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Brexit trade deal, a starting point?

UK/EU Free Trade Agreement (FTA) (Trade & Co-Operation Agreement)

So 4.5 years on from that fateful day in June 2016, we have a semblance of the future UK/EU relationship.

Before delving into the detail, my gut feel is relief that the FTA is signed, is the primary driver of the rapturous investor response. There is much to be said for relief as a motivating emotion, as November’s US presidential election proved!

A “no-deal” Brexit would have disrupted the movement of goods, introduced a tariff on EU imports and UK exports, further embittered relations with the EU, unleashed downward pressure on sterling and sterling assets. Brexit has been a debilitating fly in the ointment issue for over five years now. Thankfully in the context of the revived C-19 pandemic, Brexit became a problem that had to be fixed.

The Trade & Co-Operation Agreement has “3 major pillars” detailing a new economic and social partnership. I detail the major sections below with my views in italics:-

The UK/EU Trade & Co-Operation Agreement extract [my comments in brackets]

“*The agreement covers not just trade in goods and services, but also a broad range of other areas in the EU’s interest, such as investment, competition, State aid, tax transparency, air and road transport, energy and sustainability, fisheries, data protection, and social security coordination.

*It provides for zero tariffs and zero quotas on all goods that comply with the appropriate rules of origin.

*Both parties have committed to ensuring a robust level playing field by maintaining high levels of protection in areas such as environmental protection, the fight against climate change and carbon pricing, social and labour rights, tax transparency and State aid, with effective, domestic enforcement, a binding dispute settlement mechanism and the possibility for both parties to take remedial measures.

*The EU and the UK agreed on a new framework for the joint management of fish stocks in EU and UK waters. The UK will be able to further develop British fishing activities, while the activities and livelihoods of European fishing communities will be safeguarded, and natural resources preserved.

[under the FTA the EU’s catch share will reduce to 25% will be phased in, over 5.5 years and 25% of the EU’s catch will be repatriated to UK flagged vessels during this time. According to UK government sources, the UK’s share of the catch would rise from 50% now to 66% by 2026]

*On transport, the agreement provides for continued and sustainable air, road, rail and maritime connectivity, though market access falls below what the Single Market offers. It includes provisions to ensure that competition between EU and UK operators takes place on a level playing field, so that passenger rights, workers’ rights and transport safety are not undermined.

*On energy, the agreement provides a new model for trading and interconnectivity, with guarantees for open and fair competition, including on safety standards for offshore, and production of renewable energy.

*On social security coordination, the agreement aims at ensuring a number of rights of EU citizens and UK nationals. This concerns EU citizens working in, travelling or moving to the UK and to UK nationals working in, travelling or moving to the EU after 1st January 2021.

*Finally, the agreement enables the UK’s continued participation in a number of flagship EU programmes for the period 2021-2027 (subject to a financial contribution by the UK to the EU budget), such as Horizon Europe.

[The UK retains access to EU airspace under the EU Open Skies Directive however the ownership of EU airline assets will be regulated to ensure control remains in the EU. NB Ryanair/ Wizz Air statements on disenfranchising UK shareholders and prevention of share purchases]

*A new partnership for our citizens’ security

*The Trade and Cooperation Agreement establishes a new framework for law enforcement and judicial cooperation in criminal and civil law matters. It recognises the need for strong cooperation between national police and judicial authorities, in particular for fighting and prosecuting cross-border crime and terrorism. It builds new operational capabilities, taking account of the fact that the UK, as a non-EU member outside of the Schengen area, will not have the same facilities as before. The security cooperation can be suspended in case of violations by the UK of its commitment for continued adherence to the European Convention of Human Rights and its domestic enforcement.

[The UK will no longer have access to Europol and security related information held in EU databases such as the Schengen Information System (SIS II)]

[This is partly attributable to a recent EU report that found the UK had sold information on the SIS to US companies, in breach of EU disclosure rules]

 

*A horizontal agreement on Governance: A framework that stands the test of time.

*To give maximum legal certainty to businesses, consumers and citizens, a dedicated chapter on governance provides clarity on how the agreement will be operated and controlled. It also establishes a Joint Partnership Council, who will make sure the Agreement is properly applied and interpreted, and in which all arising issues will be discussed.

*Binding enforcement and dispute settlement mechanisms will ensure that rights of businesses, consumers and individuals are respected. This means that businesses in the EU and the UK compete on a level playing field and will avoid either party using its regulatory autonomy to grant unfair subsidies or distort competition.

*Both parties can engage in cross-sector retaliation in case of violations of the agreement. This cross-sector retaliation applies to all areas of the economic partnership.

Foreign policy, external security and defence cooperation is not covered by the Agreement as the UK did not want to negotiate this matter. As of 1 January 2021, there will therefore be no framework in place between the UK and the EU to develop and coordinate joint responses to foreign policy challenges, for instance the imposition of sanctions on third country nationals or economies.

[this leaves open the issue of how ‘retaliation’ takes place basically meaning a dispute in one part of the agreement, for example on fisheries could face retaliatory measures in say transport.]

So this is Brexit

“Brexit means Brexit” said former PM Theresa May. It became obvious Brexit meant leaving the EU single market, customs union, the loss of financial passporting rights, losing the benefits of free movement, the ability to move to EU countries and work there. Brexit keeps more of the UK population here and makes it harder for EU workers to enter and create effective competition in labour markets.

