How will the Brexit negotiations conclude?

By Karen Ward, 27 March 2019

The prime minister (PM) and UK negotiators have agreed on a Brexit deal with the European Union (EU), but it has been rejected three times by UK parliament. At the root of the problem is a conflict within the UK over what it wants from Brexit.

“Abstracting from the political drama, the important point is that UK parliament has no appetite for no deal.”

Karen Ward

However parliament is clear that no deal is not a palatable option. Of those voting against the deal, most are doing so because they want a softer Brexit. The key question therefore is how can the deal be reshaped to gain majority approval, and what length of extension is required to renegotiate.

Crunch time

The proposed deal has two key elements. The Withdrawal Agreement is a legally binding treaty that sets out the terms of the UK’s divorce from the EU, including the financial settlement, the rights of citizens, the transition period (to December 2020, or beyond if extended) and a backstop arrangement in case both sides cannot fully agree on a future partnership. The Political Declaration is not legally binding, but contains some broad areas of agreement around which the future partnership will be constructed.

There are two particular areas of contention.

The first is the backstop. Throughout the negotiation, one of the key areas of difficulty has been that of the Irish border. The UK argued that it wanted to leave the EU but did not want to create a border on the island of Ireland, given the potential for such an arrangement to undo the peace process underpinned by the Good Friday agreement. At the same time, Northern Ireland does not want to be in a separate arrangement from mainland UK.[1] The problem is that the proposed backstop does essentially leave Northern Ireland more firmly rooted in the customs union than the rest of the UK, and requires regulatory checks in the Irish Sea. The Democratic Unionist Party (DUP) in Northern Ireland - which supports Theresa May’s minority government - has said that it cannot support this deal. In addition, some members of parliament (MPs) are uncomfortable with the fact that the backstop cannot be revoked by the UK unilaterally. They argue that this limits the EU’s incentives to move swiftly towards finalising the future partnership.

The other key area of opposition is within the Conservative Party. The faction generally known as the Brexiteers are aiming for a cleaner break from Europe - a so called “no-deal” exit. Their view of the current deal is that the cost of having to abide by EU rules and regulations, and the resulting concession of “sovereignty”, outweighs the benefit of having access to the EU’s markets (which currently account for 44% of all UK exports).

While there is validity to all the concerns, the PM could never have struck a deal that pleased everyone. The UK’s ambitions were internally conflicting. The need to have free flow of trade in Ireland without Northern Ireland being carved off in separate rules, alongside the realities of an extremely integrated UK and EU supply chain, requires the deal to be based around a customs agreement in goods. This means accepting EU standards - and so the UK cannot fully regain sovereignty. (If the UK struck a trade deal with the US to compensate for a lesser relationship with the EU, it would require accepting US standards, which, in agriculture, are currently very different). As such, no deal was ever going to be a “good deal”-one that would please all MPs. This is worth remembering when considering whether an alternative MP would either wish to replace the PM, or have the ability to craft an alternative deal.

If the prime minister continually fails to get support for the deal, there is a complex web of possible outcomes and, given the unchartered territory, the legalities of all the options are not perfectly clear. But below we’ve tried to highlight the four key potential scenarios. We’ll present them starting with those we believe are least likely.

1) No-deal. There was a risk that the PM could be replaced with a Conservative MP less fearful of a no-deal scenario. Were they to face a lack of willingness by the EU either to renegotiate, or to extend the Article 50 process, the UK could have essentially fallen out of the EU. However, we are confident that there is no parliamentary majority for no-deal, so believe that there would be a motion of confidence in the government which would prevent such a no-deal scenario from happening. Should we be wrong it is worth noting that the Bank of England estimates that sterling would have to decline 25% in the event of no-deal to cushion the impact on the domestic economy from the new barriers to trade.

2) A general election. This could be initiated by the Prime Minister but requires a majority backing in the Commons. Alternatively, the Labour Party could put forward and then win a vote of no confidence in the government. The government would then have 14 days to win a vote of confidence by majority in the House of Commons (this may involve them selecting a new leader), or a general election would be held. The Labour Party are advocating a softer Brexit, at least one founded on a customs union.

