After lengthy and difficult negotiations, the United Kingdom and the European Union finalized on Monday, February 27, an agreement on rules governing trade between Great Britain and Northern Ireland, the “Windsor Framework.” This agreement should effectively eliminate the tail risk for the UK economy of a trade war with the EU. But it is not likely to significantly reduce the negative effects of the UK’s withdrawing from the EU (“Brexit”).
The UK-EU agreement addresses the serious dispute about the Northern Ireland Protocol, which set out the rules that would govern trade between Great Britain and Northern Ireland (NI) following the UK’s exit from the EU. Recall that NI is part of the UK and has a border with the Republic of Ireland (RoI), which is a member of the EU and remains in the EU Single Market for goods. Also recall that the Good Friday Agreement, which brought peace to NI, called for maintaining an open border between NI and RoI. The Protocol had the objective of preventing a hard border but required physical checks on goods moving from GB to NI, effectively creating a border between the two parts of the UK and keeping NI in the EU’s single market and subject to some EU rules. This arrangement led a dispute about the extent of those checks, which have restricted the flow of goods, and also about the application of EU rules in NI, which is not part of the EU. The Democratic Unionist Party (DUP) in NI has refused to continue with the sharing of power in the NI government until its concerns with the Protocol are addressed. The UK government threatened unilateral action to change the Protocol, and the risk of a trade war with the EU became possible.
The Windsor Framework addresses the two main concerns with the Protocol:
Trade between GB and NI. Goods destined only for NI will go into the “green lane” and will not be checked. Goods destined for the RoI and elsewhere in the EU will go into the “red lane” and will be checked. This will mean, for example, a free flow of food products from GB to NI without the delays and onerous checks under the current system.
Application of EU rules in NI. NI will stay in the EU Single Market and will be subject to some EU rules, but the number of EU rules will be greatly reduced; e.g., the UK rather than the European Medicines Agency will license new medicines for NI. Moreover, there now will be a “brake” that will permit the UK government, if it so chooses, to veto new or amended EU rules from applying to NI.
The agreement is expected to be confirmed by a vote in Parliament, possibly requiring some Labour Party votes, as some opposition is likely within the Conservative Party.
This agreement is a very positive political development for both the UK and the EU, resolving years of acrimonious dispute. If the vote in Parliament indicates strong support for the deal and political “goodwill,” it will strengthen confidence for the renewal of the 2021 Trade and Cooperation Agreement (TCA), the post-Brexit trade agreement, which is scheduled for renewal, revision, or termination every five years. That strong support would ease the uncertainty of some investors. If, on the contrary, the vote reveals a serious split within the Conservative Party, that split will imply to investors a rough road ahead for UK-EU relations and will increase their concerns about a future deterioration in access to the single market for UK-based firms.
Whichever way the vote goes, the overall effect of the trade deal on the UK economy will be far more limited than the negative effects of Brexit were. The focus of the deal is on the trade in goods between Great Britain and Northern Ireland. That trade accounts for a very small portion of the UK’s overall economic activities with the rest of the world. While it is difficult to separate the effects of the UK’s leaving the EU from the simultaneous effects of the Covid shock on the UK economy, the negative impact of Brexit is becoming increasingly evident. The TCA introduced significant friction into UK-EU trade. While tariff- and quota-free trade continues, non-tariff trade barriers were introduced, as were barriers to the free movement of people. The latter have led to serious labor shortages, which are adding to inflation pressures. Net immigration from the EU was still negative as of mid-2022, according to the Center for European Reform, which has estimated that there are 460,000 fewer EU-origin workers in the UK as a result of Brexit. Data problems make it difficult to compare pre- and post-Brexit trade and identify the dimensions of the trade destruction that is occurring. The Bank of England estimates that trade with the EU has been less than indicated by official data and that the productivity hit may have occurred earlier than expected. It is notable that trade in the UK has not bounced back from the Covid shock as fast as it has in other major economies. Business investment is no higher than it was just after the Brexit referendum in 2016. The stalling of investment appears to reflect uncertainty about the future and the Brexit-related red tape costs of doing business in the UK. For example, customs export declarations have more than tripled. Finally, the promised “dividends” from Brexit have not materialized. Instead, Brexit is proving to be a policy decision that continues to subtract from the UK economy.
Considering the above and other negative costs of Brexit, the UK’s Office for Budget Responsibility estimates that, ultimately, the UK economy will be 4% smaller than it would have been if the UK had not decided to leave the EU. The Center for European Reform estimates that the UK economy is now 5.5% poorer than it would be if the UK had stayed in the EU. The new trade deal is unlikely to have a significant effect on the UK’s overall trade situation or to directly boost the UK economy. The potential for a more constructive bilateral relationship may prove to be its most positive effect.
The outlook for the UK economy this year is the weakest among those for the largest advanced economies, being the only one with a negative forecast annual growth rate — a contraction of 0.4% (OECD) to 0.6% (IMF). However, recent data are suggesting that a less negative outlook could develop. The surprising positive jump in the February Flash PMI reading for the UK, along with the strong final February Manufacturing PMI, indicate a strong rebound in business activity despite the headwinds of rising interest rates, a cost-of-living crisis, strikes, and labor shortages. Elevated inflation pressures are likely to lead the Bank of England to make further policy interest rate increases, aggressively if conditions warrant. We note the comments of Monetary Policy Committee Member C. Mann: “Uncertainty around turning points in inflation should not motivate a wait-and-see approach, as the consequences of undertightening far outweigh … the alternative.” The resilience of the UK economy is likely to be tested in the coming months.
UK equities have done year to date better than might have been expected in view of the economic forecasts above. The FTSE 100 Index is up 5.4% year-to-date Feb. 28th. This is about half the 10.9% gain made by Eurozone stocks, as measured by the STOXX Europe 600 Index. Cumberland Advisors’ International and Global Equity portfolios currently do not hold UK-specific ETFs. We will continue to follow developments closely.
Sources: Oxford Economics, OECD.org, IMF.org, S&P Global, Reuters.com, barcap.com, Financial Times, actioneconomics.com, CNBC.com
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