March 2017

Now that UK Prime Minister Theresa May has signed the letter that begins Britain’s exit from the European Union, the two-year countdown begins. Do the risks obscure opportunities? And is there really enough time? Oliver Harvey and Mark Wall share their perspective.

Brexit is the most important political event for the UK since the Second World War, and will shape the UK economy for generations. In The Deutsche Bank Guide to Brexit, we provide a comprehensive guide for investors for the months and years ahead. The report is structured around 44 of the most important questions concerning the Brexit process.

Stop all the clocks

More than the economics, or even the politics, time will be the decisive factor in negotiations. Article 50 of the Lisbon Treaty was designed so no member state would contemplate triggering it. According to the EU Commission, an agreement will need to be concluded by October 2018, in just over eighteen months’ time.

The real timeframe will be shorter. Negotiations may not begin in earnest until after the French elections in June and important decisions deferred until after the next German government is formed in late autumn. Agreeing a wide-reaching new relationship in an eighth of the time it took to conclude the recent free trade agreement between Canada and the EU is highly optimistic. This is particularly true as EU attention will be taken up with the future direction of the European project.

Interim or out

This means two things. First, a transitional arrangement is needed to buy more time. This is not the same as the implementation period currently suggested by the UK government. Second, this will need to be simple and largely off-the-shelf, not a complex agreement containing multiple carve-outs and much negotiation.

A transitional deal still raises a number of questions. Can it be incorporated into the UK’s divorce agreement with the EU27? If so, what will be its legal basis as EU law ceases to apply? Will a deal need to be signed off by national parliaments or just a majority in the EU Council? The closer we get to March 2019, the more the details of international and EU law will matter.

Politically challenged

Negotiations will be conducted against a highly unstable political backdrop. In the UK, PM May must appease Eurosceptic MPs who see limited risks from a clean break, or underweight them relative to demands for sovereignty. With the smallest parliamentary majority since the mid-1970s, there will be plenty of opportunities for rebellious MPs to undermine talks. A snap general election this year would result in a larger government majority and be bullish for the eventual outcome.

For the EU27, the UK cannot retain the benefits and spurn the obligations of EU membership without undermining the European project. While the EU Council will initially present a united front, national differences are likely to emerge as talks progress, leaving the UK to negotiate with a moving target.

Forget global Britain; focus on the EU

A sudden exit from the customs union is the largest immediate risk for the UK and EU27, and would be very damaging for businesses that rely on frictionless cross-border trade. A transitional agreement is achievable given a common starting point and because the customs union is not intimately bound to the Single Market. But this will be binary: a sector-by-sector deal is not unachievable.

London’s role as Europe’s banker will diminish over time due to the differing regulatory priorities of the UK and EU27 and the reluctance of Eurozone authorities to tolerate an offshore financial centre with no political oversight. Short term, though, a transitional deal should maintain equivalence between the UK and EU27 to allow the financial industry more time to plan and adapt.

Neither access to the customs union nor equivalence for financial services will be of any comfort to other service industries. Single Market access is important to the legal, digital and airline sectors, among many others. A deal on services will require a mixed agreement from the EU27, meaning a transitional deal will be very difficult unless the UK pursues the EEA option.

The merits of WTO rules where the UK is free to conclude new trade deals with the rest of the world are overegged. The UK would need to rip up vast swathes of its existing regulatory architecture and still faces structural headwinds in negotiating new trade deals, such as its low share of global imports and the secular decline in world trade since the crisis. The UK should concentrate on securing a favourable deal with the EU first before devoting much energy to free trade deals elsewhere.

No such thing as a free Brexit

Ultimately, any transitional deal will have to involve UK compromises, including some form of contribution to the EU budget, pooling of sovereignty, and limited checks on EU migration. The alternative is that the UK pays through lower trade and economic disruption.

