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Brexit Deal November 2018
CIO team, 20.11.2018
A BREXIT DEAL IS FINALLY ANNOUNCED
Following nearly 2 years of back and forth negotiations, the UK finally announced that a deal agreeing the terms of the United Kingdom’s exit from the European Union had been agreed with the EU. However, despite a ‘collective’ agreement by her Cabinet, Prime Minister Theresa May is battling not only to save her Brexit deal, but her position as prime minister as several ministers, including the Brexit Secretary Dominic Raab resign. Whilst the UK Cabinet has approved the Brexit deal, it still requires approval by an EU leaders’ summit, the House of Commons and the European Parliament.
THE BREXIT DEAL
The deal that has been announced is a 585 page document that is the separation agreement between the UK and the EU, covering several main areas:
The agreement does not go into detail about the future trading relationship between the UK and the EU, although it includes a declaration on the preferred relationship.
The UK will honour its financial commitments to the EU, and will continue to pay into the EU post Brexit day of 29 March 2019, during the transition period to 31 December 2020. The UK treasury expects this to be £39bn, although commitments could extend to 2064.
The existing EU residence and social security rights of more than 3m EU citizens in the UK, and 1m UK nationals living on the continent, will be maintained.
THE IRISH HARD BORDER
By far one of the most difficult issues to resolve. A unique arrangement has been put in place for Northern Ireland, which aims to uphold the peace process between Northern Ireland and Ireland, and to prevent a hard border between the two nations. This guarantees free movement between the two countries, and lays out “backstop” arrangements to ensure the free circulation of goods across the Irish/Northern Ireland border. These will remain in place until a separate EU/UK agreement replaces them. This binds Northern Ireland to the EUs customs code and single market rules, which is a different treatment to the rest of the UK, and will prove (“DUP”) problematic to the Democratic Unionist Party in Northern Ireland, the votes of who are currently propping up Theresa May’s ruling conservative party in Parliament.
Provision has been made for a transition period until the end of 2020, which by mutual agreement can be extended for an unspecified one-off period. During this period, the UK will remain bound by the EU laws, without having any say or decision in the EU institutions – undoubtedly a worse position than remaining in the EU. This will result in the UK not moving forward until such point that a future trade agreement has been agreed, whilst any extension of the transition period will result in the UK having to pay additional amounts into the EU budget.
THE CUSTOMS UNION
The backstop plan for Northern Ireland is supported by a UK/EU customs union, something that the Brexiteers are fully against. This ensures that there will be no need for customs checks across the Irish Sea. Whilst Northern Ireland will effectively remain in the customs union, the rest of the UK will comply with a more basic customs union model, notably avoiding tariffs and quotas. The UK will continue to abide by certain EU laws (labour, taxation, the environment) and competition rules. The Brexiteers fears are that this, along with the extendable transition period, will keep the UK within the EU customs union indefinitely, without being able to negotiate its own trade treaties.
WITHDRAWAL TREATY GOVERNANCE
In order to come to an agreement over the withdrawal treaty, and effectively kick the can down the road to determine the final withdrawal arrangements, negotiators have included some rather complex oversight arrangements. It ensures that the UK and EU have equal votes (with an independent arbitration panel to resolve disputes) to agree that the withdrawal terms have been met. There is a tilt towards the EU, however, in that any issues relating to EU laws must be referred to the European Courts of Justice. Again, for Brexiteers, who resolved to ensure that the UK was no longer bound by the ECJ, this falls significantly short of their expectations and promises during the EU Referendum.
It has undoubtedly been the most turbulent few days of Theresa May’s premiership, and despite calls for her resignation, she has vowed to “see it through”. She firmly believes that the deal is the only one. “I believe with every fibre in my being that the course I’ve set out is the right one for our country and for all our people”. The prime minister may believe this, but with the most notable resignation of her second Brexit Minister amongst others, and a growing number of signatures from her party calling for a vote of no confidence, Theresa May is facing her biggest political challenge yet. The treaty may have been collectively approved by her Cabinet, but Theresa May faces significant challenges to get it through parliament.
Firstly, the remaining 27 EU members must sign-off the agreement at a summit on 25 November. At the moment, it seems that the European chief Brexit negotiator is the biggest admirer of May, praising her “courage and tenacity”, whilst at the same time adding to her woes by stipulating that there will be no further negotiations. This makes the next step even more challenging for May, which is to obtain parliamentary approval of the deal – the vote is likely to be in December. The outcomes of that parliamentary vote are varied and will have severe implications – the most likely best outcome is that she will be sent back to Brussels to renegotiate, whilst the worst outcome will lead to the fall of her government, and the UK crashing out of the UK without a deal.
Chart 1: The deal, and its outcomes
Theresa May faces an uphill struggle to have the deal passed through parliament, with Brexiter MPs not necessarily following the expected party line of no free vote (Tory ministers only being able to vote in favour of the government). The table below shows just how difficult this may be for the minority conservative government of Theresa May – the DUP have not yet indicated how they may vote, although they are bitterly opposed to the Northern Ireland terms in particular. The 320 required votes will be hard fought, with many expecting this deal already ‘dead on arrival’.
