Investors may be focusing on the wrong risk when it comes to Brexit, according to Capital Economics’ Paul Dales, who warns that any deterioration in relationships could hurt more than a ‘no deal’. 
Dales, chief UK economist at the consultancy, said that much of the analysis surrounding what happens after the Brexit transition period ends on 31 December has been focused on trying to work out whether a deal is agreed with the EU or not.
But such speculation about a deal is “impossible to call” and misses a more significant risk, said the economist.
“As the differences between a Brexit deal and a no deal are not as big as they once were, the economic costs of a no deal have diminished,” he explained.
He said this is partly due to the fact lots of arrangements have already been put in place, with the UK making progress with financial services equivalence and replicating 40 trade deals with non-EU countries.
“In a ‘no deal’ in these circumstances – a ‘cooperative no deal’ – the pound may fall from $1.29 now to $1.15, inflation may rise to a peak of 3.7 per cent and GDP in 2021 as a whole may be only 1 per cent lower than if there were a deal,” said the economist.
“And in this situation, financial services equivalence would probably be granted in 2021 and, if necessary, the UK and the EU would probably roll over any temporary arrangements in the future.”
The bigger risk is that there is an ‘uncooperative no deal’ where relations between the UK and EU deteriorate to such an extent that both sides start to unravel agreements already put in place.
The Covid-19 pandemic has diverted attention from the negotiations, while the EU chief negotiator – Michel Barnier – warned in August that a deal seemed unlikely.
Meanwhile, the controversial Internal Market Bill saw relations deteriorate as it could mean the return of a hard border on the island of Ireland. The bill means that if there is no deal, customs checks would not have to take place between Great Britain and Northern Ireland – and would therefore have to exist between Northern Ireland and Ireland, breaching the Good Friday Agreement.
UK prime minister Boris Johnson has also set a deadline of 15 October for a deal to be done, after which the UK would begin preparing for a ‘no deal’.
All this could sour relationships between the EU and UK, warned Dales.
“The UK could override part or all of the Withdrawal Agreement, the EU could respond by starting legal proceedings and few measures could be implemented to mitigate the disruption on 1 January 2021,” he said.
“In such an ‘uncooperative no deal’, the pound may fall to $1.10, inflation may rise to a peak of 4.1 per cent and GDP may be 2.5 per cent lower in 2021 as a whole than if there was a deal.
“The acrimony would probably continue beyond 2021 too, which may lead to fewer agreements in the future and the expiry of any temporary measures.”
While the fall in GDP would not be as severe as that witnessed during the Covid-19 lockdown, policymakers would have less firepower to respond, the economist said, although they would not be powerless.
“We suspect the chancellor would loosen fiscal policy by about £10bn – 0.5 per cent of GDP – and target it at those sectors hit hardest,” said Dales. “And the Bank of England would probably prop up demand, most likely through more gilt and corporate bond purchases rather than negative interest rates.”
Any kind of ‘no deal’ would be felt in financial markets first, said Dales, and it could have different outcomes.
“Just like with a deal, a ‘no deal’ would also be a double-edged sword for the FTSE 100 as the overseas earnings of its constituents would be boosted by the weaker pound, but their domestic earnings would be reduced by the weaker economic outlook,” he continued.
“At the same time, the valuations gap that opened between the price-to-earnings ratio of UK equities and those elsewhere since the EU referendum in 2016 would probably be sustained.”
The economist added: “For the FTSE 100, the boost from the lower pound will probably offset the drag from lower valuations to leave the outlook for the FTSE 100 much the same whether or not a deal is reached.
“The FTSE 100 could then continue to rise in line with global equity prices as the effects of the Covid-19 crisis fade.”
For more domestically focused companies of the FTSE 250, a weaker sterling and a hit to the economy would be “unambiguously negative”.
“This would be a repeat of what happened after the EU referendum in 2016,” he explained. “The situation for the FTSE 100 is likely to be broadly similar if the no deal is cooperative or uncooperative.”
Nevertheless, Capital Economics is currently assigning a 60 per cent probability that a deal is reached by a 31 December deadline and a 40 per cent chance that there is no extension and no deal. Dales said Johnson is likely to require a ‘political win’ as his popularity has fallen since the onset of the coronavirus.
“Given how far Boris Johnson’s approvals ratings have fallen during the pandemic, he’s in desperate need of a political win,” he said. “A deal would allow him to say he managed to ‘get Brexit done’.
“A deal would also go some way to quelling the rise in support for another Scottish independence referendum, which would surely soar after a no deal.”