Hard Brexit: 3 Ways Brexit Affects The U.K.

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Summary

Investing 101: Uncertainty breeds risk.

A Brexit-induced fall in FDI could cause a 3.4% decline in real income, or about £2,200 of GDP per household.

While weaker sterling has improved the export market, imports play a bigger role in the UK economy.

On June 23, the UK voted by a margin of 52 to 48% to leave the European Union. If you're interested in why the UK decided to leave, some history between the UK and the EU, and the implications of the split, I've written a high-level overview of the entire situation here under Skinny Specials. The focus in this article will be how Brexit has affected investors and what investors can expect for the future of the British Sterling.

The effects of Brexit have not reverberated throughout the UK as violently as many economist initially thought, although banks and the British Sterling have been hit pretty hard.

Source: Financial Times

Since the vote, the Sterling has fallen sharply. Last week, on October 4th, the currency fell to its lowest level against the US dollar in 31 years. While there is a conspiracy that the cause was a form of high-level trading manipulation, the consensus is that investors are selling due to the lack of transparency and predictability of Britain's future trade relationships. We'll discuss this more later.

"Hard" Brexit

A "hard" Brexit could be compared similarly to that of an airplane making a hard landing, except the difference in these two situations is the uncertainty in the result of the former. Hard Brexit means rejecting becoming a part of the European Economic Area, also known as the Norway-based relationship. The issue with this transition is that the UK will still be bound to make its annual, multibillion-pound payment to Brussels and still be subjected to EU laws. Of these laws includes the four freedoms: freedom of movement for goods, services, capital and labor. New Prime Minister Theresa May has made it very clear that she fully intends to put immigration at the forefront of negotiations. In her keynote speech at the Tory party conference, she said the following:

I want it to involve free trade, in goods and services. I want it to give British companies the maximum freedom to trade with and operate within the Single Market - and let European businesses do the same here. But let's state one thing loud and clear: we are not leaving the EU only to give up control of immigration all over again. And we are not leaving only to return to the jurisdiction of the European Court of Justice. That's not going to happen. We are leaving to become, once more, a fully sovereign and independent country - and the deal is going to have to work for Britain.

There are two ends of the spectrum when it comes to how these negotiations could be structured. The Norway-based, which was described above, and the World Trade Organization relationship. A WTO relationship would allow London to have complete control over its immigration policies, an issue PM May fervently emphasizes, but will seriously hinder trade and jobs. Under this scenario, the UK could find themselves, as President Obama put it, in the back of the queue. Piecemeal trade agreements, as opposed to access to one, singular market, creates vast inefficiencies and will undoubtedly increase costs for buyers. Where these negotiations will lead remain up for debate and may not be answered for quite some time. Whenever PM May triggers Article 50, the country has 2 years to get 27 parliaments to agree to terms of an exit. So what does this mean for the economy?

1) Rampant Uncertainty

The European Union is the UK's largest trade partner. Around half of the UK's trade is with the EU, and it is a mutually-beneficial relationship. The membership with the EU reduces trading costs between both Britain and the EU, which ultimately corresponds to cheaper goods and services for consumers. The uncertainty in how the UK and EU's trading dynamic will be structured post-Brexit is fueling rampant speculation and has been attributed to the large drop in Sterling's value. All things equal, the UK 's trading with the EU will drop significantly due to higher tariff and non-tariff barriers. The main benefit, though, is reduced fiscal contributions to the EU's budget. Between 2010 and 2015, the UK contributed on average £8.8 billion, net of rebates. The Centre for Economic Performance estimates that by reducing trade, UK's living standards will drop significantly. After accounting for fiscal savings, the effect of Brexit is estimated to decrease household income between 1.3% to 2.6%. In addition, it is projected that Brexit could reduce national income by between 6.3% and 9.5%.

2) Lower Trade & Foreign Direct Investment

Trade is an essential component of any economy, and the UK is no exception. The UK imports more than it exports, so although the decrease in Sterling provides for a more competitive and lucrative export market, weaker imports have an exacerbating effect. According to August trade data, the UK's trade deficit widened to £4.7 billion in August, compared to £2.2 in July.

According to the government body UK Trade and Investment, the UK is the top destination for foreign direct investment when measured against the number of successful foreign investment projects. The UK is also the leader in Europe when measured by the value of FDI project (as shown in the chart above). A look at bilateral FDI flows across all 34 Organization for Economic Co-operation and Development (OECD) countries over the last 30 years shows that being in the EU increases FDI by around 28%.

Click to enlarge

The chart above depicts the total projected impact on the UK's GDP post-Brexit under a free-trade agreement scenario and a World Trade Organization scenario. In each, investment is the most affected by a large margin due to the increase in credit risk over the short-term, and in the long-term is expected to be negatively affected due to trade barriers and border costs.

According to research at the London School of Economics, conservative estimates of the impact of Brexit would be a 22% fall in FDI over the next decade. It was calculated that a Brexit-induced fall in FDI could cause a 3.4% decline in real income, or about £2,200 of GDP per household. The catalysts behind the fall in FDI are not complex. It still revolves around the predictability of risk, and the future state of trade arrangements for the UK is still largely undecided and will tentatively remain so for at least the next two years. In addition, multi-national corporations are unlikely to commit large-scale investment expenditures in an less profitable environment. Many companies within the UK used the EU's single market trading platform as leverage in its business dealings, as they were not exposed to substantial costs driven by tariff and non-tariff barriers. This may no longer be the case.

3) Battered Sterling

The falling of the British Pound is a direct result from the uncertainty surrounding the economic impact of Brexit. Couple that with the high probability of a hard Brexit, as indicated by PM May, and it creates a bad situation for Sterling. However, there is a silver lining in the storm.

Click to enlarge

On Tuesday, Britain's top stock market index, the FTSE 100 (UKX), hit a record high due to the belief that its member companies will benefit from the Pound's tanking in currency markets. But make no mistake, the catalyst behind the increase in value of the FTSE 100 is due to the weakness of the pound, not organic strength. Neil Wilson, markets analyst at ETX Capital said:

Brexiters might point to the FTSE's rise as a sign of strength but this is very much a story of (pound) weakness boosting foreign earnings, which accounts for around two-thirds to three-quarters of FTSE 100 company revenues.

The decline in value of the pound will certainly have a drastic impact on consumers' and businesses' spending abroad, especially in the import market; however, UK firms that have developed business ventures outsides of the UK are projected to benefit from the decline in value. Simply put, when these firms make money abroad, it will be worth more when it is circulated back in to the UK, due to the Pound's relative weakness. Most notably, exporters' demand has increased significantly due to their goods becoming more cost competitive. In contrast, you can expect UK firms that rely heavily on imports, such as retailers and manufactures that purchase raw materials overseas, to see a substantial increase in costs and decrease in profits.

As with most securities, it takes a meaningful event to move its price in one direction or the other, and it appears there may be one event lurking around the corner. In the Federal Reserve's September minutes, the Feds indicated that "several members" have official plans to raise interest rates "relatively soon." This will have an adverse effect on price of Sterling, as the dollar's relative strength will increase. But, undoubtedly, the biggest mover of Sterling will be determined by how the UK structures the negotiations out of the EU. And no one knows definitvely where that will land. There are many projections for the direction of Sterling for both the short and long-term, but every projection hinges on the outcome of Brexit. I'll leave you with a quote from Mark Twain: "There are two times in a man's life when he should not speculate: when he can't afford it and when he can."

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.