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Brexit: Implications of Triggering Article 50

3 April 2017PoliticsEuropeUK

Brexit talks begin

The UK formally began the Brexit process on 29 March by triggering Article 50 of the Treaty of Lisbon. With this formal notification, the clock starts ticking. The EU and UK will now have a 2-year deadline to complete separation negotiations, agree on future UK-EU trade relationships as well as a transition between the two. The stakes are high. Unless the UK strikes a deal or all parties unanimously extend negotiations, the UK will exit EU on 29 March 2019.

A failure to achieve a deal could result in the reintroduction of binding customs controls, which will inevitably slow down UK trade. British airlines could also face restrictions on European flights. That said, EU's chief Brexit negotiator Michel Barnier has stated that the goal is to succeed and have an agreement. Citi analysts puts the probability of no deal or a chaotic Brexit at 30%.

A hard Brexit will also affect the EU. Changes to trade arrangements will affect euro area exporters exposed to the UK. On the other hand, countries that can market themselves as an alternative to the UK and attract foreign investment may benefit. On balance, Citi analysts feel that the UK needs a deal more than the EU.

Too little time

The EU is planning to make public its draft guidelines for the Brexit talks within 48 hours of Britain's triggering of Article 50. Once adopted by EU-27 leaders, potentially at the informal EU27 summit on 29 April, these will frame political priorities for the talks.

Differences are already evident on the onset. UK Prime Minister Theresa May has indicated that she would like exit and trade negotiations to run in parallel. On the other hand, Barnier has indicated that exit negotiations, which include an exit bill and the rights of 4 million UK and EU migrants, would need to be completed before any trade discussions can begin.

Citi analysts believe that progress on negotiations may be slow with the French and Germany elections taking place this year. Barnier has also stated that a future trade deal will require unanimous approval of all EU member states and their parliaments, Citi analysts believe that the time is too short for a complete settlement by 29 March 2019. As such, they expect an extended transition with Britian still in the single market and continuing negotiations about the future trade deal.

Aside from the Brexit negotiations with the EU, the UK government may also have to contend with the Scottish government's drive for an independence referendum. While polls currently do not suggest that independence is likely, a disruptive Brexit and the resulting economic consequences may swing public opinion towards greater independence.

Economic & Market Implications

Amid these political uncertainties, Citi analysts expect the UK economy to face tougher times ahead. With the EU exit now irreversible, business investment is likely to remain weak and dampen growth in late 2018 and early 2019. Rising inflation, as a result of the weakened Pounds (GBP), will also erode spending power and weigh on consumer spending. Although retail sales rebounded in February by rising 1.4%, following poor readings in January, the trend is much weaker than last quarter and points to a sharp slowdown in private consumption. Hence despite elevated inflation, Citi analysts expect the Bank of England to leave base interest rates on hold in 2017 and 2018. This will in turn help to keep 10-year gilt yields low with the potential to rally on negative headlines from the negotiations.

Equities: The outlook for UK equities is relatively benign. Citi analysts expect UK equities to move moderately higher over the course of the year and have a 2017 year-end target of 7600 for the FTSE 100 Index. Valuations look expensive on a price to earnings basis given the sharp fall in earnings in 2016. For 2017, Citi analysts expect earnings to grow 24% in 2017, driven by the banks, oil & gas and mining sectors. With 70% of profits generated outside of the UK, earnings tend to be boosted by a weak Pounds (GBP). Historically the UK stock market performance has also tracked dividends closely. A projected dividend yield of 4.05% looks attractive, especially when compared against UK gilts.

Citi analysts favour international companies with strong balance sheets and high levels of non-UK profit exposure, particularly in the commodities and technology sectors. UK domestic banks may face headwinds from overheating consumer finance while retailers may be hurt by falling real wages and lower consumer confidence

GBP: Against the political and economic headwinds described above, Citi analysts forecast the Pounds (GBP) to decline modestly from current levels. With the Fed poised to hike rates further and the European Central Bank moving