Brexit At The Crossroads

Summary

• Friday's qualified EU-UK agreement allows the EC to recommend at next week's EC council meeting to begin the next phase of Brexit talks early next year.
• The divorce round saw agreement on financial obligations structured over time and the guarantee of respective citizens' rights.
• The Irish border question opened up a prickly divide between the parties with all the potential of scuttling the future talks. Few details emerged on future border operations.
• Markets continue to apply downward pressure on British assets as current prices reflect a hard Brexit conclusion.

The ebb and flow of the Brexit negotiations continues to place analysts in a fiendishly difficult position as forward projections of sterling rallies or slides appear to gyrate almost in lockstep with the talk’s musical offering on any given day. A successful conclusion to the so-called divorce round would expect to see the pound start the process of emerging from its deep freeze since the referendum vote. And in the wee hours of Friday morning (8 Dec) we did see an agreement of sorts emerge as the pound delivered a 0.23% gain by mid-day, only to pull back by 0.82% by the market close (see Figure 1, below). Yet we saw a similar performance earlier in the week when Prime Minister Theresa May presented what was supposed to be the UK’s closing touches on the divorce round, only to be countermanded by the Democratic Unionist Party (DUP), the die-hard defenders of the Ulster protestant cause, who now just happens to provide the May government its razor-thin Westminster majority. The DUP opposes any solution for Northern Ireland that reduces British jurisdiction over the area. The pound staged a hasty retreat from a high of just over $1.36 to below $1.34 while the interest sensitive 2-year gilt crashed from a high of 0.567%—its highest post since June 2016—to just a hair above the Bank of England (BOE)'s new base lending rate of 0.5% at 0.51% at Friday’s market close (8 Dec). The yield on the 10-year gilt bounced about again before settling at just short of 1.28%—just short of its high reached in late November. Of course a failure to advance the Brexit process to the next stage, one would have expected to see the pound slide deeper into oblivion in search of a new trading floor, plunging British politics—not to mention its economy—into unprecedented doldrums of uncertainty.

Those are the extremes. The middle game appears equally dicey. Here we juxtapose the Elizabethan longings of hard-and-true Brexiters with the lawyerly calculations of a 21^st century rule-based EU leviathan. Given the dichotomy of views and the political realities on both side of the Channel, will either the EU or the UK even be able to deliver a bespoke trade agreement?

Figure 1: British Sterling (FXB) and the 10-year Gilt since the Referendum

Brexit supporters often point favorably to the performance of UK stocks in sterling terms. This year, if you compare the FTSE 100 (green line, Figure 2 below) with that of the Italian FTSE Milan (red line), the S&P 500 (purple line) and the German DAX (brown line) over the course of the year, a rather different picture emerges. Markets have inflicted an outsized hurt on UK assets since the June 2016 Brexit referendum, with the pound assuming much of the beating since the vote (see Figure 1, above). A falling pound has placed strong and sustained upward pressure on prices of sterling-denominated goods and services across the economy. Domestic energy prices, priced in dollars, have soared. Overall, the consumer price index was 3% through the end of October YOY, unchanged from September but well above the BOE’s 2% target and the highest post since March 2012. The inflation rate for food and non-alcoholic beverages reached 4.1% during the month YOY, the highest post since September 2013. The upward projection of prices has naturally caught the attention of BOE policy makers who rolled out their first 25 basis point rate increase in a decade on the 2^nd of November. Current prices on market and UK assets, continue to signal a hard Brexit.

Figure 2: The FTSE 100, the FTSE Milan, the S&P 500 and the DAX

After six months of negotiations, the Brexit talks have entered yet another critical phase. The pecuniary and citizenry rights issues of the divorce proceedings appear to have a satisfactory starting base of operations. Brussels surprisingly relented on its early demand for the European Court of Justice (ECJ) to have jurisdiction over EU nationals living in Britain. That said, the primacy of ECJ interpretation of EU citizens' rights laws will continue with UK courts obliged to pay due regard to EU case law. This ensures that the ECJ will be the final arbiter of EU law. While British referrals to the ECJ will end in eight years’ time, due regard will last indefinitely. On the monetary side, the UK will pay into the EU budget for 2019 and 2020 as if still a member of the bloc. The final monetary settlement, however, will be structured over the course of time, minimizing upfront outlays—a big win for the UK. The final estimate is placed in the neighborhood of €40 billion to €45 billion. No remaining member state will pay more into the EU budget or receive less benefit from EU programs on account of a successful Brexit agreement, according to EU lead Brexit negotiator Michel Barnier--which means the cumulative UK tab will likely drift higher.

