Executive Summary

  • The UK will likely leave both the EU and Single Market, will no longer meaningfully contribute to the EU budget, and will end free movement of people between the UK and EU. From this position, the UK will seek to negotiate a free trade agreement with the EU and with other countries globally.
  • Our base case is that the UK will trigger Article 50 on schedule by the end of March. Ultimately though, negotiations with the EU on a free trade agreement will fail. The EU will not want the UK to achieve what would be seen as a better position than being within the EU itself, and will sacrifice exports for EU cohesion.
  • Key points for negotiation will be a transition period for exit, which could be possible if designed to minimise the negative impact to both sides, and a final settlement cost for the UK to cover existing liabilities. The UK will almost certainly need to make some payment, but the final figure should be lower than the €60bn being currently used, as annual budget payments until exit naturally reduce the headline figure.
  • The UK will need to negotiate independent WTO membership, but could end up with a number of bilateral free trade and investment agreements over time, including with the USA, which will result in trade between the UK and EU being rerouted to other markets.
  • This backdrop of events will keep volatility in UK assets elevated for some time yet.

The year in review

The UK government has faced growing criticism in recent months by opposition parties, that they lack a plan for negotiations with the EU. In a move clearly designed to counter that criticism, Prime Minister Theresa May has now explicitly laid out the UK’s position and how they will approach negotiations. The UK will leave the EU and will not attempt to remain within the single market, given the intent to negotiate free trade agreements globally and exert complete control over borders. Instead, the government will attempt to strike a new partnership with the EU, negotiating a free trade agreement and continuing to co-operate on key issues. Although taking a broadly positive view, the Prime Minister also laid out a scenario where the EU took punitive measures against the UK. In this scenario the UK would look to slash corporate taxes and move to a low tax, deregulated economy, in order to attract foreign investment.

At its core, the UK government has cited 12 key points to its plan:

12 Point Plan for Britain

  1. We will provide certainty wherever we can
  2. Leaving the European union will mean that our laws will be made in Westminster, Edinburgh, Cardiff and Belfast
  3. A stronger Britain demands that we strengthen the precious union between the four nations of the United Kingdom
  4. We will deliver a practical solution that allows the maintenance of the Common Travel Area with the Republic of Ireland
  5. Brexit must mean control of the number of people who come to Britain from Europe
  6. We want to guarantee rights of EU citizens living in Britain & rights of British nationals in other member states, as early as we can
  7. Not only will the government protect the rights of workers set out in European legislation, we will build on them
  8. We will pursue a bold and ambitious Free Trade Agreement with the European Union
  9. It is time for Britain to get out into the world and rediscover its role as a great, global, trading nation
  10. We will welcome agreement to continue to collaborate with our European partners on major science, research and technology initiatives
  11. We will continue to work closely with our European allies in foreign and defence policy even as we leave the EU itself.
  12. We believe a phased process of implementation will be in the interests of Britain, the EU institutions and member states.

This is designed, from a political standpoint, to reposition away from the idea of hard and soft Brexit, instead shifting to a vision of ‘A Global Britain’, that is open to the world. The UK would exit both the EU and Single Market, but push for a ‘bold and ambitious’ free trade agreement with the EU and others worldwide.

So what happens next?

The government has firmly stuck to their message that they intend to trigger Article 50 by the end of March, which will trigger the beginning of the negotiation process with the EU. After the Supreme Court confirmed the need to obtain the approval of Parliament to trigger Article 50, the government has submitted a short bill, only 137 words long, and this has been passed by a large majority in the House of Commons. It is now expected to move up to the House of Lords on the 20th February where it is again expected to pass.

Assuming that the current schedule is kept, negotiations then begin in April and will take up to two years to conclude. Our core scenario is that the EU will not agree to a free trade agreement with the UK, and will instead accept the loss of some trade in order to deter other countries from leaving the block. This is unlikely to be immediately clear though, and it will take time for the EU to formally respond to the UK.

Business investment is expected to drop due to the uncertainty surrounding negotiations, but the negative impact is now expected to unfold over a longer period than previously thought. The IMF acknowledged this in their January economic update, when they upgraded their UK growth forecast to 1.5% from 1.1% for 2017, but at the same time downgraded their 2018 forecast to 1.4%, as they expect uncertainty to weigh on the economy for a more prolonged period. In their latest Inflation Report the Bank of England has now upgraded their 2017 growth forecast to 2% from 1.4%, well above the current consensus.

