Policy uncertainty, in and of itself, is negative for economic growth, and in this sense the Brexit deal should be positive. However, even a free trade agreement imparts significant short-term economic costs (and most likely long-term too), and remains an item in a list of reasons why the UK may emerge from the Covid-recession as an economic laggard. 
Non-tariff barriers to trade
It has been much repeated that the new trade deal with the EU avoids the imposition of tariffs. This is good news. Economic research teams at Citi, Oxford Economics or Capital Economics concluded that “no deal” would have seen 0.5-2.0 percentage points less GDP growth by the end of 2022 relative to what it might be under the trade deal.
Over the long-term, however, non-tariff barriers (NTBs) are likely to exert by far the greater cost and the trade deal doesn’t negate these. The Bank of England expected around 80 per cent of the total reduction in trade as a result of “no deal” to be attributed to NTBs. The Cabinet Office recently estimated the cost to UK companies of filling out customs declarations alone, for example, could come to £7bn.
There is some good news. An annex on medicinal products sets out an agreement on mutual recognition of inspections and manufacturing practices. Medicinal and pharmaceutical goods are the third-largest category of UK exports, with the second-largest trade surplus among categories of goods. The deal also sets out steps for UK manufacturers that prove good behaviour to become Authorised Economic Operators, which would reduce some frictions but by no means all of the costs.
The UK won’t impose the new customs regime on imports from the EU until at least 1 July 2021 to allow firms to acclimatise, while the EU will impose full checks from day one. Therefore, the UK’s exports to the EU are disrupted by more than its imports from the EU. We’ve already seen the detrimental effects on Scottish seafood or M&S’s beloved Percy Pigs.
It has been known for some time that NTBs are going up. As has the near-unanimous verdict of economists (a rarity!) that the effects will be negative for UK growth. As investors, we focus on what risks may not already be compensated for by today’s prices.
Risks to trade in services remain
The trade resolution makes us more hopeful about crucial negotiations on cross-border financial services, digital and data transfer rights between the UK and the EU, or the portability of accreditation to conduct accounting services due to take place this year. The deal contains an agreement to permit lawyers to provide cross-border services. British politicians have pointed to the framework that the deal provides for establishing mutual recognition of professional qualifications. However, the EU’s deal with Canada also contained such a framework and yet no recognition negotiations have been successful.
In short, risk and uncertainty remain. The UK runs a large trade deficit in goods that is paid for mostly by its large trade surplus in services, which is almost entirely in financial and other professional and technical services.
The UK has legislated for a temporary passporting regime that allows EU firms to continue to operate in the UK while the process of obtaining full authorisation is worked out. The EU has not reciprocated, and UK firms have transferred their EU clients to EU subsidiaries to minimise the disruption.
Investment and public policy
The costs of Brexit can be broken down into three: (i) short-term disruption; (ii) productivity and capital losses; (iii) long-run costs associated with being a more closed economy.
The drag on productivity from Brexit could be eclipsed by a publicly backed wave of digitalisation, green energy infrastructure and initiatives to raise productivity outside of the south-east. Overall public investment has been lower than in other leading economies in recent years, and investment in digital infrastructure still lags investment in transport, energy and utilities, which in turn lags the best-performing advanced countries.
Public investment and support for private business investment has been noticeably absent in UK fiscal policy during the pandemic, in contrast with the EU’s Recovery Fund. But it featured prominently at the recent Conservative Party conference. Moreover, November’s Spending Review maintained ambitious plans for public net investment, increasing from £42bn in 2019 to an average of £73bn between 2023 and 2026, targeting digital and transport infrastructure and regional “levelling-up”.
The continued uncertainty around trade facilitation and the portability of data, financial services and professional accreditations will likely continue to hold back business investment. Between the referendum and the beginning of this year, UK business investment did not grow, compared to average growth of 10 per cent in the other G7 economies.
Academic research concludes that the vote to leave has also cost billions of pounds in lost foreign direct investment (FDI), which is particularly important for the long-run productivity gains on which business profits depend. Despite its underrepresentation in the UK stock market, software technology is an important sector for FDI, often accounting for the greatest number of FDI projects in a calendar year. Business services is often the second most important sector on this basis. Future inward investment is therefore also contingent on the result of those negotiations slated for 2021. It is imperative that a concerted public policy effort is made to ensure that the UK remains an attractive place to invest for the long term, and that a decade of stagnant productivity and low rates of firm formation are put behind it.
Fiscal and monetary policy
With the second-lowest debt burden among the G7 economies, structurally low interest rates and its own currency, UK public finances are sustainable.
Discretionary fiscal spending in the eurozone will remain significantly expansionary in 2021. The US is likely to follow suit. Despite higher debt burdens, government borrowing costs in these regions have stayed extremely low. The UK chancellor has shelved plans to prematurely withdraw support. This needs to occur at some stage, but getting the timing wrong could leave lasting scars.
The weight of a pound
Although the pound has rallied substantially against the dollar since late 2020, it has done little since the Brexit deal was announced. On a trade-weighted basis, the pound is still 10 per cent below where it was on the eve of 2016’s referendum.
We expect the pound to continue to appreciate, but both global and local cyclical factors may still hold it back over the next year. The pound is a highly cyclical currency versus the dollar or the euro – it falls when global investor sentiment falls more broadly. That’s mainly because the dollar accounts for circa 60 per cent of reserve assets, the euro circa 22.5 per cent and the pound just 5 per cent.
UK equity implications
The FTSE 100 has underperformed the MSCI World equity benchmark over the last five years. This year it ranks 22nd out of the 25 developed market indices we monitor. Since the vote to leave, the gap between valuation multiples, such as price-to-book value, in the UK and overseas has widened to a degree not seen since the 1970s, when the UK had to ask the International Monetary Fund for a bailout.
The gap is now starting to close, but there are non-Brexit reasons why we expect the valuation gap to remain wide for the time being. Historically, the UK has offered a high-quality dividend yield, but it is less the case today. The UK has also outsized exposure to financial companies and oil and gas, whose profits are held back by bigger structural forces. The exposure to resource extraction may have driven some underperformance as investors formally build environmental, social & governance (ESG) factors into their selection processes.
A global antidote to UK gloom
Companies listed in the UK earn between 70-80 per cent of their collective earnings overseas. There are many for which Brexit is ‘more bark than bite’ and offer good long-term investment opportunities. We are becoming more optimistic about global activity while acknowledging short-term cyclical risks still to navigate. The approval of Covid vaccines has changed the risk-reward profile of equities in 2021 too. Given everything, we believe a global mindset is needed to participate in this recovery.
Ed Smith is head of asset allocation research at Rathbones. The views expressed above are his own and should not be taken as investment advice.