The EU and the UK have agreed to delay Brexit until 31 October if a solution cannot be found sooner. This plays into our ‘never-ending story’ scenario, which we have thought the most probable path since last July. Sterling barely moved on the news, showing investors still believe that ‘no deal’ remains a significant risk. The fog of uncertainty remains and we do not expect international fund managers to return to UK markets with confidence. This same fog will also continue to weigh on economic growth. 
‘No deal’ is still on the table
The House of Commons and the Lords passed the Cooper-Letwin Bill to force the government to extend Article 50 rather than take the UK out of the EU without a deal. But that does not mean that a ‘no-deal’ Brexit is off the table. For Parliament has already voted for the potential of a ‘no-deal’ Brexit by invoking Article 50 in the first place. The EU does not have to accept the UK’s timetable.
Our view is that the risk of ‘no deal’ may have diminished at the margins, but it remains a significant risk.
Customs union: worst of all worlds?
Leaving the EU but remaining a part of the customs unions, without any other favourable terms of trade, would help manufacturers and farmers. But the UK’s dominant services sector would remain out in the cold. ‘Passporting’ arrangements, on which international activity of many UK financial service firms depend, would come to an end.
Since before the referendum, we have highlighted the vulnerability of the financial services industry, which plays a big role in UK trade and inbound investment, both directly and through the agglomeration of other business services it supports.
UK financial services would have to seek ‘third-country equivalence’ under a number of separate pieces of EU legislation, which allows for firms from a country outside of the European Economic Area (EEA) to operate in EEA member states on similar terms to those granted by the financial passport as long as the third country’s regulatory and supervisory arrangements are judged equivalent to the EU’s.
Market access is based on continuously demonstrating regulatory equivalence between the third country and the EU. At present third-part equivalence regimes are pretty much untested, but legal experts concur that they would entail a potentially laborious and certainly costly compliance process. There’s a good chance of these regimes being used as political leverage by the EU too, and potentially removed at short notice.
Furthermore, not all financial services activities that can be passported under the current system are even eligible for third-party equivalence. In other words, there may be a complete loss of access to the EU market for some businesses. There is no third-party equivalence regime for banking services such as lending and deposit-taking under the Capital Requirements Directive (CRD IV). Or retail asset management, under Ucits. Or direct insurance under Solvency II (reinsurance is covered).
Remaining within the customs union would ameliorate much of the both permanent and temporary losses of productivity from increased non-tariff barriers to trade and supply chain disruption. But it also obliterates the possibility of doing significant trade deals with other, faster-growing economies, which is one of the few reasons why Brexit, in the long run, could make the UK better off. Sure, the UK may still be free to negotiate trade deals for services – i.e. sectors not covered by a customs union. But trade deals are usually about give and take, and Britain has such a dominant position in global services, that it’s difficult to see what another country would get in return for allowing services trade access if goods access wasn’t on the table.
Tarnished sterling
We believe that the foreign exchange market had priced in a very high probability of a hard Brexit. We anticipate sterling appreciating over the next three to five years, regardless of the nature of the deal that is eventually struck. On a long-run basis – the only timeframe over which we believe currency forecasts can be made with any certitude – sterling is very undervalued. But as we have discussed, ‘no deal’ is not off the table, and we fully expected the pound to stay volatile and under pressure.
What about interest rates?
Interest rate futures aren’t pricing in another rate rise until 2023. We believe that rates will stay low for a long time, but no rate rise for four years is unlikely so long as Brexit proceeds in an orderly manner. Remember that Brexit depresses both supply and demand, so GDP growth around 1.5 per cent will likely be consistent with 2 per cent inflation. GDP expansion higher than that will necessitate tighter monetary policy. We don’t envisage that until next year.
UK equities: let’s get defensive
A stronger pound would present a headwind for the large multinational companies in the FTSE 100 that derive most of their earnings overseas in non-sterling markets. There is a good case for a softer Brexit resulting in both a stronger pound and a stronger FTSE, a typically unusual occurrence because those foreign earnings are worth less in sterling when the pound rises. Why could it be different this time? Because the FTSE is so under-owned by global investors.
There are, however, compelling cyclical reasons for favouring the FTSE 100 at the moment. As global leading economic indicators slow, more defensive markets tend to outperform. Similarly, after the US yield curve inverts – when the return on short-maturity bonds rise above those of longer-dated bonds – defensive markets around the world tend to outperform. The earnings underlying the FTSE 100 are, in aggregate, among the least sensitive to global economic growth of any major index. That makes the UK one of the world’s great defensive markets.
UK investors are global
The most important thing to remember is that the typical UK investor is a global investor. Even if you only held companies listed on the UK’s FTSE 100 index, 70-80 per cent of the underlying revenues originate overseas. And Brexit is not a globally systemic event, like the financial crisis of 2007-08 or the European debt crisis of 2011-12. Brexit has become a national obsession, albeit a reluctant one for most. Remember the good old days when it was only the miserable weather that dominated our conversations? Unfortunately, Brexit is going nowhere anytime soon. It will continue to affect the UK economy even when nothing seems to be happening –as shown by the substantial falls in business investment. But well-diversified UK investors shouldn’t fret too much. When your home market is defensive, undervalued and global, it should help make your assets that much safer.
Ed Smith is head of asset allocation research at Rathbones. The views expressed above are his own and should not be taken as investment advice.