4 January 2021
Finally, nearly 1,500 days after the Brexit referendum, the United Kingdom has both left the European Union and signed a Free Trade Agreement (FTA) outlining its future trading relationship with its largest partner. Political partisans will continue to defend their entrenched positions regarding the merits of this deal. On the one hand, the agreement does allow the UK in large part to regain control of its immigration policy, legal and regulatory framework, and its ability to negotiate FTAs with third parties independently: all fundamental motivations behind Brexit. Initially, at least, the UK will enjoy tariff/quota-free access to the world’s largest Single Market.
However, the agreement comes at a price. Despite the absence of formal impediments to trade, non-tariffs barriers will exist, which are estimated to add 5-10% to the price of traded goods. Perhaps most importantly, the service sector, which accounts for 80% of the UK economy and where the UK enjoys a large bilateral trade surplus with the EU, is not included in the deal. Negotiations will continue on the critical financial service sector in coming months. Further, there is no getting around the fact that keeping open the border between Northern Ireland and the Republic of Ireland has required the establishment of a commercial border in the North Sea between NI and the rest of the United Kingdom — with potentially enormous constitutional implications. And, future divergence of regulatory standards between the UK and EU will involve a compensatory loss of access to the EU Single Market.
Investors must weigh up these differing assessments. To be sure, this is a thin deal, but most agree its preferable to a No Deal outcome. And, while I do anticipate border disruptions in coming weeks as businesses adjust to the new arrangements, the New Year’s chaos of No Deal should be avoided. From a financial market perspective, while fully outlining the EU-UK post-Brexit relationship will need to continue for years, the degree of uncertainty has been reduced. But, what will be the key market drivers in 2021? Will Prime Minister Boris Johnson’s new “Global Britain” triumphantly begin to emerge? Or, will the UK recede into Europe’s economic slow lane? Importantly, which scenario have UK sterling and UK financial markets priced in?
Brexit Means Brexit!
My intention is not to re-open the Brexit debate. However, as over four years have passed since the referendum, we can begin to assess the post-Brexit performance of the UK economy. The Chart above illustrates even prior to the Covid pandemic, UK economic activity has lagged the European performance by 2% since 2016. Moreover, the UK has dramatically underperformed during the health emergency.
The Chart above details the sources of UK underperformance. On the one hand, exports have fared relatively well, reflecting sterling’s sharp decline. British consumers, meanwhile, lagged EU shoppers between 2016 and 2019, before collapsing during the pandemic. However, the main problem has been the dramatic decline in UK business investment. Will the greater certainty of the FTA correct this problem…..we’ll see?!
Meanwhile, UK labour productivity growth has lagged other G-7 nations for many years. Brexiters suggest EU membership is to blame. However, German and French workers are 25% more efficient than British counterparts. As EU membership is not the cause of the so-called productivity puzzle, Brexit is not the solution. Ominously, the Chart above indicates UK productivity growth has slowed sharply further since the GFC. High levels of unemployment and surging government debt resulting from the Covid crisis could potentially limit future efficiency gains in coming years. Domestic reforms to correct the productivity gap must be the top policy priority.
Will the replacement of the Single Market’s free labour movement regime with the new points-based immigration system remedy the UK’s productivity shortfall? Not likely. The Chart above illustrates the skill level of UK immigrants is considerably higher than the native population’s. Protecting local workers from better-trained (and educated) foreign competition is not the answer.
The new UK-EU FTA will prevent the worst case scenarion. However, I have always been most concerned about Brexit’s corrosive impact on the UK’s long-term growth potential. The FTA will not remedy the UK’s productivity defficiency. And, the new immigration system is designed to limit foreign labour inflows; thereby, eliminating an importance source of labour force growth. Meanwhile, even though reduced uncertainty may help correct the previous capital spending shortfall, this remains to be seen. Overall, even under the new FTA, I expect the UK’s long-term growth will be reduced by 0.5% per year — much in line with the trend since the referendum. From year-to-year that may remain hardly noticeable. Over a generation, however, the economy could be 10% smaller than it would have been otherwise.
Global Britain?
For Brexit enthusiasts, the new EU-UK FTA marks the beginning of an era during which the UK can enhance its role on the world stage. PM Johnson heralds a new “Global Britain”. Former Tory leader Ian Duncan Smith suggests he wishes he were 21 years old to take advantage of the new opportunities. But, most young people view the future with concern: living under the burdens of the GFC, Covid, and Brexit (I would agree).
