After nearly nine months of internal wrangling, much of it within Prime Minister Theresa May’s Conservative Party, the U.K. government has formally announced its intention to withdraw from the European Union (EU). However, the two parties appear to have very different orientations to the coming negotiations. The U.K. acts as if it is beginning the negotiation of a new relationship between the U.K. and the EU. However, the Europeans appear, at least publicly, only interested in the U.K.’s withdrawal. These differences were highlighted in May’s formal letter invoking Article 50, and the reactions in Europe to it.
According to Chief Wealth Strategist Matthew Peterson, one basic tenet from the EU members is that, “The U.K. cannot be in a better place with respect to the EU after leaving it. There must be a disincentive to leaving the EU.”
May noted several things in her letter of interest. First, she acknowledged what is so often understated; the withdrawal of the U.K. from the EU resets their trading relationship to the rules established under the World Trade Organization (WTO). So the U.K. isn’t going back to highly protectionist era policies, it is just going back to the trading relationship that both the EU and U.K. currently have with the U.S., China, Japan and most other countries. Plenty of trade takes place among these countries; a specialized treaty is not necessary for trade to occur.
May also suggested the creation of a European Free Trade Association. This is far beyond the scope of the negotiations called for under Article 50. Furthermore, EU Council President Donald Tusk stated that no new trade deals can be started until the Article 50 negotiations are finished.
One of the disadvantages for the U.K. to revert back to the WTO rules is that it will need to try to soften its balance of trade in service, particularly financial services. You can see from Figures 1 and 2 that the U.K. has been running a high trade deficit in goods, but actually a significant (and growing) trade surplus in services. One focal point is the passporting of financial services firms, which is the concept that a firm located in any EU country has access to all. For example, a bank located in London (whether it’s a U.K. bank or a U.S. bank with a London headquarters) can operate anywhere in the EU.
May noted the importance of financial services in her letter. Several senior EU officials have suggested extending passporting to U.K. based banks is out of the question. Last week, executives from two major U.S. financial companies announced that they are preparing to move staff and operations from London to countries like Germany and Ireland in order to retain access to the single market.
Historically, we find the currency markets and market for banks located in Europe to be the best indicators of how the markets think the Brexit is going. Since the initial Brexit vote, the pound has fallen 16.5% against the dollar and 12% against the euro. This may have avoided some of the short-term harm caused by Brexit by making the U.K.’s goods and services more appealing to U.S. and Eurozone firms, but it also increases inflation in the U.K.
Given that the currency sensitivity, investors, particularly more risk-averse investors, may prefer to hedge their currency exposure. U.K. companies that rely heavily on imported goods, such as retailers, might struggle in this environment, particularly those than cannot pass on price increases to consumers.
Past performance is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.
The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security.
The economic forecasts set forth in the presentation may not develop as predicted.
International and emerging markets investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.
This research material has been prepared by LPL Financial LLC.
To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial LLC is not an affiliate of and makes no representation with respect to such entity.
Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit
Securities and Advisory services offered through LPL Financial LLC, a Registered Investment Advisor Member FINRA/SIPC
Tracking # 1-595417 (Exp. 03/18)