Brexit: UK Risk premium likely to remain in place

The unproductive summit of European leaders in Salzburg this week has highlighted the lack of substantive progress on finding any solution to an exit agreement for UK which will satisfy the EU, Ireland, Northern Ireland, UK government and UK parliament. Most importantly the declaration by EU Council President Tusk that the UK’s “Chequers” plan will undermine the single market highlights an objection in principle to the UK’s initiative for a free trade area in goods during any Brexit transition period. This principles-based roadblock suggests that tinkering at the edges – such as customs checks in the Irish Sea are irrelevant details. We see elevated political risk in the UK, potentially polarising the outcome between a hard Brexit and no Brexit. Investors will also need to consider the increased risk of a populist UK government.

It may have been a negotiating tactic but the only solution which the EU appears to be proposing which provides any preferential terms for the UK over a third country is continued EU membership. In this sense UK PM Theresa May would be right to feel ambushed at Salzburg, as she has made clear that it is not the UK’s policy to walk away from the results of the UK referendum.

It is also difficult to discern whether the EU leaders intent was to draw her in, offering the possibility of warm words to take to the UK Conservative party conference to consolidate her leadership – only to switch to a position which makes her position increasingly difficult domestically. We therefore suspect that trust between the parties will have been impacted.

With respect to the focus on the Irish border question, in the 21st century an effective goods border is in our view potentially possible without physical controls. This suggests other reasons are behind the impasse. Land borders with other non-EU nations are far from perfect. The Swiss border is for example minimally manned on all but major goods routes, making it effectively porous except for larger goods vehicles.
For individuals, a border may in future not be based on physical location but in terms of eligibility to government services, payments and rights to work, where proper documentation would be required.

There is however no greater red line for the UK and Ireland than avoiding the prospect of a recurrence of the violence of the previous century. A thought that the EU could require an effective “annexation” of Northern Ireland territory in return for Brexit also seems far-fetched, at least in terms of acceptability to the UK or the population of the region.

What has increased markedly with the EU’s switch to rejecting the UK’s “Chequers” solution in principle is the risk of political change in the UK. The “Chequers” deal was always at risk of rejection in the UK Parliament before any further concessions were made to appease the EU. Now, a weakened UK PM appears at risk of a leadership challenge.

If this succeeds, this is likely to be a polarising event, leaning towards a hard Brexit if the new leadership can maintain the support of Parliament. On the other hand, the political volatility would be such that another general election would be a distinct possibility, something which would be actively welcomed by the opposition Labour party whose primary objective at this point would be to seize power. In this event, all possibilities would have to be envisaged, including behind-the-scenes EU support for a second referendum (not without precedent in EU affairs) or an agreed revocation of Article 50.

For the corporate sector and investors, a populist UK government is unlikely to be welcomed, even if a hard or indeed any Brexit would in those circumstances be less likely. A hard Brexit under a right-wing Conservative leadership would on the other hand have short-term economic repercussions offsetting the benefits of an otherwise private sector friendly regime.

We have noted the decline over the summer of both sterling and the FTSE 100, breaking the typical negative correlation between the currency and the equity market and highlighting the additional risk premium international investors are placing on UK assets at present. That there are potential solutions to the future relationship between the EU and UK which are not apparently being considered is suggestive of a different agenda among EU leaders in our view.

Whether or not this is the case, the position of the current UK government has been weakened by recent events and creates increased political risks. Should there be political volatility, we can see rationale for a sustained increase in the risk premium for sterling, gilts and UK equities. This is based on the continuing uncertainty and two specific scenarios – hard Brexit with a corporate-friendly government and no/soft Brexit with a populist administration which are likely to remain a concern for investors until the situation is clearer.