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I have pretty much been ignoring Brexit over the past several weeks, apart from noting it as a risk factor. The reason was that there was no way to predict what could happen—and there were so many options that trying to analyze any one of them was, in the end, pointless.
That scenario is still true, to a large extent. But we are approaching a break point where we might actually see some narrowing of the paths forward. So, it now makes sense to think about what the possibilities might be and what they could mean for our investments.
The hard Brexit
There are really two possible outcomes. First, the U.K. crashes out of the EU without any agreement at all. This is known as a hard Brexit. No one wants this outcome, as the economic damage would be real. This option has been voted down in the U.K. Parliament several times, so the U.K. doesn’t want it. Further, the EU has been remarkably patient and flexible in trying to avoid the hard Brexit, offering several extensions to try to come to a deal.
Because of those efforts, markets have largely discounted the possibility of a hard Brexit. It could still happen, of course. But there seems to be an emerging consensus that this path must be avoided. Most recently, British Prime Minister Theresa May reached out to the opposition there (the Labour Party) to try to craft a deal. This move is something that historically happens only in major national crises (like World War II). I suspect a deal will indeed be cut, although the internal U.K. political damage may only be starting at that point.
A compromise
This brings us to the second outcome—a deal that lets Britain leave the EU and still maintain trade agreements. This option would avoid much of the economic turmoil, would let the U.K. retake much of the political independence sacrificed to EU membership, and would be a reasonable middle ground. This outcome seems to be what markets are betting on and reasonably so, as various versions of this deal seem to have the most parliamentary support.
We, therefore, have an outline of a choice: a full break or a negotiated compromise. That is the current battle being fought in London, and it gives us a framework to evaluate what it means for our investments. Although there are a great many details I am passing over, from here in the U.S., this is what matters.
A negotiated settlement will very likely mean a continuation of the status quo from an international perspective. Although there will be ongoing problems for the U.K. economy, the global effects will be minor. As an investor, if we get a compromise deal, I would expect the U.K. to underperform going forward, while Europe would not be much affected. This seems to be just what markets are pricing in. Stay calm and carry on.
The real question, then, is what happens if a hard Brexit does happen? How will we know, and what should we do?
Watch the EU
First, look for the EU to lose patience. The initial deadline was March 29, which was then extended to April 12. If the U.K. Parliament passes the current deal, there is the potential for a longer extension to May 22. Of course, there may be even more extensions beyond that. Again, I am eliding many details here. The U.K. also has some options for internal actions, such as a general election, but these would fall under the “more extensions” category above. As of right now, the EU seems to be willing to accommodate the U.K. process. When that changes, the chances of a hard Brexit will rise dramatically. Watch the EU.
Localized damage
So, what can we do if the EU loses patience, leading to a hard Brexit? From an economic perspective, there is little need to do anything, at least here in the U.S. There will certainly be economic damage in the U.K. and, to some extent, in the EU. But a damaging hard Brexit would likely clear the decks for more meaningful negotiation. All parties have real reasons to go back to the table. So, the damage would likely be limited, and it might actually be easier to get to a deal after a hard Brexit.
Similarly, for markets, there will be an initial shock—but many affected companies have already started with contingency plans. If a hard Brexit happens—although it is not what markets now expect—it has certainly been considered and gamed through. Given that economic damage would be localized and limited, the effect on world markets would also be limited and likely short lived.
More smoke than fire?
Brexit has generated an extraordinary amount of headlines. But at the end of the day, it will likely be more smoke than fire. That said, we do need to watch the politics. Like any political event, the economic impact is likely to be smaller and quicker than expected—and easier to reverse. Britain is slowly coming to terms with what it wants, which is likely a customs union, and the EU has shown patience in allowing it to get there. Watch that patience.
