Brexit - It's Happening

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By Seema Shah, Global Investment Strategist, Principal Global Investors

In a recent blog post, "Brexit: Out of Sight, Out of Mind…. But Not Out of the Woods," I discussed how the UK economy seemed to have shrugged off the inconceivable decision for Britain to leave the European Union. I noted that the key reason why markets seemed so positive was that many investors were clinging on to the belief that Article 50 would never be triggered and the UK Parliament (along with the rest of the European governments) was still on its summer recess, so Brexit-related news flow was patchy at best.

Fast forward one month: the UK Government is back in Parliament, the UK Conservative Party conference has taken place and…. pound sterling has fallen from US$1.34 on September 6 to US$1.26 on October 6.

What's happened? Firstly Prime Minister Theresa May destroyed the hope of many investors by announcing that the Article 50 notification will be made before the end of March 2017, starting the two-year countdown for officially leaving the European Union (EU).

Translation: Brexit is happening.

Second, PM May said in her opening speech of the Conservative Party conference: "It is not, therefore, a negotiation to establish a relationship anything like the one we have had for the last forty years or more. So it is not going to a 'Norway model.' It's not going to be a 'Switzerland model.' It is going to be an agreement between an independent, sovereign United Kingdom and the European Union."

Here's what that means: Norway has full access to the internal market in return for the free movement of people from EU countries and a contribution to the EU budget. Switzerland is not a member of the European Economic Area, but instead has a series of bilateral agreements with the EU in return for the free movement of people from EU countries and a (smaller) contribution to the EU budget. PM May has now made clear that Britain will follow neither of these models.

In a speech last week, Liam Fox, the Secretary of State for International Trade, went even further, indicating that he sees Britain out of the single market, operating under World Trade Organization (WTO) rules and trying to negotiate free trade deals globally. So, if "soft Brexit" means remaining a member of the European Economic area, the latest Conservative Party speeches suggest that we are heading for a "hard Brexit."

In that scenario, the UK would face a major economic shock, with serious consequences for companies, consumers, jobs and prices. Under WTO rules, neither the UK nor the EU could offer each other better market access than that offered to all other WTO members. The UK's privileged access to 53 markets outside the EU through the EU's Free Trade Agreements would be terminated. The UK would, of course, seek new agreements, but that would take years - a similar trade deal between the EU and Canada has been under preparation for seven years.

There would be a prolonged period of uncertainty, a dangerous prospect for UK manufacturing. The car industry, in particular, would suffer. Already Nissan's chief executive, Carlos Ghosn, has said that Nissan will delay investment decisions for its plant in Sunderland (north-east England) until it has certainty. UK services also face an extremely tough ride - an approach based on a Free Trade Agreement would mean UK companies had reduced access to Europe's single market in key sectors such as services, which account for almost 80% of the UK economy.

The pound has already fallen from US$1.50 in June, before the Brexit vote. I expect it to continue weakening: US$1.20 is certainly in sight now. While this will provide a welcome boost to the economy, it will not be enough to counteract the pain of losing access to the biggest single market in the world. And while the UK economy may be slow to realise the pain it's about to undergo, markets are likely to catch on far sooner. A slow, unrelenting decline is what I fear for Britain now.