The timing could not have been worse. The United Kingdom exited the European Union on January 1 in the middle of the second wave of the COVID-19 pandemic, which was striking the UK with particular force, driven by a new, more infectious strain.
On January 6, the third strict lockdown affecting all parts of the UK was imposed. Meanwhile, the difficult and lengthy negotiations on the terms under which the UK would exit the EU ended with a limited trade deal. That deal allows for tariff-free trade for goods that qualify as UK- or EU-made. But UK Prime Minister Boris Johnson was not correct when on Christmas Eve he stated that “There will be no non-tariff barriers to trade.” The experience to date has revealed what the Financial Times characterized as “a thicket of customs declarations, health checks and other barriers to trade,” which are seriously limiting some UK-EU trade flows. This is the situation for trade in goods. The situation is worse for services, which were largely ignored in the Brexit deal.
The UK did not manage the pandemic well last year, with the result that the UK has had more COVID deaths than any other European country and the highest death rate, 164.2 per 100,000 people. Since mid-January, however, the shutdowns have led to a sharp drop in COVID cases per million. Also, the UK is outperforming in the vaccination of its population. It wisely decided to opt out of the EU’s centralized vaccine procurement program and then placed bets on seven vaccines under development, in the form of early purchase commitments for about 360 million doses and the financing of local manufacture. So far, five of the seven bets have turned out to be safe and efficacious, and two have been approved and are being used, with some nine million people vaccinated so far. The EU was months behind with approval and purchases. The earlier vaccine rollout, the large volume of vaccinations, and the current strict lockdown are likely to permit the UK economy to emerge from the pandemic earlier than the EU will.
The new virus strain and the strict third national lockdown have clearly reduced the momentum of the UK economy. The January Composite Purchasing Managers’ Index dropped almost 10 points. The disruptions to UK trade since Britain exited the EU single market have been less severe than many had feared. Some problems involved adjusting to new procedures and will likely prove to be temporary, while others may be long-lasting. The farming and fishing industries have suffered, as procedural delays thwart trade in fresh produce that cannot be stockpiled. Small and medium-sized businesses have been impacted by the higher costs of cross-border trade, with some firms unsure they can maintain thriving export businesses and others moving operations to the EU. The sharp slowdown in the services sector in January was caused by the COVID restrictions, which will be temporary. The negative effects of the Brexit agreement on some services, however, risk being both long term and substantial.
For financial services, which account for some 7% of British GDP and employ more than one million people, the agreement on the UK’s exit from the EU was essentially a “no-deal Brexit.” The central issue of “equivalence” between the UK’s regulatory system and that of the EU was left to future negotiations. On the first market day under the Brexit deal, 6 billion euros of euro-denominated trades shifted away from the City of London to markets in European capitals, and that share trading is unlikely to return. The City of London had already lost some 5,000 to 7,000 jobs due to business having to migrate to Europe. Trading in derivatives, for which London has been the main hub in Europe, has also been shifting out of the UK to both Amsterdam and the US. The UK and the EU have agreed to seek an agreement on a memorandum of understanding on future cooperation in financial services by the end of March. It is looking less and less likely that this process will result in a substantial resolution of the outstanding issues by that date.
As was the case throughout the negotiations of Brexit, Northern Ireland became the center of UK-EU disputes during January, the first month under the Northern Ireland protocol that is part of the Brexit agreement. Northern Ireland is part of the United Kingdom, whereas the Republic of Ireland is a member of the European Union. Both the UK and the EU wished to avoid restoring a hard land border on the island of Ireland, the removal of which was a central part of the peace agreement. The protocol in effect created a regulatory border in the Irish Sea, where there are checks on goods sent from Great Britain to Northern Ireland. Northern Ireland is now expected to follow all the rules of the EU customs code. The initial effect was empty supermarket shelves in Northern Ireland due to Brexit-related red tape. The UK has demanded that the EU extend grace periods on the bureaucratic controls affecting this trade. The dispute on this matter reached a peak when the EU threatened to suspend the protocol to enforce controls on COVID-19 vaccine exports, evoking strong reactions on both sides of Northern Ireland’s sectarian divide. The EU quickly and publicly recognized it had made a mistake and withdrew its threat. The twin issues of post-Brexit trade between Great Britain and Northern Ireland and maintaining peace on the island still remain to be resolved.
The UK economy was judged by the Bank of England’s Monetary Policy Committee (MPC) to have ended 2020 “materially stronger” than the committee had expected. And while the MPC project a 4.2% decline in first-quarter GDP due to the current lockdown, which is scheduled to last at least until mid-February, they have increased their forecast for the second half of 2021. They expect GDP will be back at its pre-crisis level by the first quarter of 2022.
The UK equity market has held up well, with investors apparently looking past the adjustments to exiting the EU and forward to widespread vaccinations and the emergence from COVID restrictions. The iShares MSCI United Kingdom ETF, EWU, is up 11.7% over the three months ending on February 10 on a total return basis, not far below the 12.9% gain of the global iShares MSCI ACWI. Cumberland Advisors does not currently hold either EWU or ACWI in its International or Global Equity ETF Portfolios.
The author does not hold either of the ETFs mentioned in this commentary.
Sources: Financial Times, Oxford Economics, The Economist, Goldman Sachs, etf.com
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