The vote for Brexit was one against globalisation. Yet, the UK will need to become more competitive to adapt to life outside the EU, particularly if a more restrictive migration policy sees demographics deteriorate. Resolving this will be the hardest challenge for UK politicians. An industrial strategy may be the answer. But so far, proposals are not ambitious enough.

Bears here to stay

For markets, sterling will continue to be the main shock-absorber for the Brexit talks. It is likely that the market prepares for a hard Brexit (no transitional deal) at some point in the next two years, even if the ultimate outcome is positive. This is not yet fully priced, and we remain bearish. The outlook for other assets is more nuanced.

Main exit risks

After Article 50 is triggered, sequencing is the key that opens all doors to Brexit. The current timeframe to conclude negotiations is unrealistic particularly if the deal requires ratification from all EU national parliaments (a mixed agreement). The UK and EU27 must find a way to conclude a transitional deal without a lengthy sign-off process or the UK will drop out of the EU in March 2019 with no deal.
A transitional deal will be tricky but not impossible. Turkey shows the customs union is not intimately bound to the Single Market. The EEA Treaty might also provide a template. But the UK will have to accept budget contributions, pooling of sovereignty and compromise on freedom of movement.

Politics

Politics is the main risk. Behind the bluster, Secretary of State Davis has struck a more moderate tone in parliamentary testimony. But we are concerned the current strategy for a broad-based trade deal by 2019 risks jeopardising the chances of a transitional agreement. The government’s wafer-thin majority in parliament has also yet to be resolved. Eurosceptic Conservative MPs and the right-wing UK press will push for a clean break, constraining Prime Minister May’s ability to compromise. An early general election would dilute their influence.

Politics will be equally problematic for the EU27. With populism increasingly felt across the continent, the EU must take account of the threat a successful Brexit would present of the European project. The differing national interests of EU27 states will be a theme of talks. Most importantly, Brexit negotiations are just one of several competing priorities for the EU over the next two years.

Economics

Economically, the UK must prevent a sudden exit from the customs union in March 2019 or risk seeing huge disruption to existing business models. It is also in the UK and EU’s interest to seek short-term regulatory equivalence for financial services, but this will be unsustainable long term due to regulatory divergence and the risks the City would pose for the Eurozone. The future for other service industries, making up over thirty percent of UK exports, looks bleak unless an EEA approach is pursued.

The UK’s ability to conduct third-country free trade deals is at best a red-herring and at worst a waste of time and energy. They will face political, technical and structural headwinds. The primary focus of the negotiations must be to conclude a deal with the EU. Only once this is achieved should attention be turned to the rest of the world.

UK economic growth following last year’s referendum confounded pessimistic forecasts, but is unlikely to continue. There is growing evidence of the real income shock. The Bank of England seems to feel under pressure from rising inflation and robust growth to hike rates, but with little evidence of rising wages, caution on monetary policy is likely to prevail in the near term.

Medium-term, the success of a post-Brexit UK will rest on the industrial strategy. This is particularly true if net migration begins to fall, weakening demographics. The strategy should maximise the UK’s strengths in high-tech manufacturing and education, but is not yet ambitious enough.

The market should hope for the best but plan for the worst. Time constraints, the scale and complexity of talks and the threat that a soft deal represents to EU means the UK faces an uphill battle to avoid a hard outcome. The political difficulties only look resolvable with an early UK general election. Our base case is that the UK will eventually compromise, but this will depend on a weakening economy and market pressure, with a full cliff-edge Brexit likely to be fully priced at some point in the next two years.

Note: Oliver Harvey tells CNBC on 28 March 2017, “the average time to negotiate a free trade deal globally is 28 months”.

The authors’ full Brexit analysis can be found in The Deutsche Bank Guide to Brexit (which includes a useful summary diagram)

Mark Wall

Chief Economist at Deutsche Bank

Mar Wall

Oliver Harvey

UK Macro Strategist at Deutsche Bank

Oliver Harvey

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