Brexit - scenarios, next steps and implications

The United Kingdom is scheduled to leave the European Union (EU) on 29 March 2019. It is still unclear if there will be an agreement in place when the UK leaves the EU and what the longer-term relationship between the two involves given British Prime Minister Theresa May is still negotiating with UK and EU officials. The uncertainty created by Brexit is already weighing on UK investment and confidence and could intensify if there is an unfavourable outcome around the withdrawal agreement.

This article looks at what the next steps are for the UK before the Brexit deadline and what the future of the UK and Euro area economies look like post-Brexit.

Latest developments

A “withdrawal agreement” was developed by Theresa May and EU leaders in late 2018. This set out the terms and the plan for how the UK will leave the EU and what the relationship between the two will look like in the short-medium term. It does not include details on the future relationship which will be agreed post-Brexit. The withdrawal agreement was approved by EU member states but was rejected in UK parliament because of concern around the treatment of the border between Northern Ireland and the Republic of Ireland.

What are the details of the withdrawal agreement?

Under the current agreement, there will be a two year transition period from 29 March 2019 until December 2020 (or later if it’s extended) where the UK will remain in the EU’s single market and customs union. The single market refers to the EU trade bloc that has free (ie no tariffs) on goods, services and people within countries. The customs union is the EU trade bloc that has the same tariff applied to countries outside of the bloc. So essentially, the economic relationship between the UK and EU would be unchanged over the transition period, which gives businesses operating between the UK/EU additional time to adjust to the new order. The UK will have to abide by EU rules over the transition period and still contribute to the EU budget, but will not be involved in any decision-making around governance in the Euro area which is a downside for the UK economy and the British people.

The issue with Northern Ireland is about trying to avoid border checks between goods passing through Northern Ireland (which is part of the UK) and the Republic of Ireland (which is part of the EU) once Brexit occurs. The withdrawal agreement states that there would be no “hard border” (no customs or regulatory checks on goods passing through) between the two until another solution (like checks using non-physical borders through technology) can be agreed to, which effectively means that the UK still remains in the EU trade bloc. UK Parliament is opposed to this arrangement because it could potentially keep the UK in the EU bloc indefinitely.

Next steps and potential scenarios

The next update and vote on the Brexit agreement is due on 27th February. Following this vote and before the 29th March exit deadline, there are three major scenarios that could occur:

1)  Soft Brexit (75% probability) in the transition period and beyond

A soft Brexit means that the UK will still retain close ties with the EU in some capacity through the single market and customs union. This scenario involves UK Parliament approving a withdrawal agreement which would mean the UK would leave the EU on 29 March with little disruption to business.

For now, it appears that the current withdrawal agreement may not be agreed to given that no viable solutions appear to have been met in regard to the Northern Irish border. So it is likely that the Brexit date is delayed, which would give more time for negotiations. Or it is also possible that May resigns, and a new leader of the conservative party is elected. Although, May still seems to have the support of her party, and her “no confidence” win in January means that a new PM is unlikely.

There is still a chance that a new election is called, which would mean that Brexit date is delayed again. A new election might just result in continued political gridlock because no government has a clear majority

2)  No Brexit (15% probability)

No Brexit would occur if an agreement cannot be reached and a new referendum on Brexit is called. Recent polling suggests that the outcome between Brexit/Bremain would be close, although “Bremain” is winning at the moment as the chart below shows (15% probability).

3)  Hard Brexit (10% probability) in the transition period and beyond 

This would occur if no agreement is approved before the exit date. In this scenario, the UK and EU would have to trade under World Trade Organisation Rules. UK and EU leaders would want to avoid this at all costs as it would be negative for both economies and markets.

Post Brexit (if it happens), the UK Parliament must also agree to a deal around the future relationship of the UK-EU – so far there has been a “political declaration”, but the details are vague.

What are the impacts of Brexit?

The worst outcome for the UK and Euro area would be a hard Brexit because of the instant loss of access to trade, the uncertainty caused and the hit to spending via a further drop in consumer and business confidence. Confidence has been trending lower recently (see chart below), particularly for consumers. Business confidence is still holding up well. Note that confidence had a decent decline around the time of the initial Brexit vote.

A hard Brexit means that the UK will leave the single market and customs union therefore losing its access to trade with its largest trading partner. UK exports will fall as European companies shift operations outside of the UK and conduct trade with other members of the EU instead. Higher costs for consumers and businesses from higher tariffs is also a drag on growth.

The UK would also not be able to negotiate individual trade deals with its major trading partners (Germany, Spain, Belgium and Netherlands) as these countries are still bound by the EU customs union.

A hard Brexit could take around 3-4% off from UK GDP over two years and knock the UK into a short-term recession. The longer run impact would be that UK potential GDP declines to around 1% from slowing productivity and population growth.

For the Euro area, a hard Brexit could shave around 0.5-1% from growth over two years which would be troublesome given the current weakness in the Euro area. In this situation, the European Central Bank would have to respond with more stimulus. While the UK economy is only 3% of world GDP, the EU is much larger at around 21% of the world economy so there would still be a small negative impact to world GDP.

Under a soft Brexit scenario, there may still be a short-term negative impact to growth through some loss of trade, but it would be small.

Impacts on Europe and the rest of the world

For the EU, the loss of access to UK-based services (like legal, accounting and advertising) or higher costs for these services will also be negative for the Euro area. But, eventually these services will move elsewhere in the EU (for example financial services could move to Frankfurt, Madrid or Paris) which creates opportunities for some parts of the EU.

Another concern post Brexit was that anti-EU and-Euro sentiment would rise across member states. So far, this has not happened with support for the EU still remaining high across members (perhaps after they saw the trouble that Brexit has caused!).

Impacts on Australia

There is little direct impact on the Australian economy from Brexit. Australia and the UK will have to negotiate new trade arrangements but Australian exports to the UK are small overall (around 1.4% of total exports in 2018). The main impact on Australia from Brexit will be from volatility in financial markets and loss of investor confidence and the negative flow on effect from a loss in world GDP under a hard Brexit scenario.;

Implications for investors

So far, the impact of Brexit on UK and European equities has been limited with markets more concerned about corporate earnings, the Fed, ECB, Euro budgets and China. But a hard Brexit could knock the UK into a recession and UK and European equities would suffer large falls. A hard Brexit would also cause a large depreciation in the British pound which would give some support for UK shares.

Given the recent weakness in Eurozone data, any resolution to the current impasse on the withdrawal agreement and a soft Brexit outcome would be a relief for Euro equities.