Since the UK’s referendum on continued membership of the EU resulted in a leave vote in mid-2016, there has been much uncertainty over the outlook for UK stocks.
As one of the largest economies in what has become one of the most integrated trading blocs in the world, any withdrawal is set to be felt across the region.
With less than six months of the Article 50 withdrawal negotiating period to go, there have been few signs of a breakthrough with many beginning to fear a ‘hard Brexit’ scenario – with the UK leaving the bloc with no deal in place.
Unsure of its future relationship with the EU – and what impact it will likely have on the domestic economy – many international investors have been shunning the UK market since the referendum in 2016.
Indeed, since the EU referendum, the UK market has lagged its global peers with the FTSE All Share generating a 21.03 per cent total return compared with a 44.31 per cent gain for the MSCI AC World index.
Performance of indices since EU referendum
Source: FE Analytics
However, Capital Economics chief global economist Andrew Kenningham said any impact from a so-called ‘hard Brexit’ is not likely to be felt by other markets.
“While a disorderly no deal Brexit might, depending on its nature, deliver a significant short-term blow to the UK economy and financial markets, any global fallout would probably be small,” he said.
Kenningham said that while the consultancy believes an “11th hour” deal will be struck and backed by a narrow majority in the UK parliament, the risk of no deal has risen close to 50 per cent.
“In practice, the consequences of a no deal Brexit would depend on what form it took,” he said.
“An orderly no deal, which included side agreements on legal and logistical issues plus a transition period, would not be a huge shock. But a disorderly no deal, in which negotiations broke down completely, could be highly disruptive.”
A disorderly ‘no deal’ could see UK GDP fall by 3 per cent over two years due to a slump in external trade and business confidence, said the Capital Economics economist, which would come after the low levels of growth seen since the referendum result.
However, while a ‘no deal’ scenario would have a significant impact on the UK growth prospects, the likely impact for the rest of the world would likely be little disturbed.
“The UK accounts for only 4 per cent of world goods trade,” Kenningham explained. “And for most European economies, exports to the UK account for less than 3 per cent of GDP.”
“Exports to the UK from Japan, the US and the major emerging markets are 0.5 per cent of GDP or less. So even if UK imports fell by 10-20 per cent, the impact on most trade partners would be small.”
Another potential impact from a ‘no deal’ scenario would be the further weakening of sterling, which has already fallen significantly since the referendum.
Performance of US dollar & euro vs sterling since EU referendum
Source: FE Analytics
As the above chart shows, the US dollar has risen 14.31 per cent against sterling since 23 June 2016, while the euro has appreciated by 15.35 per cent.
“We suspect that a no deal Brexit would cause the pound to fall by around 10 per cent – similar to its initial fall following the June 2016 referendum,” said Kenningham.
“For the UK, this would boost net exports but dampen real incomes as imported inflation rose.
“But such a fall in sterling would equate to only a trivial appreciation of the euro and US dollar in trade-weighted terms because the UK’s share of eurozone and US trade is small.”
A hard Brexit would also have some implication for monetary policy, the economist said, who argued that the Bank of England would probably cut rates and possibly resume quantitative easing (QE).
The Bank lowered rates in the aftermath of the referendum to 0.25 per cent in a bid to reassure markets, raising it to its previous level of 0.5 per cent just over one year later. Its most recent hike occurred in August as the central bank’s Monetary Policy Committee raised the base rate to 0.75 per cent, the highest level since March 2009, giving it some room to manoeuvre in the event of ‘no deal’.
Kenningham said ratesetters at the US Federal Reserve could also hold off raising rates in March days before the Brexit deadline as they had done following the referendum.
Bank of England base rate
Source: Bank of England
“That said, the Fed would surely not hold off its tightening cycle for long,” he added. “Meanwhile, the European Central Bank [ECB] would stand ready to provide liquidity and moral support if needed but it would be reluctant to restart QE or push back its planned first rate hike.
“The bar is quite high for the ECB to change tack, and it is generally less responsive than the Fed to financial market moves and global events.”
While there is not likely to be a widely-felt impact from a hard Brexit, there is the potential for some fallout from the UK’s “outsized financial sector”, according to Kenningham.
The economist said interbank markets could freeze if no agreement is reached over the £50trn-worth of derivative contracts between UK and EU counterparties maturing after March.
However, such an event is a “known unknown” which policymakers are likely to be able to avoid a “Lehman Brothers-style meltdown”.
“European banks are well enough capitalised to withstand even a major shock,” he added. “Absent some ‘unknown unknowns’, therefore, we think a disorderly no deal Brexit would cause a big splash for the UK but only a ripple for the rest of the world.”