The FTA is a customised ‘sovereignty max’ set of menu options achieving the above. The UK can depart from the standards, regulation and oversight of the EU relatively quickly. The UK cherry picks EU single market access (albeit on a more limited basis) at no cost, departing from EU rules and regulations in exchange for vague commitments on equivalence, governance and EU standards.

However the deal is ‘thin’. It preserves the EU’s competitive advantage in a wide range of finished FMCG (fast moving consumer goods) and leaves out financial services (c. 7%-8% of the UK’s $2.8trn economy). This point cannot be understated. The FTA allows the EU some time to upgrade its financial service industry to meet the opportunity created by Brexit.

Loss of passporting rights is a headwind for the City of London. The EU is not yet in a position to finalise the UK’s equivalence position viz financial services, basically equating to there being no equivalence framework now. The EU is keeping UK expectations on EU financial passporting low.

“All will change in the City of London’s relationship with the EU” von der Leyen.

As the UK turns inwards, there is collateral damage. Brexit will impact opportunities for cultural exchange between the UK/EU. This is most obvious is PM Johnson’s crass decision to leave the EU’s Erasmus student exchange scheme. Erasmus benefits those from deprived backgrounds and its loss will reduce UK universities income by £280m. Speaking in the House of Lords, former civil service chief, Lord Ricketts said the proposed UK alternative, the “Turing scheme” would not replicate Erasmus and be a poor substitute.

Appearances are important. The status quo is preserved in the FTA – i.e. no Kent motorways crammed with lorries or Royal Navy patrols off the Isle of Wight. The FTA ensures stability in the UK public’s mind, in the media and currency markets.

The Brexit conclusion provides the UK with the opportunity for political and economic stability, that has been lacking since pre- 2014 Scottish referendum. The last four years has seen two elections, three governments, a protracted divorce negotiation – at least now there will be a “breather”.

I am hopeful the forthcoming “cooling off period” will enable negotiating positions viz equivalence to soften. I am of the view that the EU will be better off without the UK, a club member that had objected to virtually every single EU initiative for years, had opted out and circumvented its rules, obtained rebates on an exclusive basis, and frequently denigrated the club and its objectives.

Insofar as the UK is concerned, it can now forge its own way without the crutch of the EU. With independence will come opportunities, challenges and exposure to new vulnerabilities.

UK rehabilitation post Brexit?

The Brexit conclusion should help rehabilitate the UK in the minds of international investors and narrow the UK valuation gap. As illustrated below UK assets have been underweighted partly as a result of Brexit.

As discussed in previous reports this year there are other reasons for the UK valuation discount such as the UK’s low exposure to technology, internet and IT and higher weightings of ‘old’ industries including oil, retailers, banking, insurance…sectors that have de-rated and cut dividends. How much gap narrowing can be expected? Short term possibly 5-10 points.

 

The global equity context remains one of extreme valuation ‘gaps’ in US techs and US equities and depressed valuations ex USA. Despite this construct being a reality for a few years now, there has yet to be any shift towards the middle ground or gap narrowing. This is due to ongoing US tech profit growth and a lack of growth drivers/ weaker profitability elsewhere.

In fact, 2020 (a turbulent period for global equities) has proved that unless US tech profits collapse, investors will keep their faith. During 2020:-

a)        Global indices bifurcated even more, as investors chased profit growth and momentum in US techs and US blue chips as their first and second step.

b)        China has improved its credentials as an investment destination due to its higher tech/ internet content but also its C-19 resilience/ Biden election.

c)        The Rest of the world, comprising G7, developed economies, emerging economies come a distant third in the asset allocation ranking.

d)        The US Presidential election has helped Q4 global equity performance lifting all boats but not narrowing valuation differentials.

The Brexit FTA ensures the UK closes 2020 with a positive Q4 event but I wonder how far it goes to altering the UK’s underlying investment realities. Time will tell.

Will the Brexit FTA’s emerge as a driver for 2021?

a)        If the UK/EU FTA becomes a blueprint for FTAs with the USA, and/or other countries warm to bilateral UK FTA

b)        If the UK/EU FTA leads to progress on equivalence and financial passporting.

c)        If problems do not develop in the arbitration and management of FTAs. After all this novel approach is being applied in modern times with countries in large trading blocs. Countries may not adhere to bilateral treaty rules (UK/ India – Cairn Energy is a case in point).

d)        Assuming other countries do not start trade wars/ impose tariffs on the UK. Post the transition period the UK is reliant on World Trade Organisation rules that will be weaker and less effective than the collective defensive available as an EU member state. A costly trade war would quickly expose the weaknesses and limitations of bilateral FTAs.

Brexit’s UK/ EU FTA conclusion is a first step along the road to UK rehabilitation. It turns the page on EU membership and provides a coherent next step. Will it result immediately in improved export performance? No. Does it maintain the trade deficit with the EU? Yes.

Frankly, I want to see proof that FTA’s can build on the previous trade relationship, help and improve UK export penetration and provide a solid reliable basis for a trade relationship when problems arise. So for the moment, a tentative thumbs up.

 

HAPPY NEW YEAR 2021

 

 

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