Friday, 18th of October 2019
“Though hope be courteous and debonair, she’s never certain.”
– Jean de Meun
Undoubtedly the most significant news of the week came on Thursday morning, when the UK and EU finally struck a new Withdrawal Agreement to replace Theresa May’s Brexit proposals. The deal came just in time for the critical EU Council summit later that day where it was endorsed by the 27 remaining EU member states. If the deal now secures majority support in the UK and EU Parliaments then the UK will leave the EU on 31st October as planned. Most of May’s former agreement remains intact, but the much-maligned ‘Irish backstop’ has been eliminated and alternative arrangements to avoid a so-called hard border in Ireland found. Northern Ireland will now remain within the UK customs union and benefit from the UK’s post-Brexit trade policy. However, in order to avoid the need for customs checks on the island itself the UK will collect EU tariffs at Northern Irish ports on all goods (including those from the UK mainland) which are deemed ‘at risk’ of entering the Republic. If the goods are to stay in the North, companies will get a rebate on those taxes – to the extent that UK and EU tariffs differ. In addition, Northern Ireland will remain in the EU single market for goods, a concession made in the first draft of Johnson’s new plan, and this will require some additional checks at Northern Irish ports as UK and EU regulations diverge. Finally, EU laws on minimum VAT for goods will also apply in the North. Unlike the backstop, the new arrangements will be permanent unless the Northern Ireland Assembly votes by simple majority to end them and align with the UK instead. It will get this opportunity every four years from the end of the transition period in 2020, and a vote to leave will be followed by a two-year cooling-off period for EU-UK negotiations to take place. One caveat is that the Assembly must be sitting (which it has not done for almost 3 years after a dispute between the two largest parties) and, given the nature of local political institutions, this gives both sides of the unionist/nationalist divide the option to collapse the Northern Irish Parliament to prevent a vote. Other changes to Theresa May’s Brexit deal were in the Political Declaration that outlines future UK-EU relations. This has been re-written to reflect the looser relationship favoured by Johnson, including a fairly straightforward Free Trade Agreement rather than the elaborate customs partnership (which was a customs union in all but name) envisaged by the former PM.
Although the EU Parliament is almost certain to rubber-stamp the agreement, numbers are much tighter in the UK where PM Johnson heads a minority government and the Brexit divide runs deep. Importantly, the stridently unionist Northern Irish DUP – erstwhile allies of the PM – will not vote for his new Brexit deal arguing that any customs checks at Northern Irish ports threaten the territorial integrity of the UK (even if the de jure border remains within the island of Ireland itself and the Northern Ireland Assembly can vote to leave the arrangements every four years). However, almost all Tory MPs, perhaps a dozen Labour MPs in Leave-voting Northern seats and most independent MPs expelled from the Conservative Party for backing anti-no-deal legislation in September are set to support the PM in a vote on Saturday. The margin could be wafer thin, but we believe that PM Johnson is odds on to get his deal passed – particularly if he manages to convince MPs that a ‘no deal’ exit is the only alternative.
So, what does this new Brexit deal mean for investors if it passes the House of Commons on Saturday? Well, UK stocks should soon catch-up with their European counterparts as valuation multiples return to historical levels. The UK is a highly financialised economy with a large and liquid domestic stock market where indices tend to trade at a premium to their continental counterparts. However, Brexit has seen UK stocks lag ex-UK European equities – and many other markets too. Indeed, the valuation gap is so great that the 12-month forward P/E ratio of the FTSE 250 Index (made up of domestically-focused UK stocks) is roughly equal to that of the MSCI EM index! An orderly withdrawal should see strong flows into UK equities and cyclical domestics in particular (e.g., housebuilders, which have skyrocketed since talks between the UK and Irish PMs proved successful last week). The pound should also rally further, despite the significant move in recent days. Sterling has historically traded at a premium to its fair value (according to Purchasing Power Party), but the currency has been severely depressed since the 2016 referendum and has yet to pair back losses since the vote. In the short-term, a steep pound rally could cap gains on UK stocks as their foreign currency values fall and there is a recognition from the market that some large cap multi-national companies with significant foreign earnings and local costs may face squeezed margins. However, the net effect of an orderly Brexit is likely to be extremely positive for UK assets. Meanwhile, ‘no deal’ threatened to disrupt pan-European supply chains at a moment of considerable economic weakness and avoiding that outcome will boost European assets. The EUR could gain some ground, but the post-referendum fall was not as great as it was for GBP and local economic woes are likely to limit interest in the single currency. All in all, Monday could be a great open for Europe – but only if this deal passes! Given the binary risks associated with Saturday’s knife-edge vote in the UK House of Commons, we prefer to keep our distance – for now.