Yet the political divide amongst Brexiters and cabinet officials remains as wide as it is deep. Pro-Europeans like Chancellor of the Exchequer Philip Hammond and home secretary Amber Rudd want maximum UK access to the single market. The position necessarily implies the UK staying in both the customs union and the single market--red lines both for die-in-the-wool Brexiters. Foreign secretary, Boris Johnson, the environment secretary Michael Gove and the international trade secretary Liam Fox all have been vociferous proponents of a clean and decisive break with the EU. This position will set into place a friction-prone free trade agreement—at best—with the EU on a mere 20% of British annual output. Theresa May often appears to straddle both camps. The May government has already survived one palace coup attempt. This week’s tiff with the DUP over Ireland serves notice as to just how weak and dependent the May government is and just how easily the current political structure could spiral into utter chaos. The push and pull of these disparate forces within and without of government flies in the face of a united British front in the negotiations to date. The May government is widely assumed on both sides of the Channel to be one mishap away from implosion--a rather disingenuous negotiating position to occupy.

Theresa May’s Florence speech in September outlined in painstaking detail a plan to forge a separate but equal UK regulatory alignment with existing EU trade policies and standards. To EU ears, such highfalutin stylistic gymnastics simply muddies the waters and numbs the senses. If the UK want full access to the single market, it needs to follow existing EU rules and jurisdictions—plain and simple. It was Britain’s decision to leave the EU. It will be the EU’s decision as to the shape and format of any future EU-UK trade deal. A friction-prone, standard run, free-trade deal that largely sidesteps the UK service sector—or about 80% of British annual output—is at best the most likely end result for third country access to the single market. How much support such a deal will have in the UK once the terms and scope become clearer in the course of the second round of discussions is the real question at hand--and one of the main reasons why markets continue to price out a hard Brexit across British asset pools. The EU has always had the luxury of time on its side—and it will use that luxury to the fullest extent possible.

The politics on the European side of the Channel are equally equivocal. It has been almost a year since the near collapse of the EU-Canadian Comprehensive Economic Trade Agreement (CETA) in a backwater Wallonia parliamentary session—after seven long and tedious years of painstaking negotiations. CETA is still far from securing the ratification documents it needs for full implementation. More recently, that Angela Merkel even entertained the inclusion of the German Green Party as a junior coalition partner despite the latter’s strong opposition to large international trade agreements. The move speaks volumes to Germany’s domestic political impasse in the wake of September’s inconclusive election. For the Brexit process, it bodes ill for any UK-EU agreement.

According to a recent ECJ opinion, CETA is a mixed agreement, defined as affecting competencies at both the EU and member states levels of jurisdiction. Accordingly, such agreements require ratification at the EU—and member state—levels of government. In lay terms, a mixed agreement includes both goods and services. The inclusion of services complicates the process geometrically, which is the main reason why services rarely are included in free trade programs. The end-game—the ratification of any such agreement by the 38 regional and national parliaments that comprise the EU—remains ever problematic.

Last week’s DUP flareup was an attempt to scuttle a possible agreement between Dublin and London over the border issue. Dublin demanded assurances from London that a hard border along the 310-mile Irish frontier would not be a part of any final Brexit agreement. For Dublin, crossing the Irish frontier is to be akin to crossing the border between New York and Connecticut—seamless. The Good Friday Agreement (1998) is to be respected by both parties to the Brexit agreement in both form and content. Continuing cooperation north to south between Northern Ireland and the Republic of Ireland and east to west with the EU is a central part of the 1998 agreement, irrespective of the UK’s plans to leave the trading bloc. For London, the language implies the same parallel regulatory regime it hopes will govern a future EU-UK trade deal. The DUP, upon whom the May government depends for parliamentary majority, rejected strenuously to the declaration that if no other solution were agreed, Northern Ireland would maintain full alignment with the EU single market and customs union. May was obliged to blink. The tiff was quickly extinguished with a hastily drawn provision that London would guarantee Northern Ireland businesses frictionless access to the UK market. That said, the Irish frontier has all the potential of becoming the Achilles' heel of a clean-break Brexit short of decoupling Northern Ireland from the UK—and the fact was lost on no one.

The challenge here is for Britain to convince both Dublin and Brussels of its plan to avoid the appearance of either a de facto or de jure hard border between the two Irish jurisdictions, while at the same time guaranteeing the integrity of what will be an external EU border. The task is fiendishly difficult by any measure, and Friday’s deal was unsurprisingly devoid of details as to just how the UK would accomplish the seemingly Herculean feat. Previously, London has spelled out the outline of any Irish accord as including the six areas of north-south cooperation: Agriculture, education, tourism, transport, the environment and health. The EU has a rather longer list of 142 areas of cooperation, according to news reports. The May government has always insisted that the border question would be part of the future UK-EU trade agreement and has offered to date tantalizingly few details as to how the working border mechanism would work on a day-to-day basis. Accordingly, the Irish frontier mechanism remains a conceptual clog in a much bigger wheel with plenty of potential to scuttle the discussions along the way from myriad directions.

