It is an interesting time to look at the ongoing discussions between the UK and the EU on a post-BREXIT trade deal, which feel as if they have been going on forever with little progress. In any event, we are nearing the time when a deal must be struck as the witching hour approaches at the end of this year. For those of my readers living in Europe, and particularly in the UK, this saga feels never-ending. For those of my readers living in the US or Asia – and for those that just don’t care that much about the outcome save its potential effect on markets – I will aim to focus mainly on just this, meaning the effect of the outcome on markets. What is this all about? On June 23, 2016, British citizens voted by a narrow margin of 51.9% in favour and 48.1% against to leave the European Union, with 33.5 million people voting, a 72.2% voter turnout. England (53.4% leave) and Wales (52.5% leave) both voted to leave the UK, whilst Northern Ireland (55.8% remain) and Scotland (62.0% remain) both voted to remain. This site from the BBC provides plenty of details on the geographic voting in the referendum, should it interest you. There were gobs of post-BREXIT referendum analyses and articles on why the cards fell the way they did, but this is not the focus of this post. Rather, it is to focus on where we go from here.
Where do we stand at the moment?
Under the administration of Prime Minister Boris Johnson and the Conservative majority in the House of Parliament, the BREXIT Withdrawal Agreement was signed on January 24, 2020, providing the framework for the UK to officially exit the EU at the end of this year. This was a renegotiated agreement that had previously been drafted by former Prime Minister Teresa May, who left office last summer after serving as head of the Conservative Party for nearly three years. The European Parliament agreed to the treaty on January 29, and the Council of the European Union signed the treaty on January 30, 2020. The exit became official on January 31, 2020. As part of the official exit agreed this past January, the UK and EU left much of the legacy arrangements in place during a transition period during which the finer details of the exit, including for purposes of this article a trade agreement, could be agreed. The deadline of December 31, 2020 could have been extended by up to two years, but the UK decided not to extend the transition period by the deadline that occurred at the end June.
Since then, there have been a number of “lines in the sand” drawn by both sides, with all sorts of posturing going on (mainly by Mr Johnson) which, to date, have yielded nothing. However, there is rather strong speculation now that an agreement is days away, and maybe as early as this week, which would obviously be good since time is running out. There is one more point on timing. Once an agreement is reached, should it come to pass, both governments would have to approve the trade agreement, which would not of course be instantaneous but should be relatively straight-forward. My understanding is that each member state does not have to ratify the agreement, but rather this can be handled by the European Parliament and the EU Council of Ministers.
A few market parameters for context
To provide an opening context for a discussion later on the markets, I have included a few reference points in the tables below.
As the tables indicate, the UK has felt the brunt of the pain since the referendum. Although relatively speaking both the European stock market and the Euro have outperformed the UK stock market and Sterling, respectively, the performance of both equity markets has been poor compared to the US and Japanese equity markets. The FTSE has been the worst performer, not even holding its ground over a five year period whilst many other equity markets around the world have flourished. Moreover, both the UK and European bourses have arguably benefited from the recent rotation from momentum stocks into value stocks. If the same comparison were done three weeks ago (see column “October 30, 2020”), it would be materially worse for both markets.
Not to belabour the point, but the graph below shows that the S&P 500 has returned 70.2% over the last five years and the Nikkei 225 has returned 28.4%, whilst the STOXX 600 has been barely positive and the FTSE 100 slightly negative, even with the recent rally.
As far as yields on government bonds in the Eurozone (using Germany) and the UK, yields have fallen sharply in both places. However, it is tricky to try to read anything meaningful into this because both economies have been lacklustre at best since the referendum, and unconventional monetary policy in the form of quantitative easing since the advent of the pandemic has distorted information that might otherwise be available as far as relative yields. Of course, it is true that in all major economics, pandemic-inspired monetary and fiscal policy has led to many distortions, but this is a topic for another day.
How much does trade between the UK and the European Union matter to each?
Short answer – a lot. Let’s look first at the overall UK trade situation. The UK normally runs an overall goods trade deficit and an overall services trade surplus, but in aggregate, a net trade deficit. The UK trade deficit has more or less been between £25 billion and £35 billion since the start of this century, with the exception of 2011 (deficit of £11 billion).
This table, based on data from the Office of National Statistics that you can find here, shows the net trade deficit for the UK for 2019, meaning the UK vs all trading partners collectively.
Digging deeper, data shows that the European Union is extremely important to the UK as a trading partner, the most material partner by far in fact. EU countries accounted for 46.4% of all UK exports of good and for 53.4% of all UK imports of goods in 2019, as you can see in the table below.
The table also illustrates that the UK imports more from EU countries than it exports, meaning that the UK runs a trade deficit as far as goods with the EU.
