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Brexit two years on: Where things stand and what's at stake

08 June 2018 | Markets and Economy

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A conversation on Brexit with Peter Westaway, Vanguard's chief economist in Europe and head of our European investment strategy team.

Lara de la Iglesia (moderator): Hi, Peter, thanks for being here today. As we approach the second anniversary of Brexit, uncertainty abounds. Can you please provide a brief background on what happened with the historic vote in June of 2016 and where things stand now?

Peter Westaway (Vanguard chief economist, Europe): Sure, Lara. I think it's fair to say that Britain's had a slightly strained relationship with Europe ever since it joined the EU in the early 1970s. And, politically, there have always been people in the UK that would have preferred us not to have been in the European Union. And those pressures and debates came to a head about three years ago when a small party in the UK, called the United Kingdom Independence Party, was gaining votes from some of the main parties and put enough pressure on the establishment to call a referendum on the question of EU membership. Nobody thought that that referendum would lead to a decision to actually leave the EU, but in the event a vote in 2016 delivered 52%-to-48% in favour of the UK leaving the European Union.

Now back in March of 2017, so some nine months after that vote, Prime Minister Theresa May triggered what was called Article 50, which set in process a motion which meant that by two years later, March 2019, the UK would officially leave the EU.

What then remained to be done was agree on the terms of that separation. And that's the process that we're going through at the moment. Because the real problem with the referendum was, even though there was a clear yes/no decision on whether the UK should leave the EU, the terms on which we would leave it and what life outside the EU would look like, relative to the EU, was very unclear. And that's what all the debate is about now.

Lara de la Iglesia: So, Peter, what are some of the more likely scenarios that might play out with Brexit?

Peter Westaway: Yes, there are a lot of different scenarios that can play out. Probably the most simple one is a clean break from the EU. And that's really what the [British] government are aiming for as their policy. That's sometimes called a hard Brexit. And it involves the UK leaving the EU, leaving the single market.

And what it would mean is that the free movement of labour between the EU and the UK – that means citizens in the [EU] can freely come and work in the UK – would no longer be allowed. And there would also be less jurisdiction in UK courts from the EU. Those are two of the things that I think many people that voted to leave were looking for.

Now one of the big problems with that is that it does introduce complicated trading relationships between the UK and the EU. And many people think that will have quite big costs in terms of the trade between the two areas. And, in particular, it presents complications for the border between Northern Ireland and southern Ireland. The UK government is very keen that there is completely frictionless trade between those two areas, but a hard Brexit makes that very difficult.

So, increasingly, people are now talking about a customs union between the UK and the EU. So that's preserving an important element of EU membership, but it does facilitate that free trade between the UK and the EU. It means that there would no longer need to be border checks when goods went across the border in Northern Ireland and southern Ireland. And it would more broadly be slightly less economically costly.

The problem with a customs union is it prevents the UK from striking deals with third countries. And one of the advantages of the people that wanted to leave the EU, was that it would free up our ability to trade with fast-growing emerging markets or the United States and so on.

Lara de la Iglesia: Right.

Peter Westaway: So, there's a lot of uncertainty around that. But I would say that that customs union arrangement is our most likely scenario. We probably put about a 50% probability on that outcome.

Now all of those outcomes I've described so far are quite costly in terms of the economic implications. Many estimates say that, perhaps in the long run, there could be 5–10% lower GDP in the very long run because of that reduced trade.

Lara de la Iglesia: Okay, interesting. Are there other less likely Brexit scenarios then?

Peter Westaway: There's one other really important possibility that many people don't put much weight on at all, but we probably think there's a 10–15% chance of that. And that is, believe it or not, that Brexit still doesn't happen at all.

So, how would that happen when the people have voted for it? Well, the way it could happen is because there's so much uncertainty within the UK government, it's simply not possible to get any version of Brexit voted through Parliament. And if that happens, if there isn't agreement, it's possible that the government falls and another general election is held.

And, if that were to happen, it's possible that that new government calls for another referendum, and in that new referendum the vote is reversed.

So, it's not a likely outcome but, in our view, it's sufficiently likely to be worth talking about, and I don't think many people are giving that much weight.

So, overall, what's so astonishing about the situation is that the whole range of possibilities, from no Brexit to a disastrous cliff-edge Brexit, are still in play two years after the original vote and, now, less than a year before the supposed Brexit date is actually going to happen.