Figure 3: British Pound (FXB) and the 10-year Gilt, Year-to-Date

Despite some respite for the pound in recent days which broke out above its 50-day trading average in the closing days of November, the pound languishes well below pre-referendum levels, applying upward pressure on prices denominated in pounds for goods and services across the economy. Similarly, the yield on the 10-year gilt trades about 30% below pre-referendum levels, despite the BOE’s lifting of its main lending rate in November. British borrowing costs remain highly accommodative. Household spending surged 0.6% through the end of the 3^rd quarter, up from 0.2% through the end of the 2^nd quarter. The increase in spending was largely driven by new regulations on high-polluting vehicles that went into effect in April that saw automobile purchases pulled forward to escape the new levy. Household spending is expected to fall in the 4^th quarter.

Figure 4: YOY Headline Inflation in the UK through October

Headline inflation remains elevated at 2.8% through October YOY, unchanged from September—by far the highest post in the developed world. This could signal a peak in YOY inflation after a steady climb from a 0.2% trough plumbed in October 2015, eight months prior to the June Brexit referendum vote (see Figure 4, above). Rising inflation poses a tricky policy dilemma for the BOE. With markets clearly pricing out a hard conclusion to Brexit process and with the duration of that eventuality likely stretching out well beyond the proposed 2-year transition period that now goes through the end of 2021, a weak economy and high, market-induced price inflation for the period could offer up the perfect inflationary storm. Weak household spending mixed with sustained and elevated inflation and a dearth of slack in the labor market could keep BOE policy makers from increasing its main lending rate for fear of tipping the economy toward recession.

Figure 5: The 10-year Treasury Notes of the US, the UK, Germany and Japan

Here in the US, the Fed has a rather opposite problem—low unemployment, a relatively strong forward economic picture, high valued equity markets, low inflation and now the possibility of an unnecessary fiscal stimulus coming from a $1.5 trillion tax cut. The Fed has one more rate hike to complete in next week’s FOMC meeting and three, possibly more, rate hikes penciled in for 2018. At the same time, the Fed continues its balance sheet reduction, which increases to $20 billion/month in January. The impact on price and yield of US assets relative to Washington’s major trading partners remains stark. While the Republican tax plan is expected to expand the federal budget deficit by an estimated $1 trillion over a ten-year period, according to Joint Committee on Taxation estimates, there have been few signs of a selloff. In fact, the 10-year note fell back from its Monday’s intraday post of 2.411% to yesterday’s market close of 2.37% (8 Dec). The interest sensitive 2-year note continues its upward path with a resulting spread of a mere 58 basis points through yesterday’s close for the tightest spread between short- and long-term rates since August 2007. With the probability of the Fed increasing the federal funds rate at next week’s FOMC meeting approaching 100%, the spread between short- and long-term yields is likely to contract further with subsequent Fed rate hikes in the New Year. Market gauges of inflation remain muted with the break-even point for 10-year notes and 10-year inflation protected notes at 1.88% at yesterday’s market close (8 Dec). So far, the bond market appears not to be anticipating much of the corporate tax windfall wending its way into pay packets that would place upward pressure on inflation which would otherwise put upward pressure on debt yields, making an already difficult sell of the Republican tax package on Main Street that much harder. The US Treasury market remains a magnet for fixed income capital flows. The US 10-year benchmark provides the better part of twice the yield of its UK counterpart, over seven times the yield of the 10-year bund and over 51 times the yield of the Japanese 10-year note (see Figure 5, above). Little wonder why Japan holds $1.1 trillion of US government debt through the end of September, a close second to top-seeded China’s $1.2 trillion stash over the same period.

While the May government prepares for a long-delayed cabinet debate on the breadth and scope of the UK alignment with the EU, the EU has warned that any decision to leave the customs union and single market will necessarily narrow the UK-EU relationship to a standard free trade deal—a deal that falls far short from the bespoke trade agreement about which the May government has long promised—to voter and businesses alike. The May government still appears to be no further along on the matter of what kind of trade agreement it wants than in March when the Article 50 documents were submitted. The European Free Trade Area (EFTA) option offers up everything but voting power, but would subject Britain to EU jurisdiction and require compliance to the four freedoms of movement London that spawned the Brexit process in the first place. A free trade agreement along the lines of Japan and Canada will take years to accomplish and leaves out services—or about 80% of British annual output. London’s status as Europe’s financial hub is already fading as EU institutions abandon the city. Financial service providers have begun the process of staking out physical presences on the continent as the Brexit process continues to wallow in uncertainty. Six months on, the issue of the Irish frontier is shaping up to be a Sword of Damocles over the possibility of the UK achieving anything close to a clean break from the EU. Avoiding a hard border frontier appears to assume the retention of membership in both the customs union and the single market—long a redline for Brexiters. Curiously—or not so curiously as the case might be—the default position on the Irish frontier is for the EU to carve out something of an economic protectorate for Northern Ireland. The DUP will never agree to such a conclusion. Of course, all parties to the agreement want to avoid a repeat of the Irish Troubles.

