Sour Adversity

“Let me embrace thee, sour adversity, for wise men say it is the wisest course.”

Given my not infrequent comments over the last 20 years regarding markets’ attitude to uncertainty, and the possible scenarios that may occur under varying economic situations, you may not be surprised to see me commenting on the current political and associated economic situation.

Boris Johnson has stated that, ‘do or die’, the UK will leave the European Union on 31 October. Yet he also states that there is a ‘one in a million’ chance that the UK will leave without a deal. Sterling markets are confused and rattled. With the political and economic news likely to get worse in the near term, sterling assets are set to face ongoing challenges. To sum up the situation: the EU is a club of countries, members of which can trade with minimal barriers, since all countries apply common regulatory and product standards. Goods entering the EU from outside the club face a common tariff rate. The EU also strikes trade deals with other countries or blocs on behalf of all its members. There are 40 such agreements, covering around 90 countries.

If the UK leaves the EU, it still sits in a broader club of 164 countries called the World Trade Organisation (WTO). The terms of trade under the WTO are much less comprehensive, and so reverting to WTO terms would mean:

  • UK exports to the EU would face tariffs, and vice versa. The WTO prevents discrimination between members, so the tariff on each product must be offered to all WTO members (known as the most-favoured-nation rate). This equates to a weighted average rate of roughly 3.2% applied to UK exports to the EU.
  • Customs checks would be required at all border points, including those between Northern Ireland and the Republic of Ireland.
  • Neither side would recognise product standards, so regulatory checks would be required for new and existing product lines.
  • The UK financial services sector would lose its ‘passporting’ rights (its right to service EU clients from any EU country). Broadcasting and transport services rights would also be lost.
  • The UK would need to replicate the trade agreements that have been negotiated on its behalf by the EU (the UK has made arrangements to roll over 12 of the 40 so far), but would have the autonomous capacity to negotiate new trade deals independently.

The most immediate economic impact would be the supply chain disruption as firms face customs processing, and EU manufacturers seek to source appropriate component parts. It is worth noting that, in a Bank of England survey, only one fifth of the respondents stated that their businesses were ready for a no-deal Brexit as of July. The sectors most likely to be affected are food and agriculture, chemicals and pharmaceuticals, and transport and transport services.

The fall in sterling and subsequent rise in inflation would squeeze real incomes and put downward pressure on consumer spending. With regards to equity markets, there are many international companies listed on the London Stock Exchange that have significant foreign revenues and little exposure to the UK economy. In the event of no deal, the decline in sterling would boost the earnings of these companies, helping larger companies with significant international exposure to outperform smaller, more domestically exposed companies. For reference, in the ten trading days after the referendum in 2016, sterling fell 13% against the dollar. Over the same period, the FTSE 100 index rose 3.1% and the FTSE 250 fell by just over 8%.

It is not impossible that the UK and the EU could reach a deal in the coming weeks that could pass through the UK parliament. But we have consistently overestimated the willingness of some MPs to put national interests ahead of party politics. ‘Do or die’ may be seen as an acceptable political strategy. It is not a strategy advisors would deploy with our clients’ hard-earned savings.

I fear that there will be plenty of ‘sour adversity’ to come, but it is “an ill wind that blows no-one any good”, and there will be buying opportunities for the brave with a little spare cash to invest. Until next time, good luck!

David Foot

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