Brexit Fears Are Back but Still Lack Bite

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It’s aliiiiiive! Just in time for Halloween, the Brexit monster is back from the beyond! And with it all the talk of trade wars and economic calamity on both sides of the English Channel. The issue this time? The Northern Ireland Protocol, which established customs checks on goods traveling from Great Britain to Northern Ireland in order to prevent a hard border between it and the Republic of Ireland, an EU member. Neither side thinks the present system is working well, with the recent “sausage war” over the protocol’s ban on British meat entering Northern Ireland but one high-profile example. UK Brexit Minister David Frost^[i] officially announced his intent to renegotiate the agreement on Tuesday, and EU Vice President Maros Sefcovic outlined the EU’s position Wednesday. We won’t hazard a guess at how this plays out, but we still don’t believe this is 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 among the biggest sticking points. As it is one of the UK’s constituent countries, it probably goes without saying that 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, frictionless border between the two. To preserve that, the UK and EU agreed Northern Ireland would remain in the EU’s customs union. Hence, goods crossing the Irish Sea were subject to checks.

At the time, a host of observers determined that this agreement looked good on paper and would be unworkable in the real world. Thus far, reality has largely borne that out. Being in the EU’s customs union requires Northern Ireland to abide by all EU trade restrictions. 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. Faced with the prospect of no bangers in Belfast, officials agreed on a temporary grace period for this and several other rules, ostensibly to give negotiators more time to find a permanent solution.

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

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). In 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. But that article also allows the EU to erect retaliatory trade barriers, including higher tariffs, hence the trade war fears.

As we write, there appears to be a lot of daylight between the two sides. The EU is ready and willing 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. EU officials have also discussed removing all checks on goods intended to stay in Northern Ireland, rather than cross into the EU. So on this front, compromise appears workable. In a turn that surprised some observers, Sefcovic also signaled that pharmaceutical firms in Great Britain will be able to continue shipping generic drugs into Northern Ireland without going through EU regulatory processes. However, the ECJ has long been a red line for the EU, and officials likely won’t bend easily—especially while it is separately sparring with Poland over a court’s ruling there that the ECJ doesn’t have sovereignty over Polish laws and courts.

If 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. Basically, your typical Brexit-related negotiation—or more broadly, your typical EU negotiation. The heightened rhetoric will probably hit sentiment at times and might trigger some volatility if trade war fears run hot. But this public, drawn-out process also lets markets price in potential changes well before they actually occur, 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. Yet if a full breakdown does happen, stocks likely will have seen it coming a mile away, blunting its impact on returns.

Still, uncertainty will probably be a headwind while this plays out, as it was throughout the Brexit negotiations. That isn’t a reason to avoid UK stocks, but it probably does favor large entities whose revenues depend on global demand rather than Europe alone—companies that can capitalize on the UK’s increased trade ties with Asia.