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Newsletter  04/05/2017

Brexit...the clock is ticking

On the 29 March, the UK Prime Minister, Theresa May formally triggered Article 50 signalling the start of 2 years negotiations for the United Kingdom's departure from the European Union. As a consequence, Sterling weakened whilst gilts rose modestly with the 10-year gilt now yielding 1.03 per cent.

Despite often negative newsflow surrounding Brexit, the UK economy has still managed to deliver 20 consecutive quarters of GDP growth. Going forward, the main dangers are perceived to be around the nature of the negotiations and the extent to Brexit could dampen investment, export growth and consumption.  

The EU has already confirmed that it will not entertain a trade deal with the UK until its exit has been negotiated.  This is at odds with Theresa May, who stated repeatedly in her Article 50 letter that her Government sought to negotiate both simultaneously.  Any deal has to be approved by all 27 remaining members of the EU which in itself could take several months.

Whilst the full negotiating period is two years, many commentators believe that the real period is more like one year. From a UK perspective negotiations now cannot start until after the General Election on the 8th of June and if the Conservatives were to lose their majority in the House of Commons (seemingly unlikely on the basis of current opinion polls) much would change.  Either way, the danger is that if there is no clarity after one year, many businesses will be forced to assume that there will be no transition deal and will start to enact plans based on future trading under World Trading Organisation (WTO) rules.

The trade deal which is ultimately struck between the UK and EU will have significant and far reaching consequences not only for specific companies and industries, but also for the UK economy more generally. The current Prime Minister has ruled out continued membership of the single market and customs union, making some form of free trade agreement the most likely outcome. However, if the Conservatives win the General Election and increase their majority of seats in the House of Commons the likelihood of a deal being reached increases because the Government will be better placed to have it passed by Parliament.

Given both the two year time limit for any such agreement to be concluded and the need to negotiate the size of payment to the EU on exit (covering UK outstanding liabilities, pensions and budget commitments) there is every chance that no deal will be reached. In this instance, trade would be governed by standard EU tariffs, which vary significantly in their impact on different sectors and heavily penalise trade in agricultural and food products in general.  This arrangement could hurt the UK more than the EU.  At present, exports to the EU represent around 12% of UK GDP.  Conversely, the EU’s exports to the UK make up less than 4% of its GDP.

With a possible hardening in rhetoric expected by both sides over the next few months, this may result in a deeper impact on consumption and a possible slowdown in the UK economy.  Under this scenario, monetary policy is likely to remain highly stimulatory with the possibility of another round of quantitative easing and accommodative fiscal policy. 

Moody’s, the ratings agency has warned that collapsed talks or no deal at the end of Article 50’s two-year deadline would be credit negative for a number of sectors such as car and aerospace manufacturers, non-durable consumer goods producers, retailers that largely import their goods and UK airlines.  Furthermore, a reversion to World Trade Organization (WTO) trading rules would have negative implications for the UK’s sovereign rating.

Looking ahead, we believe that political and monetary forecasts will dominate the outlook for Sterling in the short term.

Looking ahead, we believe that political and monetary forecasts will dominate the outlook for Sterling in the short term. In that respect, we anticipate heightened anxiety with the early stages of Brexit negotiations to weigh on Sterling.  On the other hand, the weaker pound should boost UK export competitiveness although inflation is likely to be pushed higher.

Taking into consideration the French, German, Dutch and UK electoral cycles this year it is envisaged that the crucial period for the negotiations will be late 2017 and early 2018. This limited time frame and the lack of any early room for compromise suggests that the likelihood of a so called “hard Brexit” remains high.

Within our existing Cornelian portfolios, the UK companies that we typically hold are highly international in nature with a significant proportion of overseas earnings. 

Within our existing Cornelian portfolios, the UK companies that we typically hold are highly international in nature with a significant proportion of overseas earnings.  In addition, given current market uncertainties emanating from Brexit we remain defensively positioned and  invest in well diversified portfolios offering exposure to a broad range of markets and asset classes.

Andrew Hannay
Senior Investment Manager

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