Brexit May Day

Even though it’s January, today is May Day…Theresa May’s day. Since June 24th, optimists and pro-Brexiteers have attempted to convince sceptics that British Prime Minister Theresa May would not push for a “hard Brexit” as the United Kingdom’s (UK) departure option from the European Union (EU). However, given that PM May had previously made clear that she interpreted the referendum’s main implication to be that the UK needs to control immigration – which goes against one of the four cornerstones of the EU (i.e., free movement of people) – a “soft Brexit” was unlikely.

Cue to today (January 17th), where PM May announced that in line with her vision of controlling immigration and taking back control of its laws from the European Courts of Justice, the UK will not seek continued participation in the EU’s single market. This can be considered a “hard” Brexit.

She also announced that the UK will exit the EU customs union (this was always likely since it goes hand in hand with leaving the EU). This new-found “freedom” will allow the UK to seek free trade deals with countries outside the EU. In addition, the UK will look to build a new customs agreement with the EU in order to attain tariff-free trade with the EU.

Horse trading and threats

PM May laid out some of the tools of her negotiating strategy. She commented that “no deal is better than a bad deal.” This seemingly innocuous comment signalled that the UK is willing to walk away from the single market and simply revert to World Trade Organization (WTO) rules. PM May also played her “Trump card,” dangling the U.S. president-elect’s recent promise to the UK of a quick trade deal with the United States. She accompanied this with a warning that mutual damage could be inflicted if there was no good deal forthcoming.

“It would jeopardise investments in Britain by EU companies worth more than half a trillion pounds. It would mean a loss of access for European firms to the financial services of the city of London. It would risk exports from the EU to Britain worth around 290 billion pounds every year.”

She also echoed Chancellor Hammond’s comments over the weekend that the UK will “do whatever we have to do to protect competitiveness,” widely interpreted as cutting corporation tax and loosening regulations if the UK is denied access to the single market.

May’s strategy is a risky one. Reminding Europe of the UK’s worth is no bad thing, but threatening Europe that it could undercut taxes could prove counterproductive in EU negotiations. Not to mention that the success that other countries have enjoyed with a low-tax environment has been at least partially based on companies’ ability to engage in free trade in markets in their geographical region.

At the same time, if the UK government truly believes that reverting to WTO rules is acceptable, this ignores the fact that benefits of trade agreements go beyond the simple removal of tariffs. For example, many parts of the UK service sector would almost immediately lose their ability to provide services to EU-based counterparties. Essentially overnight, the essential administrative and legal work that enables trade in goods and services would  be left without clear foundations and guidelines. And while a trade deal with the United States would undoubtedly be hugely beneficial to the UK, it relies too heavily on a “promise” from the U.S. president-elect, who already has clouds of uncertainty around his policy directions.

Consolation Prizes

Theresa May proposed a “phased process of implementation” after the Article 50 negotiations conclude (these negotiations must be completed within the two-year timeframe). During this time, various sectors could have different transition periods. While I welcome this admission that further time is required to introduce the new framework, the government may be underestimating how long negotiations for trade agreements take. A new customs agreement, for example, would require ratification from all 27 EU member states, and would have to cover the unfathomable legal and regulatory mechanisms required for trade. The UK’s current trading relationship with the EU has evolved over 43 years – the UK government is hoping that any new relationship can be completed in two years.

The UK’s Supreme Court will soon rule on a number of legal challenges regarding Brexit and Article 50  and, today, PM May announced that Parliament will get a vote on the final agreements reached with the EU before those agreements can come into force. However, it is not clear what would happen if Parliament decided to vote against the agreement. As a result, this may not even be the consolation prize that many anti-Brexit forces were hoping for.

Market implications

Contrary to my largely negative interpretation of the speech, the sterling strengthened from around $1.20 to almost $1.24. Why such a tremendous rally? Sterling had initially fallen below $1.20 in response to leaks of PM May’s speech, so much of the move was a correction from the prior drop, helped along by comments from the U.S. president-elect that the U.S. dollar is “too strong.” Additionally, the pound sterling has positively responded to more “certainty.” Knowing what approach the UK is going to take is clearly beneficial to companies, and markets have responded accordingly. However, I expect a sustained period of economic and political uncertainty is approaching and, therefore, I doubt that this upward trend in sterling will continue.

If the pound ultimately weakens sharply, this will put further upward pressure on inflation and create a difficult decision for the Bank of England. Just this week, UK inflation came in above expectations (1.6% year-on-year) and Bank of England governor Mark Carney has very recently noted that there are “limits to the extent to which above-target inflation can be tolerated.”  Rising policy rates at a time when the UK is trying to establish its place in the world economy is a worrying prospect.

 

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