As the United Kingdom prepares to leave the European Union (EU) at midnight on the 1st of January 2021, it is worth evaluating the financial implications of one of the most historically significant shifts in British foreign policy. Dependent on whether or not a post-Brexit UK-EU trade deal can be agreed upon, the UK’s foreign policy will likely have to adapt to increased tariffs and the inability to negotiate as part of the bloc, in turn risking economic growth. As the probability of a deal remains debated, investors should understand the effects of both scenarios on the UK markets.
Pre-referendum, British foreign policy was mainly based on two pillars – Brexit threatens both. The first pillar was ‘Atlanticism’: the UK has prided itself on its ‘special relationship’ with the US, coordinating regularly with Washington on international issues, combating terrorism, the proliferation of weapons of mass destruction and ending conflicts such as in the Middle East. President-Elect Joe Biden is proud of his Irish roots, and claims there will be little hope of a UK-US trade deal should the open borders of the Good Friday peace agreement be violated by Brexit. The second pillar of British foreign policy was the benefits afforded to the UK as a member of the EU. Brexit takes the UK out of the EU’s Common Foreign and Security Policy (CSFP), meaning all goods entering the UK will require full declarations and tariffs. Tariffs raise the cost of both exports and imports. Goods exported from the UK become more expensive, and higher import prices contribute to inflation and a lower standard of living in the UK. UK companies also lose the ability to bid on public contracts in EU countries.
In the event of a deal, the sterling is expected to appreciate by 5% in trade-weighted terms because it would take the risk of an economic shock from a no-deal off the table. The implications for the FTSE 100, however, are much more difficult to predict. It is thought that a weaker sterling raises the repatriated value of overseas earnings and in turn, the benchmark index. However, the matter is more complex, as, over the past decade, the correlation between daily FTSE returns and trade-weighted sterling has been close to zero. A reason for this is that several variable factors are at play. Global events, not just those in the UK, need to be taken into consideration.
On the other hand, the lack of a deal could see the sterling fall by 10%. Most of the impact of a no-deal Brexit would be felt in the UK, an analysis conducted by the London School of Economics and the ‘UK in a Changing Europe’ organisation estimated that a no-deal would result in an 8% reduction in GDP over a decade. There would also be a broader effect on European activity. UK and European revenues constitute about 40% of the FTSE 100 company revenues. Revenues from other parts of the world could also be potentially disrupted, such as the 27% from North America or the 30% that comes from the developed and emerging markets of Asia.
It goes without saying that confidence is currently fragile given the pandemic. A prolonged disruption in discussions or an indication of the discussions leaning towards a no-deal could impact global risk sentiment and asset prices. This could then influence corporate and consumer sentiment, further prolonging the economic weakness caused by COVID-19 and further depress global commodities prices and interest rates. Therefore, it seems safe to assume that a no-deal outcome would lead to a lower sterling and be detrimental to markets.
By Veena Tadikonda
Sector Head: Jackson Philips