To be sure, since the referendum, the UK has entered into dozens of independent trade deals with non-EU partners — a key Brexit selling point. So far, however, virtually all of these deals simply roll over arrangements the UK already enjoyed as an EU member. Even the recent deals with Japan and Canada higgy-back on accords the EU had negotiated with these important G7 partners. But, the true Brexit test is whether the UK can now reach agreements before and on better terms than the EU negotiates with new partners, e.g. the USA and China most importantly. This seems highly unlikely.
Can post-Brexit “Global Britain” forge better relations with the incoming Biden Administration? To be sure, the USA and UK share common values, and a strong relationship is in the interest of both countries. The UK remains the world’s fifth largest economy, although it may struggle to remain in the top 10 by 2050. The UK both plays a vital role in NATO and possesses important “soft power” assets, e.g. scientific prowess, strong diplomatic and foreign aid relationships, adherence to the rule of law, and relatively flexible, open domestic economic institutions. Likewise, the UK, along with EU partners, is at the vanguard in confronting the climate change challenge.
In the past, however, America has relied upon the United Kingdom as a pragmatic, reliable “transatlantic bridge” in seeking partnership with the European Union. Following Brexit, the UK’s ability to play that role is diminished. Looking forward, the UK will remain an important regional power who can be relied upon to utilise its valuable assets in conjunction with the USA on the world stage. The United Kingdom’s history and geography is European. The nation’s ties with the EU will remain its most important relationship in coming decades: a prospect which should guide ongoing bilateral negotiations.
In general, I do not expect President-elect Biden will rush into new FTAs. However, given the relative size of the EU Single Market, power-politics suggest talks with the European Union would get priority — a verdict delivered by the previous Obama-Biden Administration. Ireland’s role as an English-speaking entry point to the EU Single Market may be enhanced post-Brexit. Further, Boris Johnson’s apparent willingness to break international trade agreements will not have gone unnoticed.
In the end, the United Kingdom’s most important post-Brexit, post-Covid challenges will be domestic. Climate change, improving productivity, and reducing regional wealth/income/opportunity gaps will top Global Britain agenda. PM Johnson’s pledge to “level up” — reduce the nation’s North-South divide — may be impeded by swollen government debt post-Covid. Perhaps most importantly, post-Brexit/post-Covid both Scotland and Ireland may question which union is most beneficial — UK or EU. While this may still be a generational issue in Ireland, the Scottish Parliamentary electionsin May will keep the topic in the headlines this year.
Key Economic and Market Drivers in 2021
Of course, the Covid pandemic will remain a key economic and market driver this year. Sadly, the UK’s performance lags well behind well behind that of Germany, Scandinavia, Ireland, amongst other (Chart above). The nation’s track record is more comparable to the hard-hit USA, France, Italy, and Spain. Ominously, the emergence of a new Covid variant, which now accounts for nearly 70% of new cases in London and the Southeast, has increased hospitalisations above the first peak. With the introduction of the Oxford/AZ vaccine accelerating the vaccine rollout, the logic of a full national lockdown to buy time (and save lives) may prove too compelling to ignore this winter.
Needless to say, Covid (and possible Brexit disruptions) will make Q1 2021 challenging — following 2020 when the UK economy lagged both the USA and EU significantly. However, the UK’s vaccination program appears relatively well-positioned (although I anticipate logistical delays before I get mine!), and border distruptions should be temporary. Furthermore, the following Chart illustrates the UK’s Covid fiscal stimulus is amongst the world’s largest — bigger than EU countries except Germany.
Overall, I project 2021 UK GDP growth of 5.5%% compared to 4.5% and 7.2% in the USA and EU respectively.
Time to Buy?
In a word, yes! While the EU-UK FTA is far from perfect, it does provide a future framework; thereby, reducing economic risks. Following its disasterous recent performance, the UK equity market’s relative valuation has rarely been cheaper (following Chart provided by Morgan Stanley). I anticipate gains of up to 15% in 2021.
I estimate Brexit has lowered sterling’s long-term “fair” value by roughly 10% (Chart below). Nevertheless, I believe the UK pound is now undervalued. I anticipate a recovery toward Euro 1.16 and USD 1.45 in 2021.