And then there are airline landing rights and lorry transport logistics and trade agreements with third countries from which Britain currently benefits as a member of the single market which it will not be part of any future EU package. All of these countries will wait until the terms of the EU-UK relationship are defined—a date that is likely well into the future. At that time, the agreements will no doubt offer far fewer concession for a UK market of 65 million than they were with an EU market of 500 million. Of course, a trade agreement with the EU, much less third countries, can only be signed once Britain officially leaves the bloc, which now includes a two-year transition period through at least March 2021.

The road forward looks decidedly bumpy for the May government.

Analyst’s 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.

Comments

[Fickel Finance]

The main thrust of your points seems to be that divorcing from the EU and the associated negotiations are complicated and possibly painful. No argument. The question is whether it is in the UK's long term interests to go through the pain. I tend to take a longer term decades long perspective where I believe it makes sense. Some thoughts on this.

1. Energy. Regardless of EU membership or not UK electricity generation uses 40% gas, 20% nuclear, 9% coal, source http://bit.ly/2jVzloM . Reduction of coal use is good for environmental/pollution reasons but tends to be offset mostly by gas currently. This leaves the UK economy vulnerable to gas prices, nuclear is already expensive and Hinkley C isn't changing that. However, the UK has some of the best sources in the world for wind, especially offshore. It is entirely practical that most of the UK's gas and actually all of nuclear generation could be replaced by offshore wind with a significant impact on energy cost, environment and balance of payments. It will take time but probably far less than many would guess.

2. UK was projected to grow to be the most populous country in Europe by 2050 (ONS) from third position after France and Germany in 2015. From memory Eurostat had this happening by 2060. Even the latest Eurostat data still shows the UK almost the same as Germany at 80 million by 2060 after presumably factoring in tighter immigration rules. This equates to a 15 million increase in population between 2015 and 2060 or about 23% increase. The unwillingness of the EU to compromise on free movement of people gave the UK very little ability to manage for slower growth. In my view there are significant social, political and economic risks in the population growing at such a rate. Ironically since Brexit both France and Germany have seen the threat when extremist views start to proliferate to more mainstream/moderate voting populations which is very concerning.

3. There is a lot of focus on the size of the estimated 40 billion pound exit bill. However, this is perhaps only 4-5 years worth of UK net contributions to the EU, net contributions that have been rising significantly over the last decade with something like 80 billion pounds in net contributions in that period. The UK was under increasing pressure to give more in net contributions/reduce its rebates so it is unlikely the rise in payments was going to reverse. It certainly seems worth questioning if the UK has had a good return on its contributions, particularly in recent years.

[Douglas Adams]

Thanks for your reply. I have been out of town, so pardon my tardiness in responding to your points.If the question is whether Brexit is in the long-term interests of Britain, the answer is dependent on whom you engage in discussion. In the wake of Trump, the UK in the wake of Brexit, Scotland and Caledonia in the wake of their respective independent votes, the rise of the AfD in Germany and populist movements elsewhere on the Continent, there is a growing sense of a population dividing along cosmopolitan, educational, politically liberal lines on the one hand setting up a clash with a with more rural, traditionalist voters more readily skeptical of elite opinion and metropolitan values on the other--that is now spilling into the political arena. Supporters appear to share an estranged sense of alienation, the perception of being left behind socially, politically, economically even culturally--fears that are being being picked up in polling and survey data by political scientists. It was not necessarily class or wealth that predicted a Leave vote, but rather social conservatism and whether one is open or relatively closed to new experiences. Cultural and personality, not material circumstances appears to separate Leave and Remain voters. This is not so much a class conflict as it is a values divide that cuts across age, income, education and even political affiliation. This would go a long way toward explaining why those living in London and its immediate environs were decidedly Remain voters, while voters in Sunderland, a large manufacturing center in the Midlands were decidedly Leave voters--despite the town being host to a large Nissan plant whose production is overwhelming dependent on the EU market for both parts and end sales. While many voters were largely oblivious to the potential political and economic impact of their votes, the complexity of steering the UK out of the EU has been all but mind-numbing to date, with little to show from the almost interminable expenditure of time, energy and funds to make the process work--at the expense of other, equally pressing public policy demands. It is an open question whether a similar electoral outcome would come about if a second vote were held.

