Brexit: a slow burn affair

In the City, the most important question in last week’s Presidential and Congressional elections was whether a united or divided government would make massive fiscal stimulus more or less likely. Markets tracked in real time the ebb and flow of expectations about a Blue Sweep. The spotlight, unsurprisingly, was on the economic and financial impact.

In Westminster, the focus was different, and political. The more important question for the UK government was whether it could continue to rely on a supportive ally across the pond as Brexit negotiations over here move into their tense final phase. Watching events from Brussels, you might have been forgiven for hoping that a change in the White House would shift the advantage your way.

After four years of deferred deadlines, claims that the coming week’s negotiations are do or die for a free trade agreement might sound hollow. But with ratification of any deal required in 27 countries before the New Year, the end game is surely now approaching. Whether a deal is done or not is increasingly a matter of how badly the two sides want it.

The gap between London and Brussels is wide still and could yet be unbridgeable because it reflects non-tradeable principles. The EU does not understand the UK government’s determination to free itself from Brussels’ regulatory grip. The UK does not understand Europe’s need to put in place a living agreement that can stand the test of time. These are not issues that can easily be fudged.

So, for all the hard work in the ‘tunnel’ over the past couple of weeks, the two sides are still talking across each other. This may be the usual dance, before we fall into each other’s arms at one minute to midnight. But maybe both sides really mean it, and this is not a bluff. We will find out soon enough.

The problem for the UK is that while a trade deal might be less damaging economically than no-deal, it is self-evidently worse than the status quo. The government’s own analysis suggests a cost of 5pc of GDP over 15 years for a skinny agreement with no tariffs on goods but new border checks and restricted services. It thinks no deal would cost 8pc.

These costs cannot be hidden. Not even the smokescreen of the pandemic can do that. Agreeing to a deal would, therefore, require the Government to defend its terms and to own their consequences. It might be better politically to accept the most damaging economic outcome with the get-out that it can be blamed on an intransigent EU.

If the EU digs in, the UK would have to present as a good deal all of the following: the inability to claim the fish in our territorial waters; a loss of the freedom to prop up struggling British companies or develop our own social and environmental rules; and a climbdown on the recent threat to override international law over Northern Ireland. Not everyone would see these give-aways as a diplomatic victory.

As for the EU, the integrity of its rule book has always been likely to trump its desire to strike a trade deal with its economically important but semi-detached neighbour. The EU would like to reach an agreement but not at any price.

So, while an eleventh-hour compromise still looks achievable, the odds against it are lengthening. Leaving on World Trade Organisation terms is a very real possibility. We can estimate what this will cost economically, but how much should UK investors be concerned?

That depends in large part on the extent to which your UK investments are really UK-focused or merely traded here as a matter of regulatory and legal convenience. The lion’s share of earnings for Britain’s leading quoted companies are made overseas, and only a proportion of those profits are earned in the Eurozone. More than 90pc of the value of the UK stock market is accounted for by the top 100 companies so Brexit is probably a smaller concern for investors than its importance to the economy might suggest.

No-one could claim, either, that investors have not had plenty of time to reconcile themselves to the upcoming rift. The underperformance of the UK stock market during the pandemic has been clear to see, but the UK has been a pariah market for years not months. £100 invested in the FTSE 100 ten years ago would be worth no more today. The same amount invested in the MSCI World index a decade ago would have doubled in value to almost £200. Expectations have been low for some time, and to a large degree the bad news has been priced into the UK market now.

The impact of Brexit will also be a slow burn affair. Despite the National Audit Office’s criticism of the UK’s inadequate preparation for new border controls, the economic consequences will be felt not as a cliff edge but an accumulation of grit in the system over many years. The Office for Budget Responsibility thinks we’ve already experienced around a third of the impact thanks to four years of reduced business investment, another third will be felt over the next few years and the remainder in the decade after that.

So, while it is hard to get particularly excited about the UK’s prospects, there is equally no reason to panic. A well-diversified portfolio would not hold more than 10-15pc in the UK, given our contribution of only around 6pc to the total value of global shares. That kind of exposure is justified on valuation grounds. Even if both of Britain’s key relationships have just got a little bit less special.

Tom Stevenson is an investment director at Fidelity International. The views are his own. He tweets at @tomstevenson63.