To rise from the ashes of Covid-19 into the heat of Brexit

By Tim Sharp, Hottinger Investment Management

The economy has been put into a self-induced coma to halt the spread of Covid-19 and the resulting economic downturn has been significant, requiring major support from the Bank of England and the Treasury. With the turning of June comes the first tentative steps out of lockdown on the road back to normality. A V-shaped recovery is the perfect result where the economy bounces back quickly with the R-rate remaining steadfastly below 1. We have discussed the alternatives to this optimistic scenario in previous articles while the World Bank warns that we may be heading for a global recession[1].  The quickest way to reduce the economic consequences of the pandemic is to re-open as quickly as possible and countries are increasingly shaking off the restrictions imposed during lockdown. The downside to this scenario is of course a second wave of infection which once more threatens the tender shoots of recovery.

Last week saw Michel Barnier and David Frost reopen negotiations regarding the future trade relationship between the UK and the EU with the rather inevitable result that both sides remain entrenched in their opposing positions. The week before, Mr Barnier wrote to UK party leaders to advise that the EU is open to extending the transition period by up to two years to allow time for a trade deal to be concluded. EU Commission President Ursula von der Leyen has called for a six month delay and business leaders in Northern Ireland have said that companies do not have the financial capacity to deal with new post-Brexit arrangements following coronavirus, also demanding a six month delay[2]. However, Boris Johnson and David Frost remain adamant that a trade deal must be signed by December 31, 2020. Following the stalled talks this week the next meeting will be between Mr Johnson and Ms von der Leyen, likely to take place in conjunction with the next EU virtual summit around June 19.  It is worth remembering that the last time that the UK can legally agree to extend the timetable is the end of June, therefore, the mid-June meeting takes on new significance. The rotating presidency of the EU commission moves to Germany in July and Angela Merkel promises an intense negotiating agenda with a view to ratifying an agreement at the October summit.

Right now, with the talks currently in deadlock, Britain and the EU are once again confronted by the prospect of a no-deal at a time when both economies have been ravaged by Covid-19 and the shape of any recovery is still in the early stages of formation. Julian Jessop, fellow at the Institute of Economic Affairs writes in the Financial Times that the risks to the economy from no-deal are likely to have less of an impact than Covid-19. British government analysis in 2018 expected a no-deal Brexit to lower UK economic output by at worst 8% over a 15-year period. The Office of Budget Responsibility forecasts that Covid-19 will reduce UK GDP by 13.8% this year[3]. The theory goes, therefore, that the current crisis will ease some of the side effects of dealing with a no-deal exit, taking pressure off major ports and making the case for greater re-shoring of business. The flip side of this argument is why add further pain to the already significant economic problem created by the pandemic lock down. The UK is struggling with one of the highest fatality rates per capita in the world after delaying lockdown making reopening fraught with anxiety.

Even though the pandemic fallout will disguise the impact of no deal, it will not eliminate it, with the inevitable result of slowing the economic recovery from the pandemic recession. Many companies have had to increase debt levels to ensure survival and would find it difficult to adjust to no deal with a less flexible balance sheet. CBI chief, Carolyn Fairbairn, says that companies have “almost zero” resilience and ability to cope with a chaotic changeover and BOE Governor Andrew Bailey has contacted banks to ensure that they are properly prepared3.

Throughout May and again this week the pound vs. the Euro, the main market where Brexit disappointments are historically reflected, has weakened and once more resides at the 1.12 mark as financial markets reconsider the possibilities of a no deal exit. In fact, the pound is still to recover from the 20% dip it experienced following the 2016 referendum result. The FTSE 250 mid cap index, where more domestically focused companies reside, continues its mild underperformance of core Europe, -15.9% year-to-date compared to -13.5% for the French CAC 40 and -3.8% for the German Dax at the time of writing. However, this may be reflective of the success of each country in managing the pandemic rather than the UK-EU trade prospects. Regardless, some analysts are expecting further strain on the equities of UK focused companies over the coming months. Many of the arguments regarding the effects of a no-deal remain unchanged despite Covid-19 and, with the economy already suffering, this could be viewed as a good time to bury bad news.

[1] https://uk.reuters.com/article/us-health-coronavirus-worldbank/world-bank-sees-major-global-recession-due-to-pandemic-idUKKBN21L3EN

[2] https://www.ft.com/content/aedc4a01-75f3-4905-b9cb-abea7e06cc1c

[3] https://www.ft.com/content/4440f83d-7e8a-4510-b8b7-3fb9146da51a