January 25, 2021
The UK has officially left the European Union with the transition period drawing to a close on 31st December 2020. In the eleventh hour, negotiators eked out an agreement and thin though it may be, it meant a calamitous no-deal departure was averted. With the worst case scenario for markets avoided, our clients are contemplating whether it’s time to start considering British assets in their portfolio. In our book, a wait-and-see approach is still warranted, until we have a clearer picture on the implications of the deal, especially from a microeconomic perspective: Having a deal on paper is very different from having something that industries can readily enact. In this sense, Brexit is only just beginning.
Brexit in theory
The deal is some 2,000 pages long, but the key tenets are as follows…
The EU has avoided a hard border on the island of Ireland, preserving the “four freedoms” of its single market: free movement of goods, services, capital, and people. The UK has left the customs union while securing “zero tariff, zero quota” goods trade with its largest and closest trading partner. With regards to the movement of people, UK nationals no longer have the freedom to work, study or live in the EU and visas will be required for stays over 90 days.
Given the number of supply chains that criss-cross the Channel, it was never going to be easy to draw lines of demarcation between the two sides and the UK persuaded Brussels that EU materials and processing should considered in the same manner as British input when the completed products are exported to the European market. However, there is a big “but”. “Rules of origin” stipulations mean that for products exported from the UK to qualify for tariff-free trade, they must have either been wholly obtained, or been subject to a significant amount of processing in the EU or UK. There are varying limits on how much of a product can come from outside the EU, but it is around 40%. Many industries that rely on inputs from other corners of the globe could be facing significant increases in their operating costs – for example, a clothing manufacturer based in Manchester sourcing garments from Bangladesh to sell across the EU may face double tariffs: once when the clothes enter the UK, and then again when they enter the EU.
The UK will also leave the common fisheries policy – the EU agreed to give up 25% of its existing quotas in UK waters over a transition period of five and a half years, after which there will be annual renegotiations.
With regard to services (which make up 80% of the UK economy), the situation is more complex. Professionals such as doctors, nurses, dentists and engineers will no longer be automatically recognized in the EU and will have to seek recognition in the member state they wish to practice in. Financial Services (which make up about 7% of UK GDP) are not covered comprehensively and the two sides aim to reach a memorandum of understanding by March 2021. It is yet to be seen whether they will recognize each other’s rules, a process known as “equivalence,” which would allow the finance industry to trade across the UK and EU border. Already on the first trading day of 2021, all EU equity trading (worth €6bn) was migrated from the City to European capitals.
In a major concession from the EU, the UK will be able to set up its own subsidy regime, but it will have to respect principles set out in the treaty. Both sides have agreed on a minimum level of environmental, social and labour standards which are subject to future revisions. According to Angela Merkel, the key sticking point was in agreeing an arbitration mechanism to handle future trade disputes (the European Court of Justice will no longer have general jurisdiction over the UK), with the EU concerned that over time, the UK may drift away from EU standards to garner a competitive advantage, therefore becoming some kind of “Singapore on Thames”. If either side detects foul play, it can take action after consultation. After arbitration and adjudication, if the case is found to be valid, the aggrieved side would be able to impose compensatory measures.
Tax is vaguely mentioned in the deal. A standstill clause considers the two parties’ standards at the time the deal was struck as a sort of watermark but both sides wanted flexibility in this area, particularly as they tackle hot issues such as digital tax.
Brexit in practice
From an EU perspective, comments from high profile officials tend to imply a mood of “the UK made it’s bed and now it must lie in it – even if it is discovering that it is not at all comfortable”. While tariffs were avoided in the deal, other, non-tariff barriers (customs checks, rules of origin and local content requirements) are presenting quite an obstacle course for companies and business surveys reveal that more UK manufacturers are worried about supply chain disruption than at any point since 1975. Real-life examples of this are abound. A couple of weeks ago, my UK-based mother was unable to send me a card, with the local Post Office simply rejecting mail to Europe. When sending a tiny A5 envelope across the Channel becomes problematic, one can imagine the challenges that thousands of British businesses who import and export all manner of goods must be facing and the consequent drag on the economy.
New border controls are already inflicting acute pain on fish and meat industries which have seen hundreds of thousands of pounds of produce going to waste at ports due to time consuming checks and requirements. With no mutual recognition of safety standards or systems to protect humans, animals and plants from diseases and pests, costly checks have been established and farmers face a heavy paperwork burden, involving things like vet certifications. For now, the impact has not been fully felt by other industries due to coronavirus already having reduced cross-border trade and pre-Christmas stockpiling. As trade volumes pick up, the impact will become more apparent for other industries.
Rather than grappling with the red tape, many British retailers have suspended all shipping to Europe (cutting out a huge part of their customer base), while just-in-time supply chains need time to adjust to the new reality. The Sunday Times reports that delays are halting production at some British car factories; the automobile industry is worth £42bn in exports and employs 823,000 people.
Service sector companies have received less help in the deal as the British government hoped for and basically, guaranteed access to the single market is a thing of the past. Industry by industry, new problems are presenting themselves. Days ago, the music industry – including names such as Elton John and Sting – said it had been “shamefully failed” by the deal. Given that Covid-19 has stopped any touring, the true effects are still to be felt, but essentially, touring groups and their entourage (make-up artists, lighting technicians…) will require work permits which will differ from country to country in the EU.
With regards to financial services, the UK can only hope that the EU will grant “equivalence” status, but even so, that can be withdrawn at short notice as Switzerland has learned. This is hardly palatable for investors who seek legal certainty about the status of cross-border contracts. It’s also challenging for financial stability, given the volume of outstanding contracts between the EU and the UK.
We do not yet advocate that investors jump on British assets, given that Brexit is far from done and dusted. In certain areas the deal was threadbare, introducing many frictions for businesses. We can only expect that it will be upholstered over time — through add-on agreements – but this will be an arduous process, with changes requiring the sign off of 28 different countries. As the two sides try to iron out initial creases, many unknowns still linger and it will take more time to understand the implications of the agreement. For the time being, things do not look pretty from a bottom-up perspective.
One may counter that under traditional valuation models, UK assets and Sterling are cheap. Ultimately trying to gauge fair value gives some guidelines as to whether an asset is cheap or expensive but what it doesn’t do is provide is a sense of timing. Even if an asset is deemed cheap, it could remain cheap for a very long time. UK assets have underperformed since 2016 and its economy has lagged the global recovery that is currently unfolding. Some of the Brexit discount may go away, but it is questionable as to whether it will disappear completely because Brexit will continue to carry uncertainties and complexities that we will have to evaluate in terms of real activity, flows and barriers. Then, adding to an already-complex stew, is the recent suggestion that Coronavirus lockdowns could last until Summer
Longer term, the UK must decide how best to use its newfound freedom after being engaged in a 48-year long customs union with the EU. Boris Johnson has formed a new business council with representatives from flagship brands such as BP, HSBC and BT, to revive the post-Brexit economy. Focus is expected to fall on areas such as science, infrastructure and “green industrial revolution”. While this is all good in the long run, to invest now, we need to see that businesses can cope in the short-term.
 There are a few concessions, for example in the car industry: A maximum of 60% of the content in finished electric vehicles, plug-in hybrid models and conventional hybrid models can come from outside the EU or UK by the end of 2023 to qualify for tariff-free trade. This figure will be reduced to 55% by the end of 2026.
 Mail deliveries are now subject to extra charges, the need for customs forms and a there is a complete ban on certain items being posted. At the time, the Post Office in the UK still saying that it is awaiting further clarification from the British government on the charges to impose.
Author: Group Investment Office