That said, point #1 is well taken. The issue here, however, is infrastructural funding. The European Investment Bank is a prime EU-wide source for infrastructural lending that the UK would no longer have access to upon leaving the EU. Once the trigger is pulled and the UK leaves the EU, UK borrowing costs will likely drift to much higher levels. The spread between the 10-year gilt and the 10-year bund is about 83 basis points at today's market close--already a rather hefty risk premium. That spread would surely increase with a UK exit from the EU, placing big limits on UK ability to undertake large infrastructural projects that require capital market funding. The UK already runs a hefty current account balance that is dependent on foreign willingness to buy UK debt. Large capital outlays might be difficult to fund and stretch the UK's ability to service such debt over time given the level of economic dislocation that appears in store in the post-Brexit period.

Point 2 I have no real background to comment here.

Point 3: This is a structured arrangement over time with the net coming to around 40 billion pounds. The figure is an arbitrary estimate that could rise or fall with obligations over time. Given the fact that Barnier has insisted no member state will pay more in dues on account of Brexit, it sounds like the final tab could be higher.

The issue of return is a function of just what sort of trade deal the UK is able to forge at the end of the process and whether impacted business in the UK will still be based in the UK at the end of the process. CETA took seven long years to negotiate, with few service sector provisions in the final fold. I have little doubt the UK and EU will be able to come up with a program for goods exchange at nominal tariff regimes in either direction. Still there is the issue of adjudication of trade disputes. The EU will insist on the ECJ having jurisdiction and the UK will likely be equally insistent on refusing such an arrangement, which doesn't leave a lot of room to maneuver. CETA set up an independent dispute mechanism which was quickly dropped after the Walloon parliament objected to the arrangement on the pact's first attempt at ratification in a national parliament.

CETA plus-plus-plus aims for a much deeper set of trade arrangements, keeping close ties with the standards and trade policies of the single market but rejecting two of the four basic freedoms of the single market, namely the free-movement of labor and the role of the ECJ--a path that is still a non-starter with the EU. The tariff-free portion of the equation is theoretically possible, but with the UK insistent on pulling out of the customs union, a frictionless deal without added bureaucracy at EU entry points is hard to imagine--which sinks a seamless Irish frontier.

Services will be a monumental headache to pull off as the UK's rejection of the ECJ will mean some other source of trade dispute mechanism has to come to the fore, which will be excruciatingly difficult for the EU to even phantom, let alone put into practice.

Simply stated, the more the UK bends to existing EU rules, the greater the possibility that the final deal will resemble the trade arrangements the UK enjoys as a member state--at least on the goods side. That said, I see little EU movement on services, which will mean the UK takes a huge and unavoidable economic hit--a hit that is already in the process of taking shape with London's financial services operations hedging their bets and taking on new bases of operation on the Continent. While the numbers that are scheduled to move in the near-term are on the low end of many estimates to date, that number will almost surely increase as progress on forging a final agreement drags on into the years. London will likely be a very different place in 5 to 7 years as tax revenues fall and real estate prices--both commercial and residential--adjust to the downside.

[Fickel Finance]

I don't disagree with most of the first paragraph in your last response, but I don't believe you can entirely eliminate material issues per your comment that "Cultural and personality, not material circumstances appears to separate Leave and Remain voters." This was brought home to me when I first reviewed House of Commons briefing papers published in 2013 (well before a referendum was even considered), which I only accessed just after the vote. I was very surprised at the UK population growth over the prior decade, the projections for population growth and the ethnic mix of it. The last is undoubtedly a major factor in some quarters as you detail.

However, the data also showed that immigration was impacting the lower skilled and unskilled job classes the most. This makes sense because in many (most?) cases immigrants tend to be motivated to succeed but may be initially held back by lack of written and spoken local language skills, skilled and semiskilled qualifications and certifications that aren't recognized/accepted in their new country and lack of experience/practice in their new country. When you combine these parameters you may find new immigrants prepared to work for less than indigenous workers, taking jobs well below their capabilities in some cases, while being highly motivated to work their way back up the employment ladder. In other words immigrants may out compete local labor. This can give rise to the perception or even actuality of job loss to immigrants and all the negative implications that follow from that. When immigrant numbers are relatively small their contribution is a positive for a country but if immigration rises to the point of creating social unrest then that is a risk that has to be addressed and EU rules didn't enable this. Had the EU managed to create a solution it might have forestalled Brexit. That said the increased health, education and social security costs associated with the population growth may still be the larger risk if the UK can't reduce its growth rate, given the size of these components in the UK budget.