Lara de la Iglesia: So, I have to ask, what might be the expected impacts to the UK economy for the more probable Brexit scenarios?

Peter Westaway: So, there's a lot of debate about that. I mean, the simple answer is we don't know for sure. Immediately after the vote, many commentators, ourselves included, to be honest, thought that there would be a much sharper downturn in activity than there actually ended up being. The impact of uncertainty because people suddenly didn't know what was going to happen in terms of trading arrangements might have caused a big fall-off in investment; people stopped spending money.

In the end, those things didn't happen suddenly, and because the Bank of England – because the government loosened policy, all of that meant that the immediate impact was quite muted.

Actually, two years on, most commentators, ourselves included, think that probably the UK is about 1% worse off because of the Brexit vote compared to the situation if they hadn't made that decision. And the simple way of looking at that is to see that, while the rest of Europe and the US is now growing moderately strongly, the UK is still stumbling along at around 1%, 1.5% growth. And we think, normally, we would have expected a bigger upturn in growth.

So, for now, those impacts in the short run are there, but they're not huge.

Looking further forward, the long-run impact of the UK weakening their ties with their largest trading partner is likely to be that trade will be lower. That means GDP will be lower for a while, and the knock-on consequences that might have for productivity growth and, more generally, the ability of the UK to innovate and to find new opportunities is perhaps hindered.

So that's why we think, in the long run – and many commentators have done these calculations – the consensus is the level of GDP could be 5–6% lower. Could be even more than that.

Lara de la Iglesia: So, given the uncertainty around the possible Brexit scenarios, how has the rest of the European Union reacted, and what impacts might we expect there?

Peter Westaway: Yes, that's an interesting question because before the Brexit vote, and immediately afterwards, there were many people who feared that the Brexit vote may set in motion a domino effect, where other countries looked at what was going on in the UK and thought, "Well, maybe we should leave the EU as well."

In the event that hasn't happened, and if anything, the countries of Europe have been brought more closely together. I mean, that's been helped by the election of the [President Emmanuel] Macron government in France, which has a very pro-EU tendency as well.

So, overall, I think the EU has been, probably, brought more closely together because of this rather than thrown apart.

That's not to say that there aren't still populist, anti-euro, anti-EU tendencies in the euro area and in Europe. But, perhaps, they're just not quite as strong as they were a few years ago. I mean, the obvious danger point would be in Italy where, at the moment, a populist government led by the Five Star movement and the Northern League are now in a coalition where there's some question marks about whether they really are committed to the EU or to the euro. And, if they were to start making big changes in policy that would definitely undermine the integrity of the whole European structure.

But, for now, we don't think that's going to happen, and so, the Brexit situation is an irritant for the EU. It'll certainly have a negative impact on activity in Europe, certainly for those countries that are closely integrated, like Ireland, the Netherlands, France and so on. But I think the show will stay on the road in a way that maybe some people were fearing it wouldn't when this thing first started.

Lara de la Iglesia: Okay, thank you. So, until we know what decisions will be made around Brexit and how things are going to play out, what guidance would you give to global investors?

Peter Westaway: Yes, that's a difficult one. I mean, in the run up to Brexit, many people were saying, "Should we avoid sterling [the British pound]; should we avoid going anywhere near it?" And I think, in retrospect, markets didn't react very negatively in the way people feared.

And so, again, looking forward, because there are many different options on the table, if there was a very bad Brexit, I think sterling would fall, sterling assets would fare badly. But if we end up having a much softer version of Brexit, or even no Brexit at all, then I think sterling and sterling assets could do well.

So unless you have a big conviction on which way it's going to go, I think just keeping UK assets as part of your globally diversified portfolio is still a sensible way to go. It's very difficult, at the moment, to predict exactly how this is going to play out.

And, you know, the political experiences that we've had over the last couple of years around the election of Donald Trump, Brexit, events in Europe, it's very hard to predict in advance what's going to happen. And it's also very hard to predict, even if you did know what was going to happen, how markets will respond. And so, in that environment, keep it simple.

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The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

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This material is directed at professional investors and should not be distributed to, or relied upon by, retail investors.

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The opinions expressed in this material are those of the individual speakers and may not be representative of Vanguard Asset Management, Limited.

This material was produced by The Vanguard Group, Inc. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

Issued by Vanguard Asset Management, Ltd which is authorised and regulated in the UK by the Financial Conduct Authority.

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