The UK’s twin challenges of Brexit and Covid

‘Specific and limited’

Even that limited ambition was called into question on 8 September, when the UK government confirmed that it would break its international commitments “in a very specific and limited way.” Last week, European Trade Commissioner Valdis Dombrovskis said that, if the UK does so, “there is no longer any basis for a free trade treaty.” Commission President Ursula von der Leyen then tried to keep talks going by describing the bill as a “distraction,” without withdrawing the threat of legal action.

Mr Johnson both negotiated and signed the agreement, then used it to win a general election by a landslide, before ratifying it in Parliament as recently as January. It is hard to disagree with those who say that either the prime minister did not read what he signed, or signed an agreement that he did not understand. Last week Mr Johnson tried to address criticisms in his own party by offering to make any breach of the agreement subject to a Parliamentary vote.

By seeking to reopen its agreement from less than a year ago unilaterally, the UK risks undermining its future international trade efforts.

Since Mr Johnson’s government, which enjoys a comfortable Parliamentary majority, and the European Commission’s terms both expire in 2024, both sides will have to keep working with the consequences (see calendar).

‘Prosper mightily’

“We will prosper mightily one way or the other,” Mr Johnson said last week. "They could be sensible and give us a Canada-style solution… but we're ready for either eventuality." Canada’s trade talks with the EU began in May 2009 and an agreement was signed in October 2016, and approved and implemented in 2017. The UK’s trade talks with Canada began on 7 September 2020.

The UK government did sign a trade deal with Japan on 11 September that it said will generate GBP 1.5 billion for the economy. Two-way goods and services trade between the UK and Japan is less than one-twentieth of the value of the EU-UK relationship while bilateral trade with Canada is worth less than 3% of commerce with the EU.

One of Brexit’s benefits, according to proponents, was an eventual free trade deal with the US. Democrats, including presidential candidate Joe Biden and House Speaker Nancy Pelosi have both warned that the UK government’s bill risks undermining the Good Friday Agreement, in part brokered by then-US President Bill Clinton. Respect for the Brexit deal “must be contingent” on respecting the agreement and “preventing the return of a hard border. Period,” tweeted Mr Biden on 16 September.

Coping with Covid

In addition to the uncertainties surrounding Brexit, the UK’s approach to managing the Covid-19 pandemic is often at odds with European neighbours. Total deaths in the UK from the virus are the highest in Europe, at 41,866 at the time of writing, ahead of the toll in Italy, France and Spain. The UK now has the third-highest mortality rate per one million people in Europe, behind Belgium and Spain. However, compared with France and Spain, the UK has fewer reported new infections.

Covid has already disproportionately hurt the UK economy. Gross Domestic Product fell by 20.2% in the second quarter, compared with the previous three-month period, its deepest decline on record. In the eurozone, GDP fell by a record 12.1% over the quarter. In addition to Covid, a no-deal Brexit at the end of this year may deepen the damage to the UK economy. In the worst case, a ‘no deal’ may cut more than 7% from GDP in the long run, according to a 2018 study by the UK Treasury.

Along with many other economies, the UK has benefited in recent months from government spending. In some areas, such as pay for nearly 10 million furloughed employees, some of that is set to end on 31 October. That risks knock-on effects on jobs, consumer spending and investments. In addition, the UK is approaching a ‘fiscal cliff’ as its budget deficit runs close to 8% of GDP and may reach as much as GBP 370 billion, or 17% of GDP. In response, the government is planning to raise taxes, unpopular even within its own party, which would in turn weigh on the economy.

In response to the economy’s challenges, the Bank of England is considering a resort to negative interest rates. A meeting of the central bank’s Monetary Policy Committee on 17 September discussed “plans to explore how a negative Bank Rate could be implemented effectively.”

Bricks and Sterling

Negative interest rates would impact consumer confidence and the politically-sensitive UK housing market. House prices rose 3.4% on average in the year to June, the Office for National Statistics said last week. Much of that rise was “pent-up demand” from the country’s lockdown, said the government office, further inflated by a temporary freeze in stamp duty. In contrast, rental values, considered a more accurate measure of economic sentiment because they are more closely linked to salaries and the job market, have fallen over the previous 12 months. This is especially true of London, where the lockdown has most affected commuting patterns and working habits.

The UK’s currency is beginning to reflect the threat of a no-deal Brexit. The pound looks unlikely to appreciate further until even a very basic agreement with the EU is close. Its rally against the dollar, since the end of June, is largely attributable to the US currency’s weakness. It has also gained against other major currencies as the economy has started to recover from the pandemic’s lockdowns.

However, with the UK’s fiscal stimulus slowing, those economic improvements may be about to tail off, and, we believe, sterling still looks complacent about the political and economic risks ahead. In the case of a limited Brexit agreement, we would expect the pound to initially trade around 1.33 against the dollar and close to 0.90 against the euro. Then, further into 2021, the no-deal Brexit risk premia would disappear, offering sterling more support, especially against the dollar.

Without an EU trade agreement in place, the UK would face enormous structural headwinds, which would push the currency significantly lower. We would expect the pound-dollar to trade in the lower-end of a 1.10-1.20 range, while euro-sterling would approach parity.

With either a limited agreement or none at all on offer before the year-end, frictions between the EU and UK over the details will undoubtedly continue with much political noise. We continue to expect a last-minute compromise that as in 2019, avoids a no-deal Brexit. The next few months will start to clarify the differences between Brexit as a political idea, and its real-world trade-offs.

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