Cumberland Advisors Market Commentary – Decision Time for the UK and Europe

Author: William Witherell, Ph.D., Post Date: December 2, 2020
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Time is running out for the UK and Europe to reach an agreement on the terms under which the UK will leave the European Union (EU) at year end. Also, the member countries of the European Union have yet to reach final agreement on a much-needed, massive additional fiscal stimulus package.

Market Commentary - Cumberland Advisors - Decision Time for the UK and Europe by William Witherell, Ph.D

The substance and timing of these decisions, or their absence, will have important effects on both the near-term and longer-term outlooks for the UK and Europe. They come at a particularly difficult time, with the second wave of the COVID-19 pandemic surging and the resulting shutdowns and restrictions causing recovering economies to slow markedly.

The negotiations on the future relationship between the UK and the EU, called Brexit, had progressed fairly far in recent weeks but now appear to be stuck on the issues of fishing rights, competition or “level-playing-field” rules, and governance of the deal. With the transition period for the UK’s departure from membership in the common market and customs union having just a month to go, any deal needs to come together rapidly. Meeting this deadline requires both sides to be willing to move. The stakes are very high, as are the pressures to reach a deal.

A compromise on fishing looks feasible. The level-playing-field and governance issues are more fundamental to the future relationship and thus more difficult. At least by now, both sides understand clearly the legal issues at stake. The UK has been seeking to regain “unfettered national sovereignty” and, specifically, freedom from the EU’s competition rules on government subsidies and labor regulations. The EU does not want to compromise its single-market business model and its enforcement provisions.

As has been the case throughout the Brexit saga, the Ireland border issue continues to be an important political concern, with Joe Biden’s election increasing the pressure on UK Prime Minister Johnson to agree to a deal. Failure to reach a deal would result in the reestablishment of a border between the Republic of Ireland and the UK. If the UK respects the withdrawal agreement it has with the EU, there would be a trade border down the Irish Sea between Northern Ireland and the rest of the UK, an outcome that would be strongly opposed by loyalists. Should the UK follow through with its stated intention not to respect the withdrawal agreement, and thus permit the return of a hard land border between the Republic of Ireland and the UK, that decision would risk destabilizing the Irish peace settlement and would be strongly opposed by both the EU and the US. Biden has warned that such a development would compromise the scope of an eventual US-UK trade deal.

If there is to be a deal, the December 10 meeting of EU leaders may be the deadline, with barely enough time remaining for agreement by EU leaders and the UK parliament. Should there be no deal by year end, negotiations between the EU and UK could, of course, continue. But the trading relationship would then be under World Trade Organization rules, with tariffs on goods rising from zero to as much as 40 percent. If a free-trade agreement is reached, it will very likely be limited in scope just to goods and will not provide full access to the single market. There will still be higher costs for goods trade due to customs bureaucracy and some regulatory barriers. The ability of UK financial services to work in the single market would remain to be determined. Significant UK-EU trade decoupling over the long run would be likely.

The backdrop for these negotiations is lockdowns in both the UK and the EU, enacted to curb the resurgence of the COVID-19 pandemic and now plunging services sectors into deep recession. While positive vaccine developments and support for manufacturing from the recovery in export markets have strengthened business and investor optimism looking ahead, there is little doubt that both the UK and European economies are in for a difficult winter, with the weakness likely extending well into 2021. This will be the case even if there is a “skinny” Brexit trade deal.

The UK is responding to the economic situation by increasing fiscal and monetary support that includes extending the Job Retention Scheme to the end of March and increasing bond purchases authorized by the Monetary Policy Committee. The OECD in its just released OECD Economic Outlook, December 2020   projects that the UK economy will be among the hardest hit by the pandemic of the major economies. Following a decline of over 11% this year and assuming a limited trade deal, the UK’s real GDP may advance by just 4.2% in 2021 despite a continued sizable decline in the first quarter. By the end of next year the UK economy is expected to be more than 6 % below where it was at the end of 2019. The OECD projects that only the economy of Argentina among major economies will have suffered worse.

In Europe, a massive EU recovery fund fiscal package (750 billion euros) continues to be held up: Hungary, Poland, and Slovenia have threatened to veto it because they disagree about the rule-of-law mechanism’s application. Should agreement on this package be reached at the December 10 EU leaders’ meeting, substantial disbursements could begin early in the new year. We also anticipate future monetary stimulus measures to be taken by the European Central Bank at its December meeting. Economic growth in the eurozone is projected by the OECD to register a decline of 7.5% this year. Next year, after a further decline in the first quarter, a recovery is likely, with real GDP advancing 3.6% for the year.

UK and EU equity markets have recovered from their swoon in April and have performed well over the past three months in the face of all the bad news and high uncertainty. Over the three months through December 1th at the London Stock Exchange, the FTSE 100 is up 7.7%, while in Europe the STOXX Europe 600 has gained 5.8 %. These percentages compare well with the three-month 3.9% advance of the S&P 500 in the US. Investors appear to be anticipating better times in 2021.

Bill Witherell, Ph.D.
Chief Global Economist & Portfolio Manager
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Sources: Financial Times, Oxford Economics, OECD Economic Outlook, December 2020, BBH Currency Strategy, actioneconomics.com, cnbc.com, Goldman Sachs Economic Research, bbc.com.

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