3) Another referendum. The PM could find it appealing to go back to the British public to ratify her deal. If she received sufficient support for the deal in another referendum, MPs would have to support it to respect the wishes of their constituents. While this sounds simple, the reality is far more complex. Again, there would need to be a majority in the Commons to commence proceedings. And the design of the question would be similarly contentious. Should it be this deal vs. staying in the EU, or should the option of no-deal be included?

It is worth noting that both a general election and a second referendum would be likely to be lengthy processes and there would have to be an agreed extension to the Article 50 process from both the EU and UK. The EU appears willing to entertain a longer extension to facilitate further negotiations.

There appears to be talk of a Norway-style arrangement to act as a holding arrangement. It is not immediately clear what solution this provides, since on top of continuing to accept EU rules as in the current PMs plans, there would likely be continued free movement of people.

4) This deal passes. When push comes to shove, this may be the least bad option for MPs on both sides of the house. By not supporting the PM, no-deal advocates within the Conservative Party risk losing either an election or another referendum - and potentially ending up with no Brexit at all. Ultimately we expect the PM to garner sufficient support from both sides of the house to pass the deal. Whilst our conviction on this scenario has reduced, we do not see increased risk of no deal. Instead it is becoming increasingly likely that a long extension will be required to facilitate a new deal. This will however require the UK participating in the European Parliament elections.

And then what?

If the deal passes the UK would then enter a period of transition, in which nothing would change so that businesses could adapt to the new arrangements. The finer details of these new arrangements still need to be hashed out. The ambition is that they will be sufficiently complete by June 2020 so that the new arrangement can take effect in January 2021. However, it seems highly likely that the process will drag on and the period of transition get extended.

Although near-term uncertainty would not be entirely resolved, we believe UK markets would experience a significant relief rally on passage of the Withdrawal Agreement or move to a long extension. We would expect sterling to rise significantly. Domestically focused UK stocks would likely benefit, but the rise in the exchange rate could prove challenging for larger cap stocks, which repatriate a large proportion of their earnings from overseas.

The economy would be likely to improve as business confidence lifted investment, and a rise in sterling would push down inflation at just the time when wage growth is rising, supporting consumer spending. Given that the Bank of England believes the economy is already at full capacity, we believe it would raise rates during the course of 2019.

1It is worth noting that while Northern Ireland does not want a separate arrangement, Scotland does because it wants to maintain access to the single market, and so this will reinvigorate the Scottish Independence discussion. So there is a broader question of the stability of the Union of England, Wales, Scotland and Northern Ireland.

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ETF currency hedging strategies

Static monthly hedge

  • Monthly reset reduces transaction costs.
  • Consistent with many index methodologies, which may reduce tracking error.
  • Imperfect hedge may leave investors with unexpected currency risk.

Static daily hedge

  • Daily reset increases transaction costs.
  • Consistent with many index methodologies, which may reduce tracking error.
  • Daily reset minimises currency risk, however high transaction costs can outweigh benefits.

Tolerance-adjusted hedge

  • Hedges are reset whenever hedge ratio breaches pre-set threshold, resulting in lower transaction costs than daily hedging.
  • Difficult for index providers to reflect in index methodologies, which may increase tracking error.
  • Removes more currency risk than monthly hedging while reducing transaction costs compared to daily hedging.

Spotlight on hedge ratios

To achieve a 100% hedge ratio, the value of the derivatives used to hedge a portfolio’s currency exposures should equal the notional value of the portfolio’s assets.

If the value of the portfolio’s assets rises, the hedge ratio will fall and the portfolio will be under hedged.

If the value of the portfolio’s assets falls, the hedge ratio will rise and the portfolio will be over hedged.

If hedge ratios become too stretched there is a risk that the impact on the performance of one hedged share class could impact another share class of the same fund.

Regulatory measures require ETF providers keep hedge ratios within a 95%-105% tolerance, making a tolerance-adjusted hedging model appropriate for many ETFs.