Today in Brexit, Day 1,641

For the second weekend in a row, the UK and EU’s Brexit negotiation teams blew through a self-imposed Sunday deadline without agreeing on a trade deal. The main sticking point remains fishing rights, leading to all sorts of headlines about talks floundering, officials carping about fisheries, talks facing a sole stumbling block and EU officials being koi about whether they would allow a provisional deal to take effect without ratification if one were reached in the coming days.^[i] Both sides say talks will continue, but the UK government has already ruled out extending the post-Brexit transition period beyond year-end, so the clock is ticking down toward a no-deal Brexit. However, markets are already confronting a reality including the practical implications of a no-deal Brexit, reducing whatever shock factor Brexit had left.

You see, the mutated strain of the novel coronavirus that is now circulating through London and southeast England has led governments to take actions resembling the hardest of Brexits imaginable. French President Emmanuel Macron responded by banning all freight and travel from Britain, effectively closing British ports along the English Channel. The highways are clogged with hundreds of trucks, and several thousand more have been diverted. In short, it is an extreme version of the so-called nightmare scenario of a no-deal Brexit, in which pundits feared new customs checks would cause a paperwork nightmare for truckers and result in … the highways being clogged with hundreds of trucks going nowhere for days. Only in that scenario, container ships would still be making the short journey and Brits would still be able to travel to the EU, so congratulations 2020, you have once again managed to kick society harder than anyone thought possible.

As we write, UK Prime Minister Boris Johnson is finalizing a plan to mass-test all truck drivers heading into France, and Macron has indicated a negative test result would give entrants a green light. So there is a pathway for the chaos to end, much to everyone’s relief, and by the time you read this things may be heading back to normal. But step back a bit: Is this really so different from how no-deal-Brexit-related chaos would resolve? No one expected that outcome to permanently cease trade. Rather, most expected a few days of chaos as understaffed ports tried to process reams of new paperwork, much of which might not be correct on the first attempt. But then drivers would get the hang of it, the kinks would iron out, and in the end trade would require just a bit more red tape. That is basically the process we are seeing right now. Chaos, followed by people figuring out a new system with more red tape. If society can get through that this week, is there some reason they can’t get through a second iteration after New Year’s? We have a strong hunch that this week’s events are further sapping any lingering negative surprise power. As a general rule, when markets fear something bad will happen, and the bad thing happens—or, a parallel bad thing—it enables people to see things play out, see society overcome the bad thing, and then move past the fear. Like ripping a really big bandage off, or something.

We should also point out that even if politicians agree on a trade deal, since the UK would still be leaving the EU’s customs union and single market, there would still be customs requirements at ports. So even with a deal, there were always going to be some adjustments. Both parties have known this for over a year now and have focused on staffing up accordingly. Social distancing requirements will probably make that a bit difficult in the near term, but new customs checks aren’t sneaking up on anyone. Shipping companies have been preparing. Ports operators have been preparing. Most importantly, markets are forward-looking. They aren’t looking two weeks ahead—they generally look 3 – 30 months out. So the question is, whatever delays ports face in the here and now, will Britain and the world have adapted and moved on in 6, 12, 18 or more months? In all likelihood, yes—and the more we get past the short-term uncertainty, the more clearly markets will be able to see this outcome. Hiccups now help remove the fear of the unknown, which gives markets a clearer view.

The inevitability of customs checks also make the trade deal deadline feel a bit overdramatized—especially as both sides seem to be losing a sense of urgency as said deadline approaches. Perhaps it is a tacit admission that for all the attention paid, a trade deal just isn’t make-or-break. For one, we have yet to see a free-trade deal that is actually, well, free. While many aim to reduce tariffs across the board, they also have carve-outs, rules-of-origin requirements and other sneaky provisions that codify protectionism. If someone wanted to argue a Brexit that leaves trade entirely on World Trade Organization terms, with very low tariffs but none of the associated exemptions, was actually more optimal than a broad trade deal, they would have our attention. It isn’t the sort of thing anyone can prove, as there is no counterfactual, but we think it is important to consider anything like this from all angles.

Two, as one astute Wall Street Journal columnist observed last week, trade terms have a funny way of being perpetually up for debate, even where treaties exist. The EU itself hasn’t even figured out fully free trade internally, considering the many barriers to free trade in services among member-states. As the column summed up: “It isn’t obvious why the discrete negotiating process now on a knife’s edge would be the last word on EU-U.K. relations. Nothing is forever in the global economy. Britain’s 1973 entry into the European Economic Community—the EU’s forerunner—turns out not to have been permanent, and neither was the exclusion from the EU of Eastern European states that were in the Soviet sphere (which itself was not so permanent) when the EEC was created. The North American Free Trade Agreement was renegotiated under President Trump; the Bretton Woods agreement governing currencies in an earlier era collapsed. What will be permanent about Brexit is the phase the two sides are in now, not whatever deal they strike next: a phase when trading relations between them are always open to reinspection and renegotiation.”^[ii] That is basically the status quo of modern economic history, and markets know it well.

Markets also know the numbers. They know the tariffs that would take effect if the UK and EU don’t get a trade deal aren’t high. In the UK’s case, they would represent a broad reduction from the EU’s external tariff. So while it may cost a little more to export to Continental Europe, importing from the US, Asia and other regions will get a little bit cheaper. That is a big deal, considering the EU accounted for less than half (45.7%) of UK exports and a little more than half (53%) of UK imports in 2019.^[iii] That share is down from 57.8% of exports and 56% of imports in 1997.^[iv] With Brexit empowering the UK to cut new trade deals with non-EU trading partners, we think there is a lot of untapped potential. Markets should increasingly see this, too.

So no, we won’t go so far as to say all we want under our trees this festive season is a no-deal Brexit that finally ends this never-ending saga and yields clarity. At the same time, we doubt markets would see it as a lump of coal. Yes, volatility may persist in the short term, but as time passes and the fog clears, we think stocks are likely to enjoy the falling uncertainty, deal or no.