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23 November 2018

Brexit: one step forward, two steps back? 

Hailed as a major step forward by the UK prime minister, not everyone is convinced that initial agreement yesterday on a draft ‘political declaration’ brings us any closer to a final Brexit deal

On March 29, 2019, the Brexit clock that began ticking two years earlier – triggered by the invoking of Article 50 – will strike midnight for the UK.

Yesterday, Prime Minister Theresa May declared that her country and the European Union had moved a major step closer to reaching a final Brexit deal before that deadline. May’s announcement followed agreement with the EU on a draft “political declaration” that outlines how trade, security and other issues would be addressed following the UK’s withdrawal from the bloc.

On Sunday, EU leaders will gather in Brussels to formally vote on both that political declaration – a legally non-binding statement of principles – as well as the far more critical “withdrawal agreement,” which was agreed in draft form last week.

If the EU endorses these documents – as is widely expected, despite Spain seeking additional clarity on the future of Gibraltar – the British parliament will then have to approve the same. That will clearly prove an uphill struggle for the embattled May government.

If parliament does not approve a plan by its own deadline of January 21, 2019, the likelihood a “hard Brexit” will increase significantly.

In such a scenario, economists have forecast a range of outcomes, from a short-term recession to a sustained contraction over the longer term. Inflation would likely spike in the UK in the short term, leaving the Bank of England in a bind at a time when growth would be stalling and inflation rising.

Already, the UK opposition has criticized the political declaration; opposition Labour Party leader Jeremy Corbyn called it “26 pages of waffle,” that “represents the worst of all worlds: no say over the rules that will continue to apply and no certainty for the future.”

Even if the word “consider” is used 19 times in that very high-level document, it’s worth asking how the political declaration – if ultimately approved by all sides – would shape the future of UK-EU relations, including on a wide range of areas of significant economic importance.

On trade, the two sides – as “separate markets and distinct legal orders” – “envisage” having a relationship that is “as close as possible with a view to facilitating the ease of legitimate trade.”

Those are vague statements, leaving unanswered to what extent the UK would need to respect EU standards in areas such as competition, tax, social and employment protection, and the environment. That’s why France, for example, is pushing for the UK to automatically incorporate future European climate change directives into law in return for agreement on the trade pact.

On financial services, the idea of “passporting” has been replaced by “equivalence,” the far stricter approach followed by the US and Switzerland. That’s bad news for banks in the City.

Meanwhile, a “no-deal” scenario – a clear negative for investment decisions and economic growth – would see equity markets lurch lower. This is particularly important for businesses exposed to the UK economy, which tends to be the case for small and mid-cap firms. If positive developments continue, then the reverse is true: markets would move higher, at least in the short term, and UK-exposed businesses would breathe a sigh of relief.

Following May’s announcement, the pound moved sharply higher yesterday, recording its biggest single-day rise in three weeks. But 2019 will make or break sterling, and until we know the final outcome of negotiations, it’s impossible to predict the currency’s future direction. That said, a no-deal scenario would put pressure on the pound. 

Even if the process seems to be moving two steps back every time one step is taken forward, any progress is good news – as we see in currency markets.

The start of the formal Brexit transition process in March 2019 will provide much-needed clarity and will be supportive for both the UK and Europe, coming not long after the European Central Bank’s €2.5 trillion quantitative easing program finally ends.

For now, the politics of Brexit remain profoundly thorny. And at a time when worldwide markets are highly volatile and the global economy is entering the late stages of the growth cycle, the cost of sustained uncertainty appears extremely high.