, human nature makes it easy to think in terms of “good” and “bad.” Markets don’t really use that framework, though, not least because “good” and “bad” are unprovable opinions. For stocks, it is more about change, period, and the uncertainty it drives. When a government is gridlocked, it can’t radically alter the economic landscape—taxes, regulations and property rights all stay relatively fixed, keeping the rules of commerce stable and predictable. Even if the status quo isn’t ideal, people know what they are dealing with and can work within those boundaries. When big change happens, it disrupts that happy equilibrium and creates winners and losers. That works out well for the beneficiaries, but prospect theory teaches us the losers feel the agony of defeat several times more strongly, and their net negativity can be a big drag on sentiment. It doesn’t always manifest in negative stock markets, but it can be a big overhang weighing on relative returns.

Brexit seems to prove the point. MarketMinder, of course, isn’t inherently for or against it, mind you. There are very likely benefits and drawbacks, but leaving the EU doesn’t seem all that consequential for the overall UK’s long-term economic and stock market fortunes for good or ill. It is just a change that created a handful of mostly near-term plusses and minuses, winners and losers. But it was a landmark change, and one gridlock couldn’t prevent once the government of that day fulfilled its campaign pledge to hold a referendum on continued EU membership. It was a binary question—stay or go. No watering down. There were deeply entrenched camps on both sides, making it a foregone conclusion that whichever side lost would emerge embittered and choose to berate the winners for years post-referendum. Had Britain stayed in the EU, the Leave camp would no doubt be the ones arguing growth would be faster if the UK were free of the EU’s regulatory shackles and the other presumed burdens of membership. And the Remain camp would still be putting out victory lap-type reports showing the country was reaping all sorts of benefits from continued membership.

But Leave won, so the roles are flipped. Limitless disagreement on what Britain has lost or gained remains, and the claims remain unprovable—especially considering factors from the pandemic and associated lockdowns to hot worldwide inflation exacerbated by war. But the Remain side seems to argue much louder—and gets much more attention—than the Leave side. The Guardian’s features are but the latest example, using the tried-and-true tactic of anecdotal evidence writ large. I don’t think that is a compelling argument tactic, but the human stories put a face on things and show the degree to which the pain of loss lingers for the farmers, manufacturers and retail traders who lost valuable customer relationships—or at least saw added complications—when customs barriers arose in the English Channel. You hear much less from those who have gained new business in Asia while finding workarounds to the new barriers to European trade. Those folks are out there, but the stories maybe aren’t as compelling as those of loss, perhaps because their emotions simply aren’t as strong. They may not even think of themselves as winners, but rather just people who got on with it. The others are getting on with it, too, and making the best go of it they can. But lost business is lost business, and it weighs.

And so Brexit brings prospect theory in action—in our view, a real-life proof of Daniel Kahneman and Amos Tversky’s old paper showing people feel the pain of loss more strongly (about two and a half times moreso, by their estimation) than the joy of an equivalent gain. Not only does the losers’ pain eclipse the winners’ joy, but the divide gets highlighted again and again and again. Not just in the human interest stories and studies, but every time a data release gets analyzed through a Brexit lens. Leaving the EU received some blame for every dip and disappointing twist in the UK’s economic data over the past two years since the post-Brexit transition period ended. We can’t prove that this is why the UK has underperformed global markets during this stretch, but common sense would suggest that sour Brexit sentiment played a role. It would be very, very strange for that deep net negativity to have no effect.

To me, this is why gridlock is so great. When it is an option—which, again, it wasn’t in Brexit’s case—you don’t get these sorts of divisive, radical changes that, whatever you think of their merit, roil sentiment. Whatever change does happen tends to be a watered-down version of the original ideas, creating some relief and reducing the scope of winners and losers. A tax tweak here, a small regulatory change there—not huge alterations to the economic landscape. Smaller changes are a lot easier for people to get over and move on from, as we are seeing in the US right now with the forthcoming tax on stock buybacks. Businesses don’t like it, but they aren’t stewing over it—just factoring it into their plans, remembering it could have been worse, and moving on. It seems highly unlikely that in two or three years we will be drowning in retrospectives on how this small tax change has altered businesses’ profitability permanently. More likely, the change will be forgotten. No sentiment overhang.

Remember this as we move into 2023 and the split Congress gets to work. They will shout a lot. The House and Senate will push big ideas. But only those sufficiently milquetoast will advance, with both chambers refusing to take up radical bills passed by the other house. For two years, stocks probably won’t have to worry about the prospect of radical legislation, keeping the US free of the sentiment headwind that has roiled Britain for the past few years. This isn’t the only factor that will affect stock returns, but it is a big one, and it should be a positive.