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Brexit - It’s the final countdown

With Brexit just over a year away, Hermes Investment Management discusses the road ahead in the final countdown.

Saker Nusseibeh, Chief Executive

There has been a lot of emotive discussion around Brexit, from both sides, but little regard for facts or logic. As a result, the discussion has now degenerated into a childish exchange of slogans with no real thought apparently given on the effects of Brexit on the real economy and the country. So, I propose to restrict myself to two facts:

Fact No 1: 51.89% of those who bothered to vote voted for (an ill-defined concept of) Brexit. With 72.21% turnout, that translates to 37.47% of the entire electorate voting to leave the European Union.

Given our electoral system, and the reasonably high turnout, as well as the ideological commitment of the Conservative party to the idea of leaving Europe (metaphorically speaking) some kind of Brexit is inevitable.

Fact No 2: 43% of our exports went to Europe in 2016. A further 12% of our trade is with countries outside the EU, but under EU trade agreements.

The withdrawal from the EU must result in some friction. If we assume that as a result of negotiations friction is minimal, we can guess a drag of 10% year one declining to 5% thereafter. If we further assume that the 12% with third party countries suffers minimally at a 10% drag as we renegotiate with them, then our exports will suffer a 4.3% hit immediately from the friction of exports to the EU (then settling down to 2.1%) and 1.2% from the friction of negotiating a new deal with others (then settling down to 0.6%).

To make up for that we would therefore need to grow non EU exports by 12% in the first year and 6% thereafter to get the economy back to an even keel of the position before Brexit.

For the EU, the facts are these:
a) 16% of its exports are to the UK
b) Therefore a 10% friction equates to a loss of merely 1.6% of exports
c) For the EU to return to an even keel of the pre Brexit state it would need to increase its exports to other countries by only 2% in year 1 and only 1% thereafter.

Given the above reality, the EU would be far less concerned about the economic effects of the UK leaving and might therefore see no downside in adopting a hard stance in negotiations. The UK would then have to make a choice of either minimising the friction cost as assumed above, which implies a very soft Brexit, and which will still result in a hit to GDP growth but might be manageable, or chose to pursue a tougher stance which might result in a higher degree of friction and which would result in a much harder economic hit.

For the economic effect on the EU to be equivalent to the effect on the UK of a soft Brexit (10% friction in year 1), exports from the EU to the UK would need to fall by 33%. That (a 33% decline), however, would be a scenario in which UK exports have declined by 15%! (33%x 43+1.2%) which is a hard Brexit!

The combination of the two facts then lead us to conclude:
a) That Brexit is inevitable.
b) That a soft Brexit is the most likely outcome, but that even a hard Brexit (which would seriously harm the UK) would have far less impact on the EU.
c) The position of both protagonists is a-symmetrical.

Silvia Dall’Angelo, Senior Economist

The UK is now around halfway through its two-year process of exiting the EU and, so far, its economy has held up reasonably well. However, crucial challenges still lie ahead, and as long as there is no clarity about trading arrangements down the road, medium to long-term prospects remain uncertain.

Since the EU referendum, the UK economy has faced two opposing forces. On the one hand, Brexit-related developments have had a negative impact on economic growth: uncertainty about post-Brexit trading arrangements has held back business investment, while the FX-driven increase in consumer inflation has squeezed real incomes, in turn weighing on consumption. On the other hand, since the end of 2016 global demand has staged a synchronised recovery (conspicuously involving the eurozone), which has provided significant support to the UK’s open economy. As a result, the UK economy has done fairly well in the last year and a half, yet sliding within the G7 growth league from top performer to laggard. UK GDP grew by 1.7% in 2017, compared to 2.3% in the US and 2.5% in the eurozone.

In the short term, the outlook is cautiously constructive. The UK managed to agree a 21-month transition deal with the EU, implying stable trade conditions and, in turn, the ability to benefit from the ongoing expansion in global demand over the next year or two. In addition, consumption should benefit from a return of real wage growth to positive territory, reflecting both a modest acceleration in wages and gradually descending consumer inflation over this year.

Longer term, prospects are still highly uncertain. It is unclear what kind of terms will eventually regulate the UK-EU relationship. The situation is fluid and the spectrum of possible outcomes is wide. It is worth considering that in a scenario where access to the EU Single Market was replaced by a free trade agreement covering goods only, UK total trade would decline by 22% (NIESR estimates). It would be extremely challenging to make up for that loss with more intense trade with the rest of the world.

Eoin Murray, Head of Investment

“There is no such uncertainty as a sure thing”
Robert Burns, ploughman, excise-man, and poet.

One year out from Brexit, with the recent transitional deal in the bag, it behoves us to find some more positives to report, even if that can at times seem a struggle. From perspective of the markets, securing more time should be a positive – at the very least it seems to ensure that the UK will not simply fall off the cliff. However, we cannot ignore that this must be one of, if not the, most complicated set of trade negotiations ever, and that the UK entered those negotiations completely lacking a set of institutions to deal with them. Simply put, the UK is going from a situation where it outsourced virtually all trade and regulatory functions to Brussels, to a state of bringing them back to Westminster and making them competent. The fact that the UK appears to be desperately seeking more time removes some uncertainty which markets will receive positively, but nobody will be underestimating the scale of the task that still lies ahead.

