By Bill Witherell, Ph.D.
UK economic indicators for January looked encouraging. The HIS Markit Composite Purchase Managers’ Index (PMI), combining measures of manufacturing and service sector activity for the month, rose from 49.3 in December to 53.3, the strongest in 16 months, with a robust increase in new orders. Also, several indicators of business optimism registered sharp increases. Uncertainty with respect to Brexit had declined following the British election and the passage of the government’s Withdrawal Agreement Bill. UK stocks remained flat in January, easing a bit in the final week. However, the situation as March begins is dramatically different.
During the final week of February, the outlook for the UK economy and UK stocks was transformed by two sudden headwinds. The first was a sharp increase in concerns about the possible magnitude and duration of the hit to global growth from the coronavirus outbreak. The second was the re-emergence of a significant risk that the UK will exit without a trade agreement upon the expiration of the transition period for its departure from the European Union, on December 31.
The spread of the coronavirus outside of China led to a sudden rise in risk aversion, which sent global stocks tumbling last week. Stretched valuations made equities vulnerable to sizable corrections. UK equities joined in the market fall, even though the UK had only 19 confirmed cases as of February 28 (36 as of March 2). Companies highly dependent on sales abroad and global supply chains are the most vulnerable. The companies in the FTSE 100, which fell 11.2% last week, generate 76% of their sales abroad. The drop was the biggest since 2015. The iShares MSCI United Kingdom ETF, EWU, lost 10.4% on a total return basis. Its year-to-date March 3 total return is down 14.5%.
The eventual effects of the virus on the UK economy are unknown. The February UK manufacturing PMI released on Monday shows a gain over the January reading but also includes some first indications of coronavirus-related disruptions of supply chains. Forecasts of global economic growth for the current year are being revised downward, with the OECD, for example, reducing its central global growth projection from 2.9% to 2.4% for 2020, adding that a “longer lasting and more intensive coronavirus outbreak” could cut growth to only 1.5%. It looks like the UK economy, which advanced 1.4% last year, may gain only around 1% this year, with a very slow first half followed by a recovery in the second half and into 2021.
As in other economies around the globe, the expected eventual recovery in the UK will be fueled by a very easy monetary policy, historically low interest rates, and increased fiscal stimulus. This expected environment should be positive for global equity markets. UK stocks, however, may well encounter a second headwind that gets stronger as the year progresses: the possibility that after December 31 the UK will be trading with its largest trading partner, the European Union, and with the rest of the world on the basis of World Trade Organization rules alone, rather than its current trade arrangements, all of which are based on its past European Union membership. This would be the so-called “no-deal Brexit.”
The UK left the EU on January 31 and is in a transition period scheduled to end at the close of the year. During this transition, the UK continues to benefit from all its trade relations with the EU and the EU’s trading partners. Last week both the UK and the EU published their negotiating “directives,” which outlined their opening positions for negotiating a new trade agreement. The negotiations begin this week. Both sides indicate that the objective is a free-trade agreement, removing most tariffs and quotas, with added areas of mutually beneficial cooperation.
However, the two directives indicate the two sides are far apart in areas that will be difficult to resolve. The UK has made the situation particularly difficult by placing a very short time frame on the process, insisting that it will not extend the process beyond the end of this year and even threatening to terminate the negotiations in June if it judges that significant progress has not been made.
While the two sides agreed last October that there should be a “robust” regime to ensure “fair and open competition,” it is evident from the two directives that there is wide disagreement as to what this means in practice. The EU regards its standards and rules as a necessary “reference point” and asserts that Britain’s proximity to the EU as well as the importance of its trade flows with the EU require much closer adherence to EU rules than is the case for Canada.
The UK wants full autonomy to set its own rules on state aid, labor, and the environment. State aid will be a particularly difficult issue in the negotiations, as the EU is seeking to have the UK bound to apply EU rules on state aid in perpetuity. Sharp differences on fishing rights could also become an early flashpoint in the negotiations. The EU wants to preserve its existing rights in UK waters, whereas the UK wants to regain full control over its fishing grounds. Although fisheries account for a very small share of the respective economies, the political leverage of the coastal communities on both sides is strong.
Much more economically important to both sides is the financial services sector. Financial services accounted for 6.9% of the UK GDP in 2018. The financial relationships between the City of London and the EU are important to both sides. While both sides aim for an “equivalence” framework in which each recognizes the legitimacy of the other’s regulations, there are important differences on how best to achieve a stable regime. More broadly, services account for some 80 percent of the UK economy, yet UK Prime Minister Boris Johnson says he would like a trade deal based on the “precedent” set by the EU’s trade agreement with Canada, which has very limited coverage of services.
Experienced trade negotiators say it is difficult to imagine that it will be possible to complete these complex trade negotiations successfully by year-end. The UK threat to walk away from the negotiations with no deal should be taken seriously. A no-deal Brexit would be costly for both sides, with the cost being greater for the UK. A UK government assessment in 2018 indicated that a no-deal exit would cut 8 percent off the UK’s growth over the next 15 years. The chemicals, aerospace, and motor vehicles sectors would be particularly hard hit.
Yet Mr. Johnson does appear adamant that his government would be prepared to do business with the EU based on World Trade Organization terms, including those for tariffs and quotas. He also is optimistic about negotiating a favorable free-trade agreement with the US. That too may prove to be more difficult than he expects, and the UK could find itself facing a threat of auto tariffs. The trade challenges facing the United Kingdom indeed look formidable.
Neither the author nor Cumberland Advisors own the ETF EWU.
Sources: Financial Times, OECD, Oxford Economics, CNBC, Goldman Sachs, HIS Markit
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.