4 key questions in the wake of the post-Brexit trade deal
Barely a week before the transition period was due to end on Dec. 31, 2020, the UK and the European Union (EU) reached a post–Brexit trade deal, officially known as the EU–UK Trade and Cooperation Agreement. While avoiding the potential chaos of a no-deal outcome was welcome on both sides, the free trade agreement portion of the deal turned out to be relatively thin, as the UK rejected the notion of close regulatory alignment and membership of the EU single market and customs union.
Let’s walk through some of the key questions for UK and European markets now that the deal is complete.
1. Could the GBP/USD rate climb back to pre–2016 (pre–Brexit) levels?
Reaching a deal removes the main obstacle for a continued recovery of the pound sterling (GBP) against the U.S. dollar, which is our expectation. We believe that reclaiming pre–2016 levels in the GBP/USD exchange rate of around 1.45 should be possible in the next one to two years, although the current recovery is being slowed down by the sand in the wheels of the new UK–EU trade relationship. How quickly pre–2016 levels for GBP/USD can be reached also depends on the fate of the U.S. dollar, which has lost ground amid a broad–based global recovery. It’s also possible that a return of risk aversion or significantly higher interest rates in the U.S. could halt or even reverse this weakening trend in the dollar—although this is not our expectation.
2. Will the UK experience a significant rebound in growth?
Relative to the only other realistic option of no deal, the post–Brexit trade agreement certainly leaves the growth outlook for the UK and the EU in better shape.
However, the short–term GDP (gross domestic product) path for both is dominated by the trajectory of the COVID–19 pandemic and whether the rollout of vaccinations can allow European economies to reopen. The UK got off to a flying start on its vaccination campaign, as its regulator approved the first vaccines earlier than most other countries. As of Feb. 5, 2021, 16.9% of the UK population had received a first dose of the vaccine, a share only second to Israel among OECD (Organization for Economic Co–operation and Development) countries.1 Vaccinating the lion’s share of the population could allow a faster return to normal economic activity. On the other hand, the UK’s infection rates are still comparatively high and need to come down further to enable a relaxation of lockdown measures.
As a highly service–dependent economy, the UK was among the hardest hit economies in 2020, with GDP falling by about 11%. With the successful avoidance of a no–deal outcome, a continued smooth vaccine rollout could see the UK economy experience one of the biggest rebounds in 2021, with GDP growth of 6-7%, in our view.
3. Will the FTSE 100 outperform this year?
The FTSE 100 Index was the laggard among regional equity markets last year, but we believe it could be one of the better performers in 2021. With the ever–present threat of a no–deal Brexit removed, there could be a release in some structural demand for sterling–denominated assets.
As Andrew Pease, our global head of investment strategy, wrote in our 2021 Global Market Outlook, the UK market could be one of the winners of a return–to–normal status by the second half of the year. A broader reopening of the nation’s economy should help extend the rotation that began last November away from technology/growth stocks and toward cyclical/value stocks. A successful COVID–19 vaccine rollout should allow lockdowns to be eased and early cycle recovery dynamics to resume. Investors may continue gravitating toward value and non–U.S. stocks, especially the FTSE 100. UK stocks are cheap relative to other markets and the main index is overweight the financials, materials and cyclical sectors that we believe will benefit most from the global recovery.
4. What are some of the potential stumbling blocks ahead?
Notably, some important areas of trade have not been addressed by the post–Brexit trade deal, especially in the financial services sector—with even UK Prime Minister Boris Johnson admitting that the agreement with the EU falls short in this area.
As it currently stands, to access each other's financial services markets, UK and EU firms need clearances from the other side’s regulator in a system known as equivalence. However, relative to the passporting framework in the EU, the equivalence framework does not cover all financial services, and access can be withdrawn with a notice period of 30 days. Because of this, the risk remains that valuable financial–service business (and employment) could move from the UK to the EU.
Another cause of friction in the current deal is the Northern Ireland protocol, which became evident within a month of the trade agreement taking effect. When vaccine deliveries to the EU were delayed, the European Commission threatened to invoke an emergency clause in the Northern Ireland protocol to potentially block exports of vaccines from the Republic of Ireland (i.e., within the EU) to Northern Ireland. While the Commission quickly reversed course and avoided a major rift, this episode demonstrates that some elements of the new EU–UK relationship are fragile.
The bottom line
The 11th–hour post–Brexit agreement, combined with a successful rollout of vaccines, should spur a boost in growth and a recovery in battered stock prices for the UK this year. However, with the nation still digging itself out from its greatest crisis of the past 75 years, it’s fair to say that the road ahead for Britain will not be without many bumps. We’ll continue to keep you apprised of the latest developments along the way.