Chart 2: May’s uphill battle to get her Brexit deal past parliament
It is clear, that more than 2 years after the EU referendum, there is a huge amount of uncertainty – something that both the electorate and financial markets dislike – and have reacted to.
The remaining EU governments have already sent a rather direct message to the UK, by agreeing that they are fine with the agreement. They are unlikely to request any changes before the summit.
FINANCIAL MARKETS REACT
An immediate reaction to this turmoil on 15 November was a weakening in sterling, with cable falling 2% from 1.2775, and slightly recovering to 1.2840 at the time of writing, but far from the 1.20 that some commentators had warned of. It also sank about 2% versus the euro.
A shift to the safety of UK gilts pushed the 2 year yield to 0.72%, below the Bank of England’s base rate of 0.75%, whilst 10 year yields have fallen to 1.40%, having recently peaked at over 1.70%.
Equity markets however, as evidenced by the FTSE100, did not react as badly as sterling, suffering some volatility but ending slightly up on the day. UK equities are supported by a weaker sterling as it boosts the income of overseas earnings – a major constituent of the FTSE.
Chart 3: FTSE 100 vs £/$ & UK 10Y Gilts
UK EQUITIES – SUPPORTED BY DIVIDENDS
The FTSE 100 has had a positive performance since the Brexit referendum, trading to record highs, and is +17% since the referendum in June 2016 on the back of sterling weakness. Since the beginning of the year, performance has been akin to that of global markets, falling some 8%. Performance going into the end of the year will be dictated by how the Brexit deal evolves, and although we should put aside political uncertainty and focus on the composition of the FTSE 100 to ascertain where the Index is headed, political events may overtake us.
The UK equity market is a defensive market with the highest dividend yield of 4.5% among the major markets, a positive in an environment of low bond yields. Eurozone equities yield 3.4%, the MSCI EM 3.0% and the US 1.9%. On a yield gap metric the UK remains attractive compared to bonds.
The performance of UK stocks is also inversely correlated to the movement in the pound as FTSE member companies generate about 70 per cent of their revenues overseas. The weakness in the pound since the Brexit vote in 2016, has been a tailwind for exporters. A weaker currency in the short term, has the potential for renewed divergence between exporters and domestic UK companies.
The FTSE100 is trading at 11.8x 12-month forward Price to earnings, making it cheaper than other developed markets.
Chart 3: Brexit announcement – Performance of FTSE 100 and UK domestic only FTSE 100 companies vs £/$
UK GILTS – LITTLE CHANGE
We see limited strengthening of the UK Gilts with the 10 year gilt at 1.40% and expect the potential steepening of the UK yield curve once further Brexit developments become apparent – although the curve has marginally flattened over the last year. While sterling pressure remains, we could possibly see Gilts settle around the 1.30% handle in the near term on back of volatility. However, for the mid-to long term, steepening of the yield curve risks cannot be ruled out. Any rally of safe-haven Gilts should be temporary in our view as rising concerns on the Brexit outcome, and how policies unfold (with a Bank of England dovish stance) should keep bond markets relatively range bound.
While UK inflation has been above the target for a longer period, we expect the Bank of England to tread cautiously, despite obvious inflationary pressures (wages and goods) within the system. Should there be a definitive outcome of Brexit, then a sterling relief rally will ease inflationary pressures as well as the Bank of England’s need to raise rates. Indeed, the Brexit chaos reduce market expectations of interest rate hikes next year, as the Bank of England’s Governor Mark Carney warned in this month’s inflation report that rates could go in “either direction” in response to a no-deal Brexit.
REAL ESTATE – LIMITED TRANSACTIONS
Current turmoil in Parliament does not alter our thoughts on UK real estate markets. Without any clear resolutions in sight, the UK housing market will continue to suffer from limited transactional activity, although downward spikes in GBP may give a temporary (and limited) boost to prime London residential markets from foreign value buyers.
On the commercial property side, we will continue to see investors shunning the Retail and Office sectors as they are perceived to be most at risk of a Brexit-led downturn. However, similar to Prime London residential, there will still be overseas investors acquiring single let assets in Central London. Freehold land in a major global city with an investment-grade tenant on a comparatively long lease available at a discount (in non-GBP terms) is too good an opportunity to pass up.
General poor sentiment towards UK assets will result in ‘collateral damage’ across property sectors though as correlations tend to trend towards 1.00 in a downturn. We believe that certain sectors are better placed to weather the Brexit storm – those with unrelated demand drivers (healthcare, build-to-rent, social housing & student accommodation), properties in strategic locations (long income) and strategies which are exploiting structural changes (logistics warehouses, property debt).
WHAT HAPPENS NEXT?
There are a number of possible outcomes, whether it is a deal with an orderly exit, or a no deal, resulting in a renegotiation, a chaotic exit, a general election or indeed a second referendum. It is clear that Theresa May will have to use her considerable skill, not only to convince lawmakers in Parliament to back her deal, but also to prevent a challenge to her premiership, and the coming few days are critical.
There will continue to be a period of political turmoil, to which financial markets are inextricably linked. As always, investors should be attuned to the risks of these unchartered territories. Indeed, should the deal be agreed and resolved by the current government, the next steps will for the UK to extricate itself from the transition period, the customs union and all that it entails.
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