In the financial world premiums are of course a function of confidence and perceived risk along with interest rate strategy. So exchange rates and bonds will reflect the market's confidence or lack of it in the UK. I concede that it is certainly much easier to lose confidence than to gain it with the negative outcomes you ascribe to the former. However, I wouldn't assume it. Having the Pound and not being on the Euro certainly provides more room for maneuver. As an aside its probably another major reason why contagion is a low risk for the EU.

Unlike many I am not that focused on the "final bill" because the UK might well have been committed to paying 10 billion pounds/year net and increasing with no end otherwise. Frankly it would not surprise me if the UK make development monies available to poorer EU countries as part of an agreement. The UK already commits 0.7% of Gross National Income or ~ 11 billion pounds in 2016 to International Development, one of only six countries WW to do so and the only G7 country as of 2015 an maybe still so. Of course one could make the argument that if the UK is prepared to make this ID payment then a similar net payment to the EU is just as reasonable. But then we're back at an increasing population rate.

Probably the most important part of any agreement is that it isn't a zero sum game. A financially successful UK, already a willing consumer of EU goods, provides a larger market to the EU but the converse is also true. We will have to see if politicians on both sides can get to the more positive of those two outcomes.

Thanks for the discourse and exchange. Encourages me to evaluate my own ideas.

[Fickel Finance]

There is always a lot of detail and thought in your articles but with respect I suggest you allow a bit too much bias in when a more balanced perspective would make a better, more useful and perhaps more widely read article. Just my opinion of course.

For example you state categorically "If the UK want full access to the single market, it needs to follow existing EU rules and jurisdictions—plain and simple" Its your article and your right to this opinion but that doesn't make this statement an absolute incontrovertible truth which is how it comes across. Similarly "A friction-prone, standard run, free-trade deal that largely sidesteps the UK service sector—or about 80% of British annual output—is at best the most likely end result for third country access to the single market" Why? Just because it has not be achieved previously doesn't mean it cannot be achieved by the UK because whether the EU likes it or not the UK trade agreement will be a unique one.

If a services agreement isn't achieved then I suspect a hard Brexit could result which would be a disaster for the EU too. Why would the EU work so hard on a trade deal with Canada and then walk away from one with the larger UK economy with its large existing market for EU goods? It would do a lot of harm to EU businesses, especially the politically powerful automotive industry in Europe. Also consider that if the UK and EU do achieve a frictionless free trade agreement then many of the Irish border issues go away too. It is also worth considering what the EU has already achieved and now risks losing. If no agreement results then the 40 billion Euros are off the table in a hard Brexit with real consequences for the EU budget.

In summary, it is easy to look at all the negatives and risks for the UK in this situation and certainly the UK has its challenges but the EU has some sizeable issues too. There was a lot of frankly very silly EU politician posturing and commentary about "punishing the UK" for leaving in the early days, rather bad optics for a democratic body like the EU in my opinion. I haven't seen much of that recently although I'm sure there will be some politicians more than happy to stir things up on both sides. However, I suspect as time goes on we will continue to see progress somewhat similar to the recent first stage agreement, in other words a bit slow and painful with either real or imagined brinkmanship perceived by the media, but it is in the interests of both sides to make this a success and that will likely drive the process.

[Douglas Adams]

Thanks for your comment.

I tried to offer up a flavor of both sides of the negotiating table with each being guilty of airy and matter-of-fact pronouncements of their respective bargaining strengths and weaknesses. Interestingly, the quote you cite regarding the following of EU rules was a close paraphrase from the EU's main negotiator Michel Barnier. I don't necessarily see such comments as being helpful to the overall process of garnering an agreement, but they nonetheless convey a distinct flavor of the thought going into the process on both sides of the aisle--without editorializing on my part.

In a very similar vein, the comment on setting up a frictionless trade regime is equally telling. The EU is under enormous pressure, from my reading, to make sure that the UK is not allowed to cherry pick the rules it finds advantageous while ignoring those that are less appealing. Angela Merkel has long made, and continues to make, this point. The notion being conveyed here is there really has to be a very clearly delineated difference between member state and third state access to the single market. The citation is another poignant comment made by Michel Barnier and is reflective of the EU sentiment. Otherwise, the single market and the EU experiment will see member states stampeding for the exits due to this or that provision that they don't like.

Also remember, any UK-EU pact has to be ratified at both the EU institutional and the member state levels. All 38 national and regional parliaments have to agree with the final package--unanimously. CETA still hasn't achieved this threshold. Interestingly, Germany and Austria are among the remaining holdouts. Merkel almost sold Germany's ratification down the river in the attempt at including the German Green Party as a junior coalition partner.

