Britain’s Most Likely Destination: It Won’t Become Some Sort of Hermit Kingdom in the North Sea

LONDON — Very little seems certain in Britain these days, but visitors will notice one reliable feature in almost any conversation that includes the word “Brexit.” There will be a shrug, then a sneer and then something along the lines of “nobody really knows!”

But Britain’s destination is, in fact, pretty clear. 

We don’t know quite how or exactly when, but the U.K. will wind up either just inside or just outside the European Union when the dust finally settles. In either case, its long-term economic relationship with Europe will be essentially as it is today, except perhaps a little more expensive and complicated. 

The European Central Bank’s announcement of fresh monetary support last week and expectations for further Fed rate cuts this week have partly helped restore confidence in Europe’s markets, but the Brexit drama remains a central source of agitation. Investors should concentrate on targets that can operate on either side of the line and stop worrying about the extremes in currency and bond markets which cast Britain as some sort of Hermit Kingdom in the North Sea. 

The mounting fears are easy to understand. The recent disarray in British political circles has shattered traditional party alliances. Conservatives are more split than ever and their prime minister is hardly a calming influence. Labour members of parliament seem as nervous about the ideological zealousness of their leader as they are about Brexit risks. Meanwhile, the Liberal Democrats have enjoyed a brief renaissance for their clear backing of EU membership, while the Scottish National Party has an eye on fresh possibilities for Scotland’s independence.

Oh, and there’s now talk again of Northern Ireland reuniting with its southern neighbor.

Anything is possible when so many parties are competing in Britain’s ‘first past the post’ system, in which seats are won by a plurality, but not necessarily a majority in each constituency. 

Still, the most likely outcome is between two messy alliances. One would revoke Britain’s request to leave the European Union altogether. The other would press ahead with a Brexit agreement that looks more or less like the deal Theresa May negotiated. There might be a fresh referendum in there somewhere to help cement the prevailing parliamentary alliance. 

Either outcome would face a furious reaction from the other side, but the direction would be set, allowing the gradual adjustment in the economic relationship to take shape. Most important for investors, uncertainty would begin to fall.

U.K. GILTS AND POUND STERLING SINCE BREXIT VOTE

SOURCE: FACTSET, BLOOMBERG AS OF SEPTEMBER 12, 2019

If the “Remain” forces succeed, current commercial and legal arrangements will continue in force, although Britain’s role in Europe will drift to margins. Its EU partners will see little need to accommodate London’s concerns, especially if there is some chance that the Brexiteers find a second wind. Businesses, too, will continue to hedge bets and keep that second office in Frankfurt or Dublin, just in case. 

If new leaders can actually ink an exit deal with Brussels, the changes will likely be gradual. Even as a former member, however, there will be a lot of negotiating to retain access to what is still overwhelmingly Britain’s largest trading partner. (Europe accounts for 46% of Britain’s exports and 54% of its imports.)

And what if no one is reasonable and everyone miscalculates? There is, to be sure, a small chance of a “crash out.” But even then, both sides will scramble to manage the disruption.

It may bring a smile to the faces of continental Europeans who view Brexit as a betrayal, but their schadenfreude will be brief. While Europe hardly wants to reward Britain for choosing to leave, it doesn’t necessarily benefit from lost markets or clogged borders either. Already, German exports to Britain fell 21% between the first and second quarters of this year.

It’s not just the headline numbers of imports and exports. It’s the deep interdependence of commercial activity. German parts are sold to Britain to make cars that sell on the continent. European fishing vessels depend on access to British waters, but British fish start to turn if there are lengthy border delays on their way to Europe’s dinner tables. Nearly every business in both Britain and the European Union depends on the free flow of data, which will require them all to follow EU rules on privacy protection. 

To be sure, there are wild cards. A Labour alliance with the SNP might shift British economic policy sharply toward greater government control and higher taxes even as Scotland heads for independence. A narrow Tory victory could lead to both a disorderly exit and an inability to negotiate fresh terms of engagement. 

But these are truly long-odds scenarios, and calmer players will focus on the much higher probabilities of a Britain that is slightly on the outside or slightly on the inside, where commercial flows may be slightly more convoluted and rules a little more complicated.

Then, the question becomes how soon the more open and flexible U.K. economy can bounce back from this painful, self-inflicted detour.

Dr. Christopher Smart is Chief Global Strategist and Head of the Barings Investment Institute. The Barings Investment Institute conducts proprietary research to help Barings' investments teams make the most of the firm’s unique expertise in public and private markets around the world, while exploring the forces that shape long-term investment and capital decisions.

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