Seeing Through Politicians’ Spin on Brexit Phase One

(Insert bad metaphor about the deal being a bridge to the next round of Brexit talks here.) Photo by Elisabeth Dellinger.

It is a truth universally acknowledged that two parties negotiating before arbitrary self-imposed deadlines will kick the can when said deadline arrives. To blatantly mix Jane Austen metaphors, you might call it good sense as well as sensibility. So naturally, one day after the US House and Senate kicked the can on a government shutdown for two weeks, the UK and EU kicked the can on Brexit. Of course, that isn’t how either side describes it. No, no, this is a major breakthrough on Brexit Phase One! Call the Queen! Alert the corgis! Pip pip! But once you see through their marketing spin and break down the deal, two things remain apparent: Not much has changed, and Brexit remains a glacial process with little to no ability to surprise markets for good or ill. We believe it is mostly a part of Britain and the EU’s long-term structural backdrop, not a reason for investors to be bearish or bullish today.

To understand how we got here, see Exhibit 1.

Exhibit 1: The Brexit Timeline Everyone Is Trying to Stick To

Source: Various EU memoranda.

Once an EU member-state invokes Article 50 of the EU Treaty, it launches a two-year exit process. Within those two years, the departing nation and EU must negotiate exit terms, which all member-states must ratify for the agreement to take effect. Presuming that happens, voila, Splitsville is official.

This is much easier said than done. As with any long marriage that ends, it is complicated. For one, there is the money: The UK already committed to the EU budget through 2020, and its EU pension commitments stretch decades beyond that. Then there is the matter of EU citizens living in Britain (and UK expats living in the EU): Can they stay? What are their rights? Will EU laws protect Europeans in Britain? Whose courts have jurisdiction? Oh, and then there is the not-so-trivial matter of the border. While most everyone short-hands “UK” as “Britain,” it is actually the United Kingdom of Great Britain and Northern Ireland. The latter, of course, shares a border with the Republic of Ireland, which is in the EU. But it is a “soft border,” with free movement of humans and grazing cattle. Many people live on one side and work on the other. This is one of the crowning achievements of the 1990s’ Good Friday accords, which brought peace to Northern Ireland. Ending free movement would bring back terrible memories of the Troubles.

With the exception of the Irish border, which impacts trade, Phase One is full of sociological issues—not economic. But because they were preconditions for beginning Phase Two, which centers on post-Brexit trade talks, investors cared about them. When Phase One talks seemingly collapsed earlier this week over the Irish border issue, many thought it was a big deal. Now the resolution has everyone chattering, trying to figure out whether it improves the UK’s chances of getting a “good” trade deal, whatever that means.

In our view, it doesn’t make them better or worse. Rather, it shows both sides are dedicated to maintaining the pretense of following a timeline. They’d already penciled in the December 15 EU summit as the Phase One ratification date, and if they didn’t meet it and get on to Phase Two, to say politicians would face a backlash probably understates it. We suspect this is why they are now touting an agreement that, near as we can tell, doesn’t really address the more difficult issues.

Claim: The UK and EU agreed on a £39 billion “divorce bill,” which refers to how much the UK will pay into the EU budget after Brexit.

Reality: That £39 billion comes from “conservative” estimates of expected future payments, which the EU let Britain use when presenting the agreement to citizens. EU officials’ estimates peg it closer to £60 billion. In other words, the true divorce bill remains TBD. But considering EU commitments were already built into the Her Majesty’s long-term spending plans, nothing here is really a surprise or make-or-break for UK public finances. They agreed to pay something, but that was already a foregone conclusion.

Claim: The European Court of Justice won’t have jurisdiction in the UK.

Reality: When deciding cases relating to EU nationals living in Britain, UK courts must defer to the European courts’ precedents and legal interpretations. For the first eight years, UK courts can voluntarily refer cases to the European court. In other words, expect plenty of grousing about sovereignty.

Claim: EU citizens living in Britain can get permanent residency status, preserving access to benefits, while UK nationals living in EU states will have similar rights.

Reality: Pretty much as advertised.

Claim: No hard border between the UK and Ireland, with full regulatory “alignment” between Northern Ireland and the EU and no internal borders within the UK.

Reality: Just a bunch of loose promises on both sides, with no practical details. They basically punted the issue as an item to address for real in Phase Two. Britain promised to present “specific solutions to address the unique circumstances of the island of Ireland.” The EU’s chief negotiator, Michel Barnier, said, “No one should underestimate the issues that we will face on this issue.”

In our view, it all amounts to a largely empty “hey, look, we did it!” for the sole purposes of ticking a box and going on to the next round. Which is totally fine. That’s how the eurozone got through its debt crisis, and it is what politicians do. But it doesn’t change anything about Brexit overall. Questions still abound. Talks will still be tense. Everyone will quibble over the meaning of “alignment.” Rumors and leaks will still roil observers on both sides, sending lobbyists into overdrive. The EU is already warning divisions within Theresa May’s cabinet could delay the start of Phase Two. If her government is as fragile as most presume, we could have an entirely different cast of characters negotiating this thing by the end. Oh, and the end isn’t really the end. All involved are still largely in favor of a post-Brexit “transition period,” which would let the actual Brexit phase in slowly. May envisions a two-year period, but EU leaders are thinking it will stretch to 2025, with the final accord not signed and ratified until then.

2025 is seven years and change away. For markets, this is a long time! Stocks usually look about 3 – 30 months ahead. Seven-plus years is far outside that realm. For the foreseeable future, it looks increasingly likely that the rules of doing business won’t change much. Changes taking place afterward should be well-known long beforehand, giving markets ample time to adapt. There is very little room for sudden, sweeping change to take place the day after people discover it, and surprises are what move stocks most.

Overall, we see Brexit similarly to the eurozone’s efforts to complete the currency union after the debt crisis: structural issues that fade into the background with time. Everyone knows they exist, with the potential to bring change years down the line. Sometimes they create uncertainty, which can weigh on sentiment. But they haven’t prevented economic expansion or a bull market. Eventually, it can lower sentiment further than fundamentals warrant, making positive surprise—and outperformance—more likely. So it was with the eurozone this year. Brexit can be the same.

While the ultimate exit may carry consequences for stocks (depending on the specifics), in the near term, Brexit matters mostly for its influence on sentiment. Continued dread of a “hard Brexit” that chokes off UK/EU trade, coupled with fear that every seemingly weak economic data release is a result of Brexit, has baked Brexit jitters into UK stock prices. In our view, that sets up plenty of room for reality to surprise positively. How the media and investors treat Brexit from here will be one sign of how sentiment is evolving in the UK. But that’s about the extent of Brexit’s near-term stock market relevance.