How to trade a hard Brexit

Despite the recent breakthrough in Brexit negotiations, the government’s position is looking increasingly precarious. There are seemingly contradictory positions on key regulatory issues, deep divisions within the Conservative Party (and DUP coalition), and concerns about the need for parliamentary and EU approval of the final Brexit bill. And if any one of these issues unravels, we could see Britain head towards the hardest possible Brexit – a ‘no-deal’ scenario.

What would a no-deal Brexit actually look like?

Under a no-deal Brexit scenario Britain would leave both the single market and customs union, and default to World Trade Organisation (WTO) rules. This would have two key implications for goods and services moving between the UK and EU, with repercussions across stocks, indices, forex and more. 

Firstly, tariffs would be applied to British exports to the EU. The tariff applied would vary by product category, but couldn’t be higher than the lowest percentage applied to equivalent goods from another WTO member (known as the EU’s ‘most favoured nation’). The lowest numbers currently range from 0% for pharmaceutical products to 49% for meat. Britain is likely to copy the EU’s schedule of tariffs when it leaves, so the EU’s exports to the UK would be subject to the same rates.

Secondly, goods and services would be subject to increased regulation, which could be more of a burden. Border checks would be implemented on goods to ensure the relevant standards and regulations are met, with the cost of these checks (including detention and tests) absorbed by the exporter. 

Days or weeks and thousands of pounds in costs could be added to every shipment. Services would fall under separate WTO rules and individual countries’ regulations, which could significantly reduce trade. Some firms could also lose ‘passporting rights’, and require re-approval by each individual member state to operate. 

What does a hard Brexit mean for the markets?

Approximately 43% of the UK’s exports go to the EU, and 7% of EU trade is accounted for by exports to the UK. This trade would be reduced significantly as a result of a hard Brexit, so it’s possible that both would experience a significant economic downturn. Here’s how the markets could shape up: 

Forex
Sterling would likely fall drastically if Britain appears to be heading towards a hard Brexit given the potential for a severe economic shock, and the euro could also fall to a lesser extent. The dollar could strengthen if investors look to move their money into a more protected economy.

Indices
The indices that will likely take the biggest tumble as a result of a hard Brexit are the FTSE 100 and FTSE Mid 250. The FTSE 100 is more reliant on exports, so reduced trade with Europe could see a major price correction. The more domestically-focused FTSE Mid 250, on the other hand, would likely suffer more as a result of rising inflation, as well as reduced consumer and business confidence. 

Indices in other EU countries which do a lot of business with the UK are also likely to take a hit. Watch the CAC (France), DAX (Germany), MIB (Italy), IBEX (Spain) and AEX (Netherlands). 

Stocks
Consider which companies and industries are most likely to be weighed down by tariffs, border checks, and service regulations. EU tariffs are highest on agricultural products, food, tobacco, textiles, clothing, and vehicles, while border checks are likely to disproportionately affect manufactured goods including electronics, vehicles, perfume, cosmetics, toys and sports equipment. 

And in terms of services, airlines, transportation businesses, and financial services firms would likely feel the effects EU regulations most strongly. 

Commodities
The effects of a hard Brexit are likely to be mixed. Investors may look to invest in safe-haven assets, so precious metals including gold and silver could rise. Other commodities – especially those priced in London – are likely to take a hit due to reduced demand, though this could be offset (nominally) by a rise in inflation. Watch London Cocoa and London Wheat.

Bonds and rates
The yields on UK gilts would likely rise if a hard Brexit materialises, if investors sell due to uncertainty and the anticipated inflationary pressures. However, yields on Bund and Treasury Bond Decimalised could fall as investors look to move their money overseas. 

At the same time Euribor would be likely to rise due to reduced liquidity between European banks (in the absence of London’s banks and clearing houses), while Short Sterling could fall if inflation rises faster than expected.

How to spot a hard Brexit

The financial markets would be likely to price in the uncertainty created by a hard Brexit before the actual event, so traders looking to capitalise on such an eventuality will need to be vigilant. In particular, there are three key things to pay attention to:

1.  How the second stage of negotiations plays out

The second phase of negotiations will be kicking off in early 2018 and continue until at least October but, if these talks break down, a hard Brexit could be on the cards. Rhetoric from Brussels and London (and EU27 capitals) should act as a useful barometer of how talks are progressing.

     2. Ratification in Parliament, and beyond

If the Brexit deal makes it beyond the negotiating table, the exit terms will still need to be ratified by the UK Parliament, EU Council and Parliament. Similarly, the terms of any new trade deal will need to be approved by the UK Parliament and remaining EU27 states. Either process could lead to significant delays or even a rejection of the final bill. Again, the result would be a hard Brexit and a significant change in market sentiment.

    3. Any problems at home

Finally, dissent within the Conservative party or the coalition government could undermine the UK’s negotiating position or lead to lengthy delays – if, for example, another general election or leadership contest is required. So watch out for any signs that Theresa May’s position is becoming untenable.