Are financial markets really prepared for a hard Brexit?

While equities are adjusting to the latest failed negotiation, we do not think the market is really prepared for what could happen on Sunday and how it will impact the market on Monday. Depending on how the UK and EU frame a failed trade agreement Sunday, UK equities could be down as much as 5-7% on Monday in severe risk-off scenario with banks, industrials and FTSE 250 leading the declines. This is our best guess in a very bad scenario as we have no statistics to rely on making this event about uncertainty in the word’s true meaning. Investors could hedge their portfolio through CFDs, futures or options depending on what fits the portfolio and objectives best, but we urge investors with a lot of UK equity exposure to consider the risk picture going into the weekend.

A logistical mess on January 1, an economic shock, and a new city of London

If a trade agreement is not reached, then a logistical nightmare will happen on 1 January as the EU and UK will fall back into rules and tariffs established by WTO in 1995. This means that the UK will have to start paying tariffs on imports from the EU, and vice versa. The UK consumer can expect a rise in prices on grocery with 85% of the food imported from the EU will at least get a 5% tariffs rate. UK carmakers would experience a 10% tariffs rate and being the biggest export category of the UK economy, this will have a significant impact on the export economy. The services sector will likely have to set up local offices in Europe to service clients. In terms of energy infrastructure, the UK would also be cut off from the EU energy market. Allianz estimates that the UK could experience an overall increase in import prices of 15%, a 10% depreciation of the GBP, increased supply chain and administrative costs, on top of a 5% drop in GDP and 15% drop in total exports.

UK export composition in 2018 (chart below)

There are also implications for Europe. Countries such as the Netherlands and Germany are big exporters to the UK economy and would lose out on a hard Brexit, so we should expect German industrials to underperform on Monday and in 2021 on a hard Brexit. Losing easy access to its second-largest trading partner would be a big economic blow to Europe as well and coming at a very bad time with the European economy suffering hard from the Covid-19 pandemic with many countries in new strict lockdowns.

Covid-19 has hit the UK and its economy hard and the speedy rollout of the vaccine is essential for the economic recovery next year. The UK has quickly approved the vaccine from Pfizer and BioNTech, and started vaccinations, but as Belgium’s Prime Minister pointed out the other day, the Pfizer vaccine is produced in Belgium and thus if the trade agreement fails, then import duties and customs delay are ensured on 1 January. As a result, the Foreign Office minister has said that the UK military might be applied to ensure vaccine delivery to the UK population. Think about that picture for a moment.