How bad would a no-deal Brexit be for UK equity investors?

In light of the economic damage the pandemic is doing to the UK economy, David Prosser mulls the prospect of departing Europe on WTO rules.

Amid growing excitement about the impending reopening of pubs, at least in England, the UK let a significant date pass with little comment on 30 June. This was the final day on which the UK had the right to request an extension to the transition agreement, the standstill period that began on 31 January, when the UK formally left the EU. During this period, the relationship between the UK and the EU has largely continued in its pre-Brexit form, but once the transition agreement expires on 31 December, all bets are off.

Both sides have always hoped that by then the detail of a new trading relationship between the UK and the EU will be in place, courtesy of a free-trade deal attractive to all. But that now looks a tall order – and the UK no longer has the option of asking for more time.

One problem is that Boris Johnson’s government wants a trade deal where the UK is much less closely aligned to the EU than Theresa May had proposed; that is hard for the EU to countenance, given its determination to emphasise the value of EU membership for those that accept the responsibilities that come with it. In addition, the coronavirus pandemic has thrown negotiations into turmoil, with all talks between the EU and the UK suspended completely for six weeks at the height of the crisis.

A deal is still possible, but with time running out, reaching agreement on intricate and sensitive areas across the economy looks ever more difficult. That would mean trade between the UK and the EU from 1 January onwards taking place on the default terms provided by the World Trade Organisation (WTO) – with, in the view of most economists, significantly adverse effects on the economies of both sides.

That would be a dismal prospect at the best of times, but in the context of the economic damage that the pandemic is doing to the UK economy, further Brexit-related impacts are potentially disastrous. The OECD already expects the UK to be more damaged by the pandemic than any other developed nation, with an 11.5% hit to the economy in 2020.

- JP Morgan’s Georgina Brittain: Brexit risk will lead to volatility and bargains

Looming risk

Tristan Perrier, a senior economist at Amundi Asset Management, argues: “[Brexit will] be seen as a major risk factor by investors if the major worries related to the pandemic ease in developed markets, which is our scenario.” Nervousness will climb steadily the closer we get to 31 December with no deal, he warns.

It’s a prospect that investors could easily walk into unawares. The market volatility seen in the first six months of the year – with UK equities down 20% or so overall and 35% at the lowest point – has been so dramatic that it is easy to lose sight of other icebergs looming on the horizon. “The impact of Brexit has been put into a different context as a result of the dramatic economic effects of the pandemic,” says Azad Zangana, senior European economist at Schroders. “Nonetheless, it is back in the spotlight and is likely to remain so in the coming months.”

The key to understanding where Brexit will have the greatest adverse impacts in the event of no-deal lies in the detail of the WTO’s arrangements. In practice, there is no single set of WTO rules. Rather, each of the 164 members of the WTO, including both the UK and the EU, has a list of tariffs and quotas that it applies to imports from all other countries that it doesn’t have a free-trade deal with. The list specifies any taxes due on such imports and any limits on how much may be imported.

In May, the UK announced details of a new set of tariffs it will charge from January 2021 to countries it doesn’t have a treaty with – including the EU, assuming no deal is done by then. It plans to maintain tariffs in most areas, but is removing all tariffs below 2.5% and reducing the number of tariffs it applies; in all, 47% of products coming into the UK will be tariff-free, up from 27% now.

This sounds like good news for importers – and the consumers who buy their products. Right now, however, there are no tariffs at all to pay on imports from the EU. The UK government hopes unveiling this streamlined list of tariffs will encourage the EU’s negotiators to come to the table for fear of EU businesses’ competitiveness being eroded, but there are no guarantees.

Meanwhile, UK firms exporting to the EU are stuck with the EU’s existing list of WTO tariffs and quotas. Overall, the average EU tariff rate is low – around 1.5% – but there are stand-out examples of much higher costs. On cars and car parts, for example, the tariff rate is 10%. And since most UK-based car production is both exported and dependent on imported parts, there’s a double whammy here. The impacts would also be large on agriculture, where EU tariffs and quotas are challenging.

Moreover, for many businesses, non-tariff barriers to trade are even more important than tariffs. These are obstacles such as product standards, safety regulation and the administration of trade – the nitty-gritty governing how goods cross borders and what checks are applied.

Here, the EU appears to be playing hardball. While the UK has said it will phase in checks on EU goods coming into the country – so that firms don’t have to complete customs forms and tariff payments, or submit goods for physical checks for six months – the EU has not made any such promise. It still proposes to introduce full import controls on UK exports from 1 January 2021.

Brexit shock

The upshot is that a no-deal Brexit will inevitably have a significant impact. While the WTO fall-back position provides a basis for continued trade between the EU and the UK, new tariffs will mean increased inflation in the UK, including for some basic foodstuffs. Exporters, meanwhile, will find themselves at a competitive disadvantage when they try to sell in the EU – and may face significant delay and disruption as they try to get their goods across the Channel.

Even if a free-trade deal is done, most economists think Brexit will have a significant adverse impact on the UK, because there is no deal in prospect that will give such attractive trade terms as EU membership.