To look at this from the perspective of the European Union, the UK is an important trading partner indeed, but not as significant as China (imports) and the US (imports & exports), as you can see in the graph below from the Eurostat website.
To provide more granularity at you think about this issue, the table below illustrates the top 10 trading partners of the European Union in 2019 (source: European Commission).
How does the UK look at the moment as far as agreements with other countries aside from the European Union?
According to a recent BBC article that you can find here, the EU has 40 trade agreements with 70 countries, and of these, 20 (50%) of the trade agreements involving 50 of the countries will “roll over” and be effective January 1, 2021. That’s the good news. The bad news is that these trade agreements only represent around 8% of UK trade in 2018, assuming all of the agreements are in place at the beginning of next year. Other deals have also been reached, most recently Japan, the largest to date accounting for £29.1 billion of trade. Even with others like Switzerland (£32.4 billion), Norway & Iceland (£26.8 billion), and South Korea (£14.8 billion) that have been agreed, these pale in comparison to the UK’s trade with the EU-27 (£463.6 billion). No progress has also been made that I could find on trade discussions with the United States (£109 billion total trade) or China (£75 billion total trade), both important trade partners for the UK. The conclusion is simple – the UK needs to strike a deal with the EU or will face economic consequences.
I am not writing this article to go back and look at the positives and negatives of BREXIT, but it is almost certain in my opinion that the UK – economically speaking – is stronger economically within a significant trading bloc like the EU rather than outside of it. Size and economic diversity give a trading country strength at the negotiating table, and the reality is that the UK will be just another second-tier country after it leaves the union. The graph below shows the line-up of top trading countries in the world by goods post-BREXIT.
You can draw your own conclusions when looking at the graph. The UK post-BREXIT will be in good company as far as other countries, so this is not meant to demean this. However, there is no doubt that the country’s strength at the negotiating table as far as trade agreements will be greatly diminished.
As for where we currently stand with the UK and EU-27 on a trade deal, the view seems to be that the successful implementation of a trade agreement remains stuck on only a handful of key issues, in which both sides seem to be digging in their heels. However, the media is full of rumours suggesting that a trade deal is imminent, as soon as this week.
What does all this mean, and why should an investor care?
It is first important to say that a trade agreement substantially reduces friction in trade, mainly by reducing or eliminating tariffs. The less friction in trade, the better off both parties will be. Without an agreement, companies trade on WTO rules which you can read about here, and which are not generally advantageous to a country because they include tariffs, as well as soft restrictions like regulatory requirements. Tariffs, regulatory barriers / red tape, and the like introduce friction into trade between countries, and this in turn reduces trade flows and hurts both countries’ economies.
A trade agreement between the UK and the European Union is important to both, although data clearly suggests that it is much more important to the UK. For this reason, I believe that the failure of the UK to strike a trade deal will damage the UK economy much more than it will the economies of the EU-27 countries. Both Sterling and the FTSE have rallied the last several weeks, which could be attributed to expectations of a pending trade deal, suggesting that it might be close at hand. However, the FTSE has come off its lows rather quickly over the last three weeks, as the UK equity market (and the European equity markets) have benefitted from a general rotation by investors out of US momentum stocks – the big gainers for 2020 post-pandemic – and into value stocks, including less expensive international markets like the FTSE and STOXX 600. In fact, both the UK and European equity markets have risen nearly 14% in only three weeks, since the end of October. It is difficult to determine if this is happening because of rotation in the preferences of global equity investors, or if it reflects optimism in both the UK and European Union over a pending trade deal. I suspect it is somewhere in between.
As for Sterling, which was hammered after the referendum and has never really been anywhere close to its pre-referendum levels since, the current level of $1.325/£1.00 is a 2.5% improvement since the end of October, also a move in the right direction. The Euro has also strengthened albeit less than Sterling. Again, this could reflect a weakening dollar as investors roll into riskier assets, including riskier currencies, or it could reflect optimism over a potential trade deal and the positives that such an agreement would mean for both the UK and EU-27 economies.
As an aside, one thing that has been unusual in this rally has been the simultaneous rise in the FTSE and the strengthening of Sterling. It seems as far back as I can recall (without checking), a weaker pound has helped UK equities since most UK companies are exporters and benefit from a weaker pound. In this respect, this rally has been different as both the UK equity market and Sterling have been moving in the same direction.
Conclusion
My opinion in closing is that investors stand to gain less from a trade deal given the recent appreciation supported by the expectation that a trade deal is imminent, than they stand to lose from a potential trade deal not being completed. In other words, I believe the risk is skewed to the downside. Truth be told, it’s hard to tell, but I hope that this article frames the issue for you and helps you understand why a deal is so important to the UK (more so) and the European Union. There’s more Sterling and FTSE upside if a deal gets done, albeit modest compared to the downside if we reach the end of this week no closer to a trade deal.
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