‘Doomsday’ Preppers: Brexit and Tariff Edition

Brexit and tariff fears have dominated financial headlines this year. Though shrill warnings make waves, reality isn’t quite as dire as pundits make it seem. Why? Government officials and business leaders alike have been adjusting and preparing for myriad scenarios, decreasing the likelihood of a negative surprise. In our view, Brexit and tariffs provide a timely illustration of why widely discussed events often don’t damage commerce as much as feared—important for investors to keep in mind.

Gearing Up for Brexit

Though Brexit’s exact timing and shape remain unknown, regulators and business executives alike have been preparing contingency plans in anticipation of post-Brexit day-to-day life. On the government’s side, the UK has continuity deals with countries representing 72% of goods trade previously covered by EU trade agreements—not huge relative to trade with the EU, but still progress. Public officials have also taken steps to mitigate potential disruptions in the event of a no-deal Brexit. For instance, the Department for Transport announced an extension of air traffic rights for EU airlines until October 2020, regardless of Brexit’s form. Logistically, the CEO of the Port of Dover—which handles a sixth of the UK’s trade in goods—believes they will sail through without major disruptions.

Business leaders are preparing, too. We have written before about firms building up inventory in anticipation of the original March 29 Brexit deadline. That messes with long-term investment and economic activity, but it also should prevent supply hiccups when Brexit finally takes effect, regardless of the terms. Beyond that, a recent BoE research paper found, “… between November 2018 and January 2019, 10% of CFOs and 6% of CEOs were spending 6 hours or more a week on Brexit preparations, while over 70% of both CFOs and CEOs reported spending some time each week on Brexit preparations.” Though running through hypothetical no-deal scenarios that may never be used perhaps isn’t the most productive use of time, it reinforces how much emphasis businesses are putting on Brexit preparations.

Meanwhile, across the Channel, France has hired 600 extra customs officers while also upgrading its IT system and facilities in ports like Calais, the main European conduit to Dover.^[i] Dutch officials plan to add 900 customs officers and extra parking spots in the port of Rotterdam.^[ii] Further, the EU has granted regulatory “equivalence” to UK banks operating on the Continent. This means the EU will allow them to operate on the Continent, although that permission can be revoked. Brussels also approved contingency measures that will allow firms to trade in derivatives in London through March 2020 with or without a Brexit deal. These may not be ideal arrangements at this juncture, but they do mitigate the worst-case scenario so many feared previously.

To see how businesses are getting along, we parsed some Q2 2019 earnings calls, accessed via FactSet. Those mentioning Brexit were less Chicken Little and more wait-and-see.

“And I think the bank is well prepared as well in terms of our activities in the UK and has the right licenses to continue, so we are prepared for that. And then the question is, of course, what does that mean for the overall activities in the Netherlands? We expect that it will mainly be a second order effect. We have carefully worked with our clients that have direct exposure to the UK to see whether they are well prepared and if we have concerns we have put them on the watch list in the meantime.” – Tanja Cuppen, Chief Risk Officer, ABN AMRO Bank NV, August 7, 2019

“I personally think we're at a level now that it's just waiting to see what happens post October. We have a number of contingency plans in place because it's anybody's guess as to how this game can play out. You can take a bull view of it and say that post Brexit there will be a significant investment program across the United Kingdom for infrastructure. It certainly has those great needs. You can take the bear view that it's going to lead to the collapse of the UK economy. I think it's going to be somewhere in between the two.” – Albert Jude Manifold, Group Chief Executive & Director, CRH Plc, August 22, 2019

As we have written for months, getting on with Brexit—even of the no-deal variety—would allow businesses and investors to finally move on. The transition may not be seamless, but companies could finally unleash investment plans that were collecting mothballs while they were doing all this prepping, and investors would have one less thing to worry about.

Taking the Tariff Test

As the US and China keep haggling over trade, businesses continue finding tariff workarounds. We wrote earlier this summer about how firms are finding both legal and illicit ways to skirt tariffs. One popular route: getting exemptions. The Wall Street Journal reported today more than 2,500 companies asked for exemptions for about 31,000 products affected by tariffs.^[iii] One auto parts seller alone has filed 10,000 appeals.^[iv] Some of these efforts have been successful. American companies got an additional three months to work with a major Chinese telecom firm the US government effectively banned doing business in the US. A huge US Tech firm that rhymes with “grapple” just won exemptions on 10 items it imports from China. On September 20, the Office of the US Trade Representative announced a temporary tariff exemption on over 400 types of Chinese products.

Beyond exemptions, some firms are adjusting their business operations. Research by Japanese bank Nomura found companies are diverting production from China to countries including Vietnam, Taiwan and Thailand—accelerating a longer-running trend. Companies are also diving deep into the rulebooks to circumvent duties. Some US firms are using the Foreign Trade Zone Act of 1934, which allows them to import products tariff-free as long as the final products they sell aren’t meant for domestic consumption. Hard data are scant, but evidence suggests some companies are taking advantage of this law to dull tariffs’ bite. These tactics illustrate why we believe even the 0.4% of global GDP all threatened or enacted tariffs impact is too high an estimate.