How Does a 'Hard Brexit' Effect Global and U.S. Markets?

MORE THAN THREE YEARS AFTER BRITISH CITIZENS VOTED to withdraw from the European Union, “Brexit” seems more uncertain than ever. The original departure date of March 29, 2019 has been delayed twice, and the latest October 31, 2019 deadline may be pushed back further as British and European officials struggle to preserve key elements of free trade.

The saga has already cost two British prime ministers their jobs and cast doubts on the future of current leader Boris Johnson. But the real turmoil could come with a “hard Brexit”—if the U.K. leaves the EU with no trade agreement—says Kathryn Cassavell McDonald, vice president and market strategy analyst in the Chief Investment Office for Merrill and Bank of America Private Bank.

That scenario could lead to new tariffs, higher costs for consumers, setbacks for the U.K. and EU economies and challenges for U.S. companies who do business in both areas, she says. Though fears of a hard Brexit have abated somewhat in recent weeks, a new CIO report, “‘Hard Brexit’ Q&A,” explains why the worst could still happen, what to look for next, and what’s at stake.

Where do things stand?

Johnson, a Brexit advocate, has threatened to pull out by October 31 with or without a trade agreement, McDonald notes. Yet a new British Parliament law requires him to seek a deadline extension if no deal is struck, at least temporarily averting a hard Brexit. “The EU would probably grant that extension, and a solution would be kicked further down the road,” McDonald believes.

With so little certainty on any front, McDonald outlines five possible outcomes:

1. Remain in the EU. A second British referendum reverses the 2016 vote, scrapping Brexit and leaving the U.K. as part of the EU.
2. Single market. The U.K. and EU sever political ties, but retain free movement of goods, services, people and capital.
3. Customs union. Post-Brexit trade stays tariff-free with reduced border checks.
4. Free-Trade Agreement (FTA). The U.K. and EU negotiate a new FTA similar to the one between the EU and Canada.
5. Hard Brexit. Despite the recent British law requiring an extension, “The chance of a hard Brexit, where the U.K. exits the EU without a trade agreement, is far from eliminated,” McDonald says.

The answer could hinge on British elections that would likely take place if the October 31 deadline is extended—and there’s no perfect scenario. “If the Conservative Party increases power, prospects of a hard Brexit would rise,” she says. “A surprise victory by the Labour government could result in more anti-business policies, and a hung parliament could just cause more delays and uncertainty.”

Who would feel the pain from a hard Brexit?

“Losing preferential access to the EU market would be a significant blow to U.K. companies,” McDonald says. “Exports to the EU make up more than 13% of U.K. GDP.” The economic impact on the EU, while lower, would still be substantial, she adds. Along with tariffs, a hard Brexit would result in other trade barriers, such as customs inspections and regulatory and compliance hurdles.

“The most likely early effect, in my opinion, would be a decline in the value of the British pound, resulting in higher inflation in the U.K., and higher costs for goods imported from the U.S. and elsewhere,” notes McDonald. While a hard Brexit would likely have only a modest long-term effect on the global economy, it could create significant challenges for U.S. companies. “For decades the U.K. has been a strategic, profitable gateway to EU markets for U.S. multinationals,” she says. “They may now have to rethink their global supply chains.”

What could investors consider?

“Given higher uncertainties in Europe and the U.K., we’re cautious about international developed markets right now,” McDonald says. “We think investors should consider having their portfolios focus more on the United States, where the U.S. economy and consumers remain strong.” Despite potential challenges for U.S. multinationals, it’s too soon for investors to take action, she believes. “This is something we’ll watch very closely,” McDonald says. “But the potential paths for the U.K. and Brexit are so diverse that the important thing is to maintain a balanced portfolio exposed to very strong companies.”