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Janus Henderson: Brexit - the end of the beginning

Paul O'Connor, Head of Janus Henderson's UK-based Multi-Asset Team, gives an update on Brexit negotiations between the UK and the European Union.

An important milestone on a long road

The good news on the Brexit front is that, after many days of political drama and uncertainty, the UK has reached an important agreement with the European Union (EU), clearing the way for negotiations to move onto the second phase. Talks about trade arrangements can now begin. The bad news is that, nine months into the two-year negotiations, political opinions in the UK on Brexit remain highly polarised and most of the hard decisions have yet to be made. An important milestone was passed last week, but the road ahead still looks long and difficult.

What was agreed?

Although much of the political commentary on last week’s agreement focused on the concessions made by the UK on the exit bill and citizens’ rights, it is the third topic: ‘the Northern Ireland question’ that touched the key issues that will really determine the long-term economic impact of Brexit. The written agreement on this subject last week was a convoluted text that remains open to interpretation. It was a pragmatic fudge. However, a few points of clarity did stand out:

The UK government guaranteed to avoid a hard border between Northern Ireland and the Republic of Ireland.
The UK committed to keeping Northern Ireland’s regulatory regime in “full alignment” with UK law.
The UK committed to ensuring that no new regulatory borders emerged between Northern Ireland and the rest of the UK.

Constructive ambiguity – incompatible objectives

The significance of these issues for the wider Brexit debate is that the UK government’s ability to deliver them will depend on the UK’s ultimate trading relations with the EU. The important point here is that the above objectives appear to be incompatible with the government’s previously stated desire of taking the UK out of the Customs Union and the Single Market. Something must give.

Some believe that this contradiction can be resolved by restricting regulatory alignment to only those sectors that are significant to Northern Ireland. That opinion requires faith in the idea that it would be politically feasible to keep some sectors in the Customs Union and the Single Market, while taking others out. Others believe that this will not be politically or practically possible and last week’s promises imply that the whole of the UK will now have to remain in the Customs Union and the Single Market. That would point to a very soft Brexit and one which would limit the ability of the UK to conduct third-country free-trade deals. Whether this is what the government really intends now, or is politically deliverable is open to some debate.

Looking ahead

A broader context here is that the Northern Ireland issue has moved the Brexit debate from unconstrained rhetoric towards the harsh realities of political and economic constraints and trade-offs. As we learned last week, the political imperative of retaining regulatory alignment between Northern Ireland and both the EU and the UK looks set to significantly limit the scope for UK regulatory divergence from the EU after Brexit. Further down the line, when discussions on the nature of future trade arrangements begin in earnest, economic constraints will come to the fore. That is when the UK will have to confront the difficult Brexit trade-off between regulatory freedom and free-trade access to the EU.

There is no doubt that the decisions to be made in the second phase of talks will be more difficult than in the first. Last week’s agreement was a positive step forward, but the most difficult decisions lie ahead and political tensions are likely to resurface at many stages on the road to Brexit. To contain simmering political tensions within both the Cabinet and the Conservative Party, the government is incentivised to defer the discussion of future free trade arrangements as far into the future as possible.

Before that, attention will turn to the talks on transition arrangements, which sources say will start in January, with a view to completion within a couple of months. The expectation now is that the transition phase will extend the current trading relationship for about two years from when the UK formally leaves the EU in March 2019. Nailing this down in the New Year would be greatly welcomed by the corporate sector and would build on the general perception that last week’s agreement has lowered the probability of ‘hard Brexit’ outcomes.

The market reaction to these recent developments has been fairly modest. Quite correctly, in our opinion, investors are uncertain about how to balance the positive progress made here with the longer-term challenges that lie ahead. The risks to sterling remain fairly balanced. We remain partly currency-hedged on foreign equity holdings in our multi-asset portfolios.

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