How to invest for Brexit – whatever the outcome

published 22 November 2018

So that's it. After more than two years of talks, Prime Minister Theresa May has finally agreed a draft withdrawal agreement with the European Union (EU). The UK is on its way out of the EU. Brexit is assured. Or is it? We look at concerns about the deal which stretches to 585 pages of impenetrable legalese in more detail in the box below, but in short, no-one is especially happy with it.

However, her chances of getting her withdrawal agreement through parliament in its present form appear non-existent she simply doesn't have the support (and that's assuming the EU even signs it off this Sunday, which is by no means assured, given that Spain wants more clarity on Gibraltar while several other countries want to discuss fishing rights). If the deal is knocked back when parliament votes on it in early December, there are basically four options left.

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Two of the options involve returning to the country for a second opinion. One is to hold another general election, the other is to hold a second referendum. Both are fraught with difficulty. They would take time to organise (not least agreeing the question for the referendum), and they would require the backing of MPs. The first point is probably surmountable. Under the terms of Article 50, the UK is set to leave the EU regardless of where negotiations are on 29 March next year. But while it would require the assent of all of the other 27 member states, the EU would probably agree to extend this deadline, as either a general election or a second referendum could result in Britain simply voting to "remain", which the EU would ultimately prefer.

However the second point is much tougher. For another general election to take place, two-thirds of MPs need to back it. That, as Samuel Tombs of Pantheon Economics notes, is a gamble that most Tory MPs will be unwilling to take, particularly as there's no obvious outcome in which they stand to gain anything. A second referendum might appeal if there is no sign of any sort of agreement in parliament, but it really would be a sign of weakness on the part of the government and of course, if the public voted anything other than "remain", then parliament would end up facing the same set of problems again.

So what does that leave? There are really only two options in the likely event of rejection. Either talks continue, or Britain leaves without agreeing a deal. Pantheon is optimistic on the first option, which amounts to a standard dollop of political face-saving EU fudge. "Ample time remains for the political balance to shift back in the prime minister's favour." So May is rejected, injecting a sense of artificial panic and urgency into the talks, helped perhaps by a panicky slide in sterling. In the end, perhaps after several Greek crisis-style "last-ditch" summits, she returns again from Brussels with "a superficially refreshed withdrawal agreement that enables some MPs to abandon their original opposition, or to switch to abstaining from the vote". As a result, "while the probability of a no-deal Brexit probably has risen it remains far from the most likely scenario". Vicky Redwood at Capital Economics, on the other hand, is less convinced, believing that "it is hard to see the EU giving further ground," particularly on the most contentious part of the deal, the "indefinite backstop" (see box on page 10).

So what happens if we can't agree, there's no extension to Article 50, and Britain leaves the EU with no deal on the table? There are a range of short-term scenarios, reckons Capital Economics (the long-term scenarios are almost impossible to calculate as they depend entirely on what direction future governments take upon leaving the EU). All would have some sort of "negative effect in the short term", but the scale depends on exactly how a "no deal" unfolds. At one end of the spectrum, you have an "orderly" Brexit in which relations between Britain and the EU "remain cordial" despite the lack of a formal trading agreement. As a result, you could have widespread co-operation on big administrative issues such as "aviation, custom checks and visas", with disruption kept to a minimum. In this case, "any short-term economic damage would be limited".

What if it's "disorderly"? This would probably result in "outright recession" and a hit to GDP of as much as 3%, reckons Capital Economics. The biggest hurdle in the short term is not so much trade tariffs, which average out at around 4%. The real issue is "non-tariff barriers including the administrative burden of customs controls". Even although only roughly 3% of non-EU trade is currently subject to documentary checks, and less than 1% to physical inspection, border checks would still take longer, which "could cause supply chains to collapse, production of some goods or services to be halted and confidence to plummet". Yet "any period of disruption would be short-lived". The weak pound would hit disposable incomes, but make British exports cheaper. Meanwhile, there would be official support the chancellor would increase public spending, and the Bank of England would likely cut interest rates (although don't expect it to admit that up front).

That said, "any rebound in economic growth would be more muted if the domestic political situation was still in turmoil, or if a Labour government had got in, introducing anti-business and tax-raising measures". If markets really believe that the UK is on the brink of a genuine crisis, then the obvious "tell" would be if sterling and gilts (UK government debt) both weaken at the same time. For now, the pound falls but gilt prices rise when a disorderly Brexit threatens, because gilts still benefit from the "flight to safety" drive. But if investors start to expect "a full-blown sterling crisis" that would force the Bank of England to raise interest rates, then "they would be as keen to ditch gilts as currency traders are to sell pounds". For now, "Britain's political crisis has yet to become a financial one". Could a Jeremy Corbyn government be the thing to tilt the balance? Possibly, but anything short of that seems to be within the market's capacity to cope with. One way or another, both Capital Economics and Pantheon reckon that "no deal" would send sterling down to somewhere between $1.12 and $1.20, although the question of how long it stays there would depend on how orderly or disorderly the deal was.

If a deal is done, sterling will almost certainly rally, potentially quite vigorously. That would normally be bad news for UK stocks, but given that surveys suggest that fund managers are extremely "underweight" UK assets right now, they would probably return once the uncertainty has passed. Domestically-focused stocks would probably do particularly well, whereas dollar earners might struggle as the pound rallied. But even in the case of "no deal", the reality is that British stocks look cheap. As Jim Wood-Smith of Hawksmoor Investment Management points out, "UK assets (or shares) are already effectively on sale'. A small number of valuations are verging on the ludicrous 5% dividend yields are now commonplace, while there are several shares where we believe the dividend is safe and the yield is 7% or more."

However, we really are at the point where you're being paid handsomely to wait. The FTSE All-Share, according to Bloomberg, is now trading on a dividend yield of around 4.4%, which is getting on for the highest it's been since the financial crisis. One investment trust worth looking at in this respect is the contrarian-minded Temple Bar Investment Trust (LSE: TMPL), with big holdings in the (still widely detested) UK banks, which trades on a discount of around 5%. On the smaller-cap side, one interesting option is Montanaro UK Smaller Companies investment trust (LSE: MTU) which trades on a discount of nearly 12% and currently yields 5.1% (paid out of capital). Top holdings include Entertainment One and Hilton Food.

By far the most contentious aspect of the withdrawal agreement are the arrangements for deciding on a future relationship with the EU. This hinges around the border between Northern Ireland and Ireland. If Britain and the EU can't agree on a trade relationship within the "transition period" (likely by the end of 2022), the "backstop" kicks in. This prevents a "hard" customs border by aligning Northern Ireland with the EU single market, and keeping the rest of the UK within the customs union. What worries some is that this might end up being a permanent state of affairs, as both the EU and the UK have to agree on it ending, and the UK cannot unilaterally walk away.

MoneyWeek backed Brexit mainly to prevent further moves towards ever-closer union. We want to maintain our trade links with the EU (we like free trade) and have no major qualms about freedom of movement so we are far from "hard" Brexiteers. Yet the risk here seems to be that the UK could possibly be locked into a disadvantageous, ongoing Brexit process indefinitely. Hopefully, there will be more definitive clarity on this before the Commons vote but if it is indeed the case, it's clearly not an acceptable deal.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.