Stock markets too sanguine about Brexit

July 28, 2016

The author is a Reuters Breakingviews columnist.  The opinions expressed are his own.

Financial investors seem to think the UK will settle easily into a new deal with the European Union. More likely there will be cabinet wrangles, tortuous negotiations with the EU, and an unsatisfactory conclusion.

The pound has suffered since Britain voted to quit the EU, falling 12 percent against the dollar. But stock markets have regained their poise.

The FTSE 100 is up 8 percent meaning that, even in dollar terms, it isn’t down that much. Even the more domestically-focused FTSE250 index of mid-cap companies has pretty much recouped all its post-Brexit losses.

Although the UK economy grew 0.6 percent in the second quarter, more up-to-date indicators are worrying. Retail sales suffered their sharpest fall in sales in four years, the Confederation of British Industry says manufacturers are more pessimistic than at any time since 2009, and the purchasing managers’ index has fallen to its lowest since early 2009.

In other words, the views of the stock market and those of the real economy aren’t in synch. Businesses are probably more on the ball. Consider the following.

Theresa May will struggle to get her cabinet to agree to a common line on what Brexit means. Although the prime minister campaigned to stay in the EU, she won’t find it easy to get the government to line up behind so-called “soft Brexit” – a deal that would allow Britain to retain reasonably good access to the single market, which is responsible for almost half its trade.

The reason is that Brussels will almost certainly insist, as a quid pro quo, that the UK continues to allow EU citizens to settle freely in Britain. That is anathema to many “hard Brexiteers” – including the ministers May has chosen to lead the divorce process as well as many lawmakers from her Conservative Party and supporters in the country.

It’s not clear how the prime minister will resolve this division at the heart of her government. But it will probably take many months and lots of arguments before she thrashes out a common position.

That’s one reason why May won’t trigger Article 50 of the Lisbon Treaty, opening formal divorce negotiations, until next year. Another is that she also needs to consult far and wide – listening not just to parliament but also to Scotland and Northern Ireland, both of which voted to stay in the EU and could be destabilised by Brexit.

In the meantime, the prime minister will find it hard to get a clear steer from the EU over what sort of deal it is prepared to offer. Brussels has said there will be “no negotiation before notification” under Article 50, even if that doesn’t stop informal talks.

Some officials think May won’t be ready to press the Article 50 button until around March of next year. But even then negotiations won’t begin in earnest because France will be heading into presidential elections and Germany’s general election will follow after the summer break.

Given rising euroscepticism, neither government will want to offer Britain any concessions until after these votes. There’s not much May can do to hurry them along either. If she has taken time to set out her negotiating position, the EU could reasonably say it needs many months to figure out its response which, after all, needs to be coordinated among 27 different countries.

When the talks finally get serious, probably in the final quarter of 2017, May will face another problem. There are actually two separate processes: quitting the EU and agreeing a new trading deal.

Brussels is currently insisting that the first process, which is supposed to last two years, must be finished before the second can start. It may relent on that view. But even then, few experts think the new deal could be completed in two years.

So the UK would probably leave the EU in, say, 2019 without a long-term trade arrangement. If it then had to fall back on its membership of the World Trade Organization, which does virtually nothing to open up trade in services, the economy would be badly hit.

Admittedly, there might be alternatives. One is that Britain might be able to stay in the single market for several years after leaving the EU while it negotiated a new long-term deal. But it would be hard for May to secure such a deal and, even if she could, it wouldn’t be cost-free.

Meanwhile, the UK couldn’t just gallivant around the world cutting trade deals with other countries. Trade deals interact with one another in a complex cat’s cradle-like structure. So it makes sense for Britain to finalise its arrangements with its prime trade partner, the EU, before nailing down other smaller deals. That’s what the top US trade negotiator, Michael Froman, seems to have told the UK’s international trade minister, Liam Fox, this week.

As financial investors come to grips with all this complexity, they may start to become as pessimistic as real businesses.

(Hugo Dixon is chairman of InFacts, a journalistic enterprise arguing for strong relations between Britain and the EU.)

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