The historic record of trade agreements of the past 40 years have been exclusively free trade arrangements on goods--specifically exclusive of services. There are myriad reasons for this type of format. Service agreements are nightmares with all the follow-up logistics of compliance, regulatory procedures, capital requirements, background checks etc, etc, etc. Service providers need boots on the ground in local markets which means the free movement of professional personnel plying products and services across international lines. Safety standards come into play. It is difficult enough to vouch for the regulatory alignment of a member state. With a third country, all of these issues would have to be verified and updated on a continuing basis by a constant stream of inspectors and compliance people checking and rechecking the flow of services and their products into the market. That is the friction part of any UK-EU agreement. The current experience of Turkey, a member of the EU customs union, is a prime example.

And that doesn't even consider jurisdictional reach--the loss of sovereignty to the ECJ--one of the main red lines of the Brexit process. Interestingly, it was an incredible climb-down for the UK to agree to an indefinite review by the ECJ that ended the divorce round.

I can't imagine the EU agreeing to a service agreement in the upcoming trade round of the EU-UK talks--which again is about 75% of the UK's annual output, hence the comment regarding the friction-prone standard free trade agreement in goods. This is also a paraphrase of Michel Barnier. A CETA-style agreement plus, plus, plus is the current reference point coming from the May government. All of the public comments I have seen on the EU side interprets such a program specifically in terms of goods--about 20% to 25% of UK annual output--currently a balance of trade deficit for the UK for the past several years. With frictionless access to the EU clearly viewed as a benefit of a member state, all of those just-in-time cross border operations at present in the automotive sector will grind out at a much reduced pace at Dover and elsewhere until Nissan and Toyota decide that the heightened bureaucracy at the border, not to mention the likely 10% tariff on parts and finished goods, undermines the viability of making cars in the UK for the EU market.

Britain’s chemical and pharmaceutical industries have called on the government to allow them to remain within EU rules after Brexit to avoid endangering investment and supply chains, even as Euro-skeptic ministers ratchet up the pressure for a clean break from EU regulations. British chemical exports were about £50 billion a year, according to news reports. Of course, the European Chemicals Agency which sets EU standards, comes under the legal framework of the ECJ.

The Brexit made little economic sense back in March when Article 50 was triggered. It makes even less economic sense six months hence now that the terms of such a move are becoming a bit clearer. The Irish frontier is now the new Achilles heal of the process as Britain will be hard-pressed to deliver on an open border while guaranteeing the integrity of a 310-mile border with the EU as a non-member state. May's current position, or lack of a position, will be hammered home by the EU in round two, with Northern Ireland becoming something of an economic protectorate in lieu of an agreement. This would be akin to decoupling Northern Ireland from the UK. We already know the DUP will never agree to such a premise--and there goes May's thin parliamentary majority. The May government is one mishap away from implosion--with little Tory or Labor heft waiting in the political wings to see the Brexit process through to some political conclusion. There is scant economic sense emanating from the process to date. I imagine this sad state will continue.

The hope is for the scope of the EU free trade program offer will be so meager in comparison to the access Britain now enjoys as a member state that the 45 billion to 50 billion pound exit arrangement will seem a waste of money and the abandonment of Brexit becomes a foregone conclusion. Brexit full circle is a much, much better play for everyone concerned.

[Fickel Finance]

Thanks for the detailed response. I'd make two main points.

1. Everything the key negotiators say in public is for effect and to pander to whichever constituency they feel the need to address. It may or may not represent reality. For this reason I don't think we can give much weight to any public pronouncements from either side. Most especially I would not expect either side to publicly give up a negotiating point in casual comments. So for example if a services agreement becomes reality I would not expect anyone on the EU side to even acknowledge it as possible until it is actually part of the agreement.

2. Every significant, especially public, concession from the UK gained by EU negotiators becomes a poison pill against a failure to get an agreement and the resulting hard Brexit where the EU get nothing. Ironically the UK's exit bill of 45-50 billion pounds is now a huge loss to the EU if it goes away. This can be a very strong lever for the EU within the EU against those that might threaten to derail the deal; either by buying them off or by threatening them with a lack of future financing if they don't agree. This wasn't an option with Canada, hence Wallonia.

Oh and probably best to never say never in politics :-)

[Douglas Adams]

I would agree that public statements by key negotiators are for public consumption/effect and don't necessarily reflect position content. That said, these comments set a certain tone to the discussions and create the stuff from we analysts attempt to derive content and for that reason cannot be blithely dismissed out of hand.