“While Number 10 is keen to present the overall cost as a ‘one off’, this does not reflect the reality,” warns Maddy Thimont Jack, a senior researcher on the Brexit team at the Institute for Government think tank. “There are big up-front costs in establishing new processes, from new administration systems to the personnel to run them. There will be ongoing costs as businesses meet the burdens of trading with the EU. Many services firms have already had to set up subsidiaries within the EU to allow them to remain operational in EU member states, and it will become more expensive to recruit EU citizens to UK businesses.”

Nevertheless, the impact of a no-deal Brexit will inevitably be more serious. We are already seeing a repeat of the no-deal warnings last year. The CBI says that businesses battling to survive the pandemic crisis will have no resilience left to deal with the fallout.

How bad might it be? Well, in a dozen forecasts collected by the Institute of Government in recent analysis, the best-case scenario is that a no-deal Brexit knocks around 2.5% off UK GDP over the next 15 years; the most pessimistic forecast is for an 18% loss. That compares with a range of 0.5-12% for the hit that the UK economy will take from Brexit with a free-trade agreement.

The government’s own assessment is towards the more upbeat end of the spectrum. It sees a 5% hit to GDP from a free-trade deal Brexit, deteriorating to a 7.5% decline in the event of no deal.

However, these effects would not be felt equally, with some sectors of the economy much more vulnerable to Brexit risk than others. Top of the list is the manufacturing industry. Automotive exports slapped with a 10% tariff would face big problems, particularly in areas of the sector where profit margins are already thin. Nissan, for example, has already warned that its Sunderland factory might not be economically viable in these circumstances.

In the aviation sector, companies such as Airbus with major manufacturing operations in the UK rely on just-in-time production lines based on components passing back and forwards across the UK/EU border with no friction; disruption at the border would be hugely problematic. In chemicals, meanwhile, there is mounting concern that a lack of regulatory alignment might prevent UK businesses selling in the EU. That applies both to industrial chemicals and the UK’s significant pharmaceuticals business.

Tariff turmoil

Agriculture is another major problem area. UK farmers send about two-thirds of their exports to the EU, which would be subject to steep tariffs under a no-deal Brexit. For some cuts of beef and lamb, tariffs exceed 40%. On imports of food, meanwhile, UK retailers would face some tough decisions – do they pass on tariffs to shoppers and risk a backlash, or do they take a hit to their margins?

The outlook for the UK’s dominant services sector, which is not so thoroughly covered by WTO rules, is also highly uncertain. The biggest issue is likely to be whether the EU will recognise the UK’s professional qualifications and regulatory standards in the event of a no-deal Brexit. If not, many UK businesses, – including much of the financial services industry – may not be able to continue serving EU-based clients, or will be forced to set up EU subsidiaries.

These sectors, then, represent particularly risky options for equity investors in the event of a no-deal Brexit. More generally, Darius McDermott, managing director at Chelsea Financial Services, warns: “The one thing we have learned from previous Brexit talks is that a lot of it is played out in the currency markets; today we are almost at one euro to the pound, which is a low level historically, but if it were no deal, it’s likely the currency would fall further.”

In which case, as in previous rounds of Brexit anxiety, it is likely large-cap stocks that make much of their earnings in currencies other than sterling would outperform the rest of the market. Businesses heavily dependent on imports in their supply chain would face tough headwinds. For primarily domestic businesses – often small- and mid-cap stocks – the no-deal Brexit impacts may be more subtle, depending, for example, on how consumer demand is affected.

Still, market analysts counter caution. One consideration is the EU’s record of reaching last-minute compromises where impasse had previously seemed inevitable. Jason Hollands, managing director at Tilney Investment Services, warns: “I would caution against trading out of UK equities in a wholesale manner, because if an eleventh-hour deal is reached, much of that pent-up anxiety in sterling could rapidly unwind.”

There’s also the possibility of significant upside in this scenario, with valuations in the UK market having been held back in recent times, at least relatively, by Brexit uncertainty. Resolving that anxiety once and for all could provide a boost, though much will depend on where we are with the pandemic at that stage.

Indeed, as Schroders’ Zangana points out, everything looks small beer compared with the pandemic. “The negative impact from a no-deal Brexit would be a drop in the ocean compared with the impact of the coronavirus lockdown,” he says.

Positional considerations for a no-deal Brexit

For investors seeking to protect their portfolios from the worst potential impacts of a no-deal Brexit, actively managed funds with broad remits offer clear advantages, argues Darius McDermott: “In an actively managed multi-cap fund, the manager can hopefully invest in the stronger businesses that can survive a difficult transition, and also invest in all sizes of UK companies in a diversified portfolio.”

The idea here is to pick managers that are less constrained by a strict mandate and therefore have more freedom to avoid sectors and individual stocks most at risk from a no-deal. McDermott picks out Liontrust Special Situations, Ninety One UK Alphaand Man GLG Income as worth considering in this context.

Tilney Investment Management’s Jason Hollands is also a fan of Liontrust Special Situations, and also likes TB Evenlode Income. He says: “[These funds] are predominantly invested in UK businesses with international earnings, and their focus on quality growth stocks means they have little exposure to more cyclical businesses.”

However, stay vigilant about the prospects of an unexpected lastminute agreement between the UK and the EU, which could undermine calculations made on the assumption there will be no deal. Diversification will be crucial.