IMF UK Growth Forecasts

IMF UK Growth Forecasts

Sources: IMF

With growth reasonably resilient, inflation will continue to trend upwards, driven by FX pass through caused by the drop in Sterling, and also as a result of domestic factors such as a planned 4% increase in the UK minimum wage.

UK Inflation Rate and Earnings vs Trade Weighted FX

UK Inflation Rate and Earnings vs Trade Weighted FX

Sources: Bloomberg

Although we believe that the EU will not agree to a free trade agreement, a transitional period for exit is likely to be more palatable. One significant factor for this issue, though, will be the UK’s position on trade agreements with other nations. The UK has already started preliminary talks for free trade agreements with a range of countries, including Australia, New Zealand, Canada and India, although the legal question mark over these talks is making some countries reluctant to commit to firm negotiations. There is now a debate regarding whether the UK is legally able to negotiate these deals, with the EU claiming that it is illegal under EU law to do so whilst the UK remains part of the EU. The UK takes a different view, arguing that the EU has no jurisdiction on what trade deals the UK has once it has left, and therefore there is no reason for the UK not to negotiate on deals which would only come into effect post-exit.

A more significant and recent development has been the joint announcement between Theresa May and Donald Trump, that there will be immediate talks regarding the creation of a free trade deal between the UK and US. Two Republican congressmen have co-sponsored a resolution for a new bilateral trade agreement, to be called the North Atlantic Trade and Investment Partnership.

Politically this would be a coup for the UK government, although practically it may be less significant due to the low existing tariffs between the US and EU, which gives the deal limited benefit. It also carries some dangers though, as Donald Trump could quickly change his position or become more unpopular within the UK.

Investment flows resulting from a deal could be an important step going forward, though, especially if both sides agree to lower visa requirements for highly paid migrants, and if the service sector is covered in any agreement. Even if a deal can be quickly struck, it is not a quick solution for the UK given the large (albeit tightening) gap between exports to the EU and US.

Rolling 12 month UK Exports to the USA and EU (in GBP) 5 Year Change

Rolling 12 month UK Exports to the USA and EU (in GBP) 5 Year Change

Sources: Bloomberg

We should not expect exports to the EU to stop once the UK leaves, as tariffs in most sectors are very low, averaging around 3%. The most likely scenario is that exports simply decline slowly - a headwind that the UK has already had to face in recent years, given weak European growth.

It is also notable that, in addition to these new trade agreements, the UK will also have to establish an independent position within the World Trade Organization (WTO). This would almost certainly be necessary before other countries would enter into any bilateral agreements, as membership of the WTO creates a forum for any future trade disputes, without which there could be significant future legal complexities. The WTO has 163 members, and the UK will need to gain the agreement of all of these countries to gain entry.

In December, Liam Fox, the UK’s International Trade Secretary, stated that the UK has already begun to prepare for independent WTO membership, and that it would be seeking to closely replicate existing obligations that form part of EU WTO membership. Although this is believed to be the fastest way to gain agreement, the process could still take considerable time, complicating the timelines of negotiations elsewhere.

A similar strategy, of agreeing to continue existing obligations, will also likely be used to strike bilateral agreements with some, if not all, of the countries who already have a free trade agreement with the EU. South Korea, which is one of the countries which has most increased exports to the UK in recent years, after agreeing a free trade agreement with the EU, has already established a working group which will meet with UK counterparties every three months to discuss a separate bilateral deal.

So what are the risks to UK growth?

The most significant factor driving expectations for UK growth to decelerate in 2017 is business investment, which is now expected to contract over the year. It is possible that business investment could be even weaker than expected, and that this will feed into rising unemployment, dampening consumption. At this stage though, the CBI Industrial Trends Survey suggests that optimism amongst manufacturing firms is at a two-year high.

Confederation of British Industry Quarterly Business Optimism Survey

Confederation of British Industry Quarterly Business Optimism Survey

Sources: Bloomberg

The housing sector is often cited as another source of vulnerability for the UK and, with historically elevated price/earnings ratios in London, there is a rational reason for concern. It is notable, though, that London has significantly outperformed the UK as a whole, and that in many other parts of the UK house prices have increased very little over the last decade.

Nationwide House Price Index, Cumulative % Change from 2007

Nationwide House Price Index, Cumulative % Change from 2007

Sources: Bloomberg

The government appears to have successfully deflated the price of prime London property in 2016, with prices in central London dropping by 5-10%. This resulted in price growth in London as a whole at just 3.7%, according to data from the Nationwide Building Society, the first time since 2008 that London underperformed price gains in the UK as a whole. With the marginal rate of sales tax on property above £1.5m at 12% (15% if the buyer already owns a property anywhere in the world), this should keep the higher end of the market subdued for some time to come and further falls are possible.