I forgot to mention this pointed reference to CETA in an internal EC document either leaked or released last week, I'm not sure which. CETA's references to services is mostly reflective of the current state of openness applied to all WTO members and does not contain, implicitly or explicitly, any new service access for Canada in the EU or for the EU in Canada. So any service inclusion in a UK-EU trade agreement would be without precedence in the annuals of free trade agreements to date. This is a pretty novel undertaking.

It would also be a very difficult slog through the mud. In the financial sphere, the ECB has long-standing concerns over the clearing and settlement of euro-denominated derivatives outside the continental EU. The ECB even brought suit and lost a 2015 court case in the ECJ over the matter. Since the ruling, the ECB has set up a swap line with the BOE where sterling can be exchanged more readily for euros in case of unforeseen shortages occur due to seizure. London currently clears a whopping $573 billion a day in euro-denominated derivatives, according to ICE data. With the UK heading for the exits, its hold on the euro-denominated derivative trade is almost guaranteed to leave its current London base.

Other financial services behemoths are also making relocation plans of a ever growing percentage of their respective London-based operations--largely out of the mounting uncertainty around the sustainability of the current passporting regime that governs firms' access to the continental market. Frankfurt, Paris, Dublin, Brussels are all destinations of this financial service flight. Sadly, by the time any agreement makes it to final form, if CETA is any example, many of a London-based financial services operation will likely to have long implemented the bulk of its relocation plans.

Point number 2, remember the exit bill is a structured arrangement over the course of time--a really big win for the UK and one to which few would have anticipated such an EU concession. While this means no upfront capital being paid out by Downing Street, the net bill over time will likely be even more of a hit to the UK public accounts when the books are finally closed. The UK will pay into the EU budget through 2020 as if a member state of good standing and will likely continue the regime through 2021, which is the end of the two-year transition period. Presumably, the exit payments will accrue over time, beginning with the end of the transition period which we all hope won't constitute a cliff-edge.

Throughout the period, the EU will retain its decided advantage in the talks, an advantage that is consistent with its 560 million consumer market heft in discussions with a UK market just over a tenth its size in overall purchasing power. On account of that market heft, the EU is in the position to call the shots at almost every turn. I don't see why they wouldn't use that advantage to its fullest extent.

Germany's Daimler or Italy's Prosecco might suffer short-term market dislocations, but the EU export machine will likely survive just fine. It's the British economy about which we all should worry.

[Paulo]

As you say, it will be a bumpy road ahead for the May (or any other) British government.
And yes, after 7 long years of tedious negotiations the EU free trade agreement with Canada still has not been ratified.
Further, Britain wants a Canada plus, plus agreement which it can only begin to negotiate after it has left the EU.
As it simultaneously engages in trade negotiations with the U.S. (I am rolling on the floor laughing) and, of course, China, and India is rolling its eyes.

[Douglas Adams]

Well said.

Reality is always tough to swallow. I fervently await the white paper that outlines the Irish frontier. Britain faces the rather stark choice of decoupling Northern Ireland from the UK over the frontier issue or remaining in the customs union and single market--which means Brexit will have come full circle. And if Northern Ireland does default to an EU economic protectorate for lack of agreement, Scotland and Gibraltar will likely follow suit. The United Kingdom could become a good deal less united by 2021. Personally, I'm rather surprised the EU allowed such a fudge on the Irish frontier to pass as significant progress. There has been no progress on this front at all that has hit the public domain.

On the goods side, the impact studies on British goods manufacturers that David Davis flippantly referred to last week in an off-the-cuff remark to parliament--never really existed. That means the government negotiated round one largely blind, which explains a good deal of the reality check in the final hours that brought round one to a close last week. Brexiters have had to swallow a lot lately: a big exit bill that will stretch on for years and likely the better part of the next decade, indefinite judicial oversight from the ECJ, ongoing regulatory alignment with the EU trade and regulatory standards--all in exchange for a Canadian-style free trade agreement on goods that amounts to about 25% of its annual output that has long been in deficit to the EU.

CETA's mention of services is merely reflective of current WTO provisions guaranteed to all members and carves out no new access to Canadian service firms, according to an internal EU position paper released last week. Financial services accounted for about 30% of UK service exports and added roughly 23 billion pounds to Britain's balance of payments spreadsheet for a 14 billion surplus with the EU in 2016, according to news reports.

Another interesting point is that service providers--architects, insurance and financial product sales, banks accepting deposits, management consultants usually require people to be on-site, which means local capital outlays for banks, local regulatory oversight and the free movement of professionals across national borders. I"m waiting for the white paper that outlines the logistics of this proposal as well.

Reality will be even tougher to swallow in round two. The reality lesson of round two is shaping up to be just how unworkable Brexit really is for all concerned.