But back to reality. To paraphrase Prime Minister Bettel of Luxemburg: “They were in with a load of opt-outs. Now they are out, and want a load of opt-ins”. We have recently had UK Prime Minster May’s third big speech on Brexit, but its intended audience seemed principally domestic. The EU responded by publishing a framework for a free trade agreement between the UK and the EU. It makes clear that there is scope for a trade-off between fewer barriers to trade and relaxation of the UK’s red lines. However, it is equally clear that there is no room for compromise on the Irish border issue. This remains a source of significant political risk, with resolution unlikely and extremely problematic for the UK.

As for our industry, whilst much remains unknown, this week’s news that officials from the EU27 have agreed that there should be specific and explicit language preserving ‘appropriate’ market access for the City of London after Brexit has assuaged some fears. : “The extent to which Brexit may restrict the access of the UK financial services sector to the EU27 market is of acute economic relevance. The EU27 market accounts for some 25% of UK financial service business – a business that is a significant component of the UK economy” . To that end, this news as well as the fact that ESMA, the EU’s main securities authority, is making positive noises about the possibility of taking steps to minimise the impact of a "cliff-edge" Brexit on investors in cross-border funds provide a glimmer of hope. For those reasons, we continue to hope for a positive outcome (permanent transition, anyone?) and prepare for the worst.

Andrew Jackson, Head of Fixed Income

“Nothing in the world causes so much misery as uncertainty”
Martin Luther

One should not be surprised by the fact that fixed income markets initially reacted to the referendum result with a combination of fear and pessimism and that the second was of stubborn intransigence. Fixed income markets do not reward participants for irrational optimism. The best evidence of the market’s reaction was perhaps the decline in prices in UK commercial real estate debt assets and the gating of “liquid” funds who invest in this asset class. That initial reaction proved reasonably short lived and the more liquid markets even more rapidly reversed their initial declines. The aftershocks have tended to persist for longer in the less liquid areas of our markets.

Economics and corporate fundamentals in the UK do not look to be displaying significant signs of Brexit related weakness. Property values both in residential and commercial property are mixed but it would be hard to point to any meaningful declines (or rises) in value as a result of either the initial announcement or the subsequent negotiations.

Two areas where we see clear signs of challenge are financial services and the UK retail high street. Within financial services there are very obvious and dangerous consequences of a “hard” Brexit. The industry drives a large part of the UK economy and as such will form a vital part of the negotiations. The lack of clarity and lack of progress in the negotiations to date has been unhelpful for decision makers and has encouraged organisations to plan for “the worst”. A solution which ensures the pre-eminence of London as Europe’s financial hub is currently built into market prices. The UK high street shows significant signs of weakness with several retailers struggling and others looking vulnerable if conditions worsen. This may not be a UK phenomenon, but those seeking to improve profitability through rent reductions may struggle given Brexit driven uncertainty. Major declines in consumer discretionary spending resulting from uncertainty may be sufficient to tip the most vulnerable and more levered companies into a terminal decline.

All that said, markets are strong, we continue to see the UK as a creditor friendly jurisdiction and continue to see ample opportunities to lend. We are likely to continue to focus our attention on securities and structures that protect us from downside risk as well as avoiding industries with a high degree of cyclicality. There are few, if any, parts of the market where we see an unwarranted Brexit premium being priced in and as such we see less upside from a “successful” outcome than downside from an “unsuccessful” outcome. The probability and definition of one over the other appears as difficult to predict as it was immediately after the referendum.

Chris Taylor, Head of Private Markets

The nature of private markets investment assets means that in the pre Brexit/post referendum phase volatility has generally not been as apparent as in public markets. Overall, investor demand and pricing has remained robust and recovered strongly post the short-term downward move that occurred immediately after the referendum.

Looking forward towards the impact of Brexit on real estate and infrastructure, while the economic, regulatory and political dimensions are material, the longer-term drivers of change are likely to continue to be equally if not more significant. This includes changes to how space is utilised by office occupiers, and technology driving fundamental structural changes in the use of, and demand for, retail and industrial space. Both are changing the landscape, creating both threats and opportunities – regardless of Brexit. Similarly, regulatory and fiduciary changes are driving ESG issues to the top of the agenda for investors which means that the nature of investment is changing rapidly – regardless of the shape of the UK’s relationship with the EU and the rest of the world. Furthermore, the unintended consequences of ultra-loose monetary policy has undoubtedly created a platform for a real asset bubble, so irrespective of Brexit risks, we would be wary of the underlying real estate cycle and mispricing particularly as rates normalise ahead.

The previous two decades of relentless globalisation of both investment and product markets means that Brexit – in whatever form it takes – will present serious challenges to private markets investors. Any Brexit agreement that hinders cross border capital flows – which have been a significant driver of pricing and liquidity in real estate and infrastructure in the last 20 years – would be likely to have a negative impact. Furthermore, if occupiers found it more difficult to trade, source materials and employ talent then the occupational demand for real estate would be negatively impacted too. With the battle for talent a significant reason for occupiers to choose to locate in particular cities this is a significant Brexit impact that should not be underestimated. Both real estate and infrastructure are assets that derive their value from their location - if the economic use or desirability of a location changes then value will change too. Arguably, the biggest risk for real estate markets arising from Brexit uncertainty - apart from short term investment decisions being put on hold, would be artificial barriers to attracting and retaining global talent in our biggest cities.

However, there will be opportunities, not least if investors over-react, positively or negatively, to announcements and plans for Brexit. A long-term view of value, and an awareness of the structural phenomena driving that long term value, will ensure well informed investors will be able to take advantage of those opportunities when they arise.

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