For the Bank of England, this change in taxation could prove an important factor in allowing interest rates to be kept at historically low levels, and they will be less concerned about house price gains in the rest of the country as long as London prices are subdued.

How much will the break cost?

Although the economic cost, at this stage, appears manageable, there will also be a financial cost which the UK will need to settle in order to leave the EU. The EU has stated that the UK will need to pay a €60bn settlement upon leaving and this has been rebuffed by the UK. The Centre for European Reform has broken down the €60bn figure. The majority of this comes from the UK’s contributions to the EU budget. The current budget runs until 2020 and the UK has, as a member of the EU, committed to making contributions until that date. The UK’s share of this budget is estimated to be between €29-36bn.

The second cost is that of retirement benefits for EU officials, which is currently estimated to total €63.8bn. These liabilities are to be funded from future EU budget payments, with no underlying pension asset pool. The UK’s portion of this liability is estimated to be between €7-10bn. The final part of the bill is made up of various commitments that the UK has made. These include guarantees on loans made by the EIB, and loans made to various EU countries under programs such as the European Financial Stabilisation Mechanism (EFSM).

These costs will be a critical part of Article 50 negotiations. If the UK does not leave the EU until 2019, and potentially agrees a transition deal which extends beyond this date, then a large part of this bill will have already been paid naturally via the UK’s annual budget contribution. The question is then whether the UK will dispute the remainder of the budget contributions, most likely arguing that the remaining money has not, at that stage, been spent and thus shouldn’t be part of the UK’s liability. The EU Commission have made it clear, though, that any shortfall from the UK will need to be made up by other countries, making this a contentious issue. As such, it is probable that the UK will simply accept the payment of the smaller amount at that stage, hoping that the much smaller amount is politically manageable.

Pension liabilities are an area in which the UK is more likely to take a harder line, and where the EU may be more able to negotiate. If the UK were to cover the costs of only the liabilities accrued by UK officials, then the amount would be smaller. The UK may well also argue that rather than making a single lump sum payment, it should simply continue to pay its annual share of these contributions. Assuming that it accepted the full liability this would amount to around €120m in 2017, rising to €218m by 2045. Some compromise that lies between these two factors may be possible.

Finally, with regard to guarantees, these are less contentious and can be spun by both sides for individual political advantage. Loans made under programs such as the EFSM are, ultimately, expected to be repaid. So the UK’s liability could offer a continued guarantee to make good any losses should they occur. EIB loans are more complicated as they include more risky advances to countries such as the Ukraine. Under current rules, only EU members can be shareholders in the EIB which would mean that the UK would have to relinquish its shareholding. With a 16% stake, though, the UK is a sizeable part of EIB capital, and the EIB have recently stated that it may change its rules to allow the UK to remain a shareholder after it leaves the EU.

In Conclusion

The UK’s position on how it will approach negotiations with the EU is now quite clear. The country will very likely exit both the EU and single market, but will attempt to continue to have free trade with the EU via a new free trade agreement. The free movement of people would come to an end, and EU workers would need to obtain visas to work in the UK, in line with non-EU citizens. The new £1,000 per annum levy on firms for each non-EU migrant they employ, which will be introduced in April, will likely be implemented for EU migrants as well at some stage. In order to cope with seasonal demand, short term visas will be issued, allowing labour intensive industries to issue 3-6 month visas but with which workers are required to return home as the visa expires. These new rules should result in a sharp fall in UK migration, from in excess of 300,000 to below 100,000 over time. The UK would largely stop contributing to the EU budget, but commitments already agreed to the end of 2020 will see the UK unable to stop payments in the short term. The UK will almost certainly find itself with some final settlement bill to pay, either as a lump sum or ongoing payments, and both sides will attempt to portray this as a political victory.

Faced with this starting point, we do not believe that the EU will agree to a free trade agreement with the UK, and that Article 50 negotiations will move towards the negotiation of a transition period for exit, which minimises the damage to both parties. The UK has already started to negotiate free trade agreements globally, and is likely to have various agreements in place to start as soon as they exit the EU, assuming that WTO negotiations are completed. This should, over time, result in a decline in trade between the EU and UK, with trade flows reallocating to other parts of the world. A trade deal between the UK and US is politically very important, but not a short term solution and uncertainty will thus prevail for some time yet.