Brexit Negotiations: What’s Next?
By Paul Ehrlichman, Managing Director, Head of Global Value, ClearBridge Investments
March 25, 2019
Continuing a trend of drawn-out planning and implementation, the most likely outcome of Brexit negotiations will be another extension. Pressure from the European Union, led by France, could lead to a “soft Brexit” that leaves in force much of the framework between the EU and United Kingdom. UK equities have severely underperformed global markets, creating valuation opportunities that will likely be supported by aggressive stimulus.
The British ejected their Prime Minister in June 2016 with a referendum to leave the European Union – Brexit. But like many decisions driven by emotion and political opportunism, the years since have been filled with regret, realization and unintended consequences.
Everyone claimed Brexit was a “mandate of the people,” with no one exactly sure how to do it.
Brexit did not even look good on paper, let alone when contemplating the reality of abandoning a 46-year-old relationship. The UK petitions website crashed on March 21 with 1500 signatures per minute in support of revoking Brexit. By week’s end, the total number of citizens asking to stay reached 3 million.
So much for the “mandate of the people” invoked by pro-Brexit Members of Parliament.
Since the Brexit vote, UK shares have badly lagged global equity markets and risen less than half as much as the MSCI ACWI Index. On a sector-adjusted basis, this has pulled the relative valuations of UK companies down to levels last seen during the downturns of 2001 and 2008.
While British exporters have benefited from the weak currency, domestically-dependent shares have contributed most to the underperformance. Corporate investment has been particularly weak, contracting year-over-year at the sharpest rates since the 2008-2009 Financial Crisis.
While the UK is enjoying record high employment and improving wage growth, consumer confidence has plunged to recession levels. As with much of the world, uncertainty surrounding trade, political and monetary policy has led to an “air pocket” in economic activity.
A reasonable path forward would be to call a “time out” with an extension, or a “do over” with either a new vote or soft Brexit that keeps the UK in the common market – the Norway option.
The UK has taken significant actions to limit trade disruption if there is a “no-deal” Brexit, especially in relation to the Irish border. They enacted a temporary import regime that removes tariffs on 87% of goods for the next 12 months. The UK will remain a member of the Common Transit Convention which moves checks away from the borders to their final destinations.
This is helpful but would not eliminate all costs of leaving the Common Market, such as biosecurity checks, dangerous chemical declarations and VAT duty reporting requirements.
The benefit of a longer extension is the greater likelihood of a more workable “soft” Brexit that limits the harm to UK companies and consumers while keeping Ireland border-free. Either an extension or deal approval could support a sharp economic rebound. A no-deal/hard Brexit, or the formation of a new government, could keep the UK economy under a cloud of uncertainty.
Worst case could be an essentially powerless non-majority Labour government, led by Jeremy Corbin. This would likely weaken the economy, currency and stocks. The Conservative government is planning significant stimulus over the next five years, with a reduction in personal taxes and subsidies that encourage capital investment. If Brexit-related uncertainty is removed, this fiscal support could add to the strength of an economic rebound.
An extension should not be a surprise given it took four years, from 1969 to 1973, for Great Britain to work out terms for originally joining the EU. Hopefully the divorce is less painful and faster than the courtship, but that is not always the case.
Paul Ehrlichman is the Managing Director, Head of Global Value, at ClearBridge Investments, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
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