Beyond Bulls & Bears

Fixed Income

Brexit Saga Meets Trade Roadblocks

The United Kingdom officially left the European Union in January of this year, but issues remain in the Brexit saga, namely trade relations. David Zahn, our Head of European Fixed Income, weighs in on the odds no deal will be reached by year-end—and the market implications.

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The United Kingdom voted to leave the European Union (EU) more than four years ago, and the process has been long and complicated. While ties to the EU were officially severed in January, the two sides still need to work out their new relationship in many areas before a year-end deadline, including trade, immigration, the Irish border, citizens’ rights and fishing access.

In our view, negotiations will probably continue right up until the final days of the year, even though leaders on both sides have been throwing out various dates to get a deal done in the next few weeks. Brexit remains incredibly fluid and both sides are posturing. If no deal is reached by the end of the year, arguably the most important aspect—trade—would default to World Trade Organization (WTO) rules.

We are getting brinkmanship on both sides, and neither is being very flexible. It is interesting that the United Kingdom was able to sign a free trade deal with Japan—the first it has inked as an independent trading nation. The UK government has stated the deal will bring a £1.5 billion boost to its economy.1 So clearly, trade deals can be done fairly quickly.

UK-EU Sticking Points

The EU and the United Kingdom are not negotiating like two independent countries. The EU seems to  be putting an emphasis on their past relationship, but the United Kingdom wants to exercise its sovereign rights. The latter makes sense—that’s why people voted to leave the EU in the first place.

Fishing rights have been a big sticking point—both sides want the bounty of fish that swim in UK waters. Until year-end, the United Kingdom remains bound by the EU’s Common Fisheries Policy, which gives European fishing fleets access to UK waters beyond a coastal boundary of 12 nautical miles. The UK government wants to take more control over its waters—and of course the fish.

Another major issue is the Irish border. UK Prime Minister Boris Johnson recently unveiled an Internal Market Bill (IMB) that essentially states Northern Ireland is part of the United Kingdom, but the EU Withdrawal Agreement states there cannot be a border between Northern Ireland and the Republic of Ireland. As such, there has been a discussion on whether the IMB violates international law. Johnson has stated the UK has the right to override the agreement, claiming the EU had not acted in “good faith” amidst threats to block food imports.

As these and other issues remain unresolved, the odds of a “no-deal” Brexit are increasing, in our view. As such, many investors may consider hedges with UK gilts, sterling will likely continue to come under pressure, and we will probably see yield spreads widening in sterling corporate names. That said, we believe the market reactions are likely to be short term, and by year-end we could see a very basic, goods-only deal to allow EU-UK trading and alleviate some of the worst potential impacts.

Economic Impact

The UK government seems to be preparing for a no-deal situation, and if it does play out that way, the COVID-19-ravaged economy is likely to see another hit.

The pandemic has already done a lot of damage throughout Europe, so the impact isn’t going to be that significant when looking at the numbers, but it’s definitely not positive. A no-deal Brexit and default to WTO rules will likely lead to further disruptions in supply chains. There will likely be more checks at the border, things will get more sticky, and there will be more uncertainty. For example, would France want to inspect every truck coming across its border, while the United Kingdom decides to let all trucks in or vice versa?

Under WTO rules, there will be more trade frictions and likely more tariffs. There’s also more bureaucracy—more paperwork for items coming in and out. That extra bureaucracy will make it difficult to maintain the current level of (free) trade between the United Kingdom and the EU, which has benefitted both economies.

Given these uncertainties, the UK economy could remain vulnerable into the start of 2021. Interest rates are likely to remain low, long-dated bond yields would likely move lower, and the Bank of England could come in with more quantitative easing given the downside risk to growth.

The bottom line is that neither side is acting rationally, for different reasons. I always say a good negotiation is fair when both sides are a little unhappy, because neither party got everything they wanted. We shall see if that turns out to be the case once this chapter of the Brexit saga ends.


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1. Source: Gov.UK press release, 11 September 2020.

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