Are financial markets really prepared for a hard Brexit?

Are financial markets really prepared for a hard Brexit?

Equities 10 minutes to read
PG
Peter Garnry

Head of Equity Strategy

Summary:  If we get a hard Brexit on Sunday evening the market will be shocked. Market participants are used to politicians reaching a deal in the last minute, but the UK and EU are far from each other in terms of reaching a trade agreement. In the case of a hard Brexit without any soft tones from either party, the UK equity market could fall as much as 5-7% led by banks, industrials and FTSE 250. We recommend investors to understand the event risk and consider hedging the portfolio. But the implications go far beyond Monday, as chaos is ensured to happen on 1 January with the UK leaving the customs union and tariffs being applied to many goods. Are financial markets and the UK consumer ready for a hard Brexit?


The failed negotiation between Boris Johnson and Ms von der Leyen has suddenly increased the likelihood of a hard Brexit event on Sunday. The UK officially left the EU at the end of January but remains in the EU’s single market and customs union until 31 December, so the hard Brexit is directly related a trade agreement between the UK and EU. This has implications both for investors and traders on Monday, but economically the impact will stretch far into 2021. The talk between the UK and EU has been described by insiders as “frank” and that large gaps remain. We have heard this before and ultimately it seems a hard Brexit is now the most likely outcome. However, financial markets have learned since 2008 through all the various crises from US budgets to the euro crisis that politicians despite their differences always strike a deal in the last minute. But will they this time?

Financial markets are beginning to understand the implications with FTSE 250 Index down almost 3% this week and Barclays down almost 9%. The past weeks news has also continuously highlighted how large banks are moving trading assets from London to trading hubs at Paris, Amsterdam, and Frankfurt. Morgan Stanley is reportedly planning to move $120bn in trading assets by first quarter next year joining many other banks in relocating assets and workers to the European continent. The impact on the banking sector employment in London is significant and to top it off London could potentially move into tier three restrictions due to rising Covid-19 infection rates. As the UK finance minister Rishi Sunak said recently, the UK is facing its biggest economic crisis in 300 years.

Source: Bloomberg

While equities are adjusting to the latest failed negotiation, we do not think the market is really prepared for what could happen on Sunday and how it will impact the market on Monday. Depending on how the UK and EU frame a failed trade agreement Sunday, UK equities could be down as much as 5-7% on Monday in severe risk-off scenario with banks, industrials and FTSE 250 leading the declines. This is our best guess in a very bad scenario as we have no statistics to rely on making this event about uncertainty in the word’s true meaning. Investors could hedge their portfolio through CFDs, futures or options depending on what fits the portfolio and objectives best, but we urge investors with a lot of UK equity exposure to consider the risk picture going into the weekend.

A logistical mess on January 1, an economic shock, and a new city of London

If a trade agreement is not reached, then a logistical nightmare will happen on 1 January as the EU and UK will fall back into rules and tariffs established by WTO in 1995. This means that the UK will have to start paying tariffs on imports from the EU, and vice versa. The UK consumer can expect a rise in prices on grocery with 85% of the food imported from the EU will at least get a 5% tariffs rate. UK carmakers would experience a 10% tariffs rate and being the biggest export category of the UK economy, this will have a significant impact on the export economy. The services sector will likely have to set up local offices in Europe to service clients. In terms of energy infrastructure, the UK would also be cut off from the EU energy market. Allianz estimates that the UK could experience an overall increase in import prices of 15%, a 10% depreciation of the GBP, increased supply chain and administrative costs, on top of a 5% drop in GDP and 15% drop in total exports.

UK export composition in 2018 (chart below)

Source: The Observatory of Economic Complexity: OEC

There are also implications for Europe. Countries such as the Netherlands and Germany are big exporters to the UK economy and would lose out on a hard Brexit, so we should expect German industrials to underperform on Monday and in 2021 on a hard Brexit. Losing easy access to its second-largest trading partner would be a big economic blow to Europe as well and coming at a very bad time with the European economy suffering hard from the Covid-19 pandemic with many countries in new strict lockdowns.

Covid-19 has hit the UK and its economy hard and the speedy rollout of the vaccine is essential for the economic recovery next year. The UK has quickly approved the vaccine from Pfizer and BioNTech, and started vaccinations, but as Belgium’s Prime Minister pointed out the other day, the Pfizer vaccine is produced in Belgium and thus if the trade agreement fails, then import duties and customs delay are ensured on 1 January. As a result, the Foreign Office minister has said that the UK military might be applied to ensure vaccine delivery to the UK population. Think about that picture for a moment.

In our view, and this we have said many times in our research, the UK has the weakest hand but a defeat to the EU would be humiliating to the political class and as such Boris Johnson might be willing to cross the line and take the fallout to save face. According to Boris Johnson, the UK would prosper mightily as an independent nation. Based on the predicted costs for the UK economy and consumer, the likelihood that Boris Johnson would fail is high in such a hard reset of the economy. At this point we guess that the probability of a hard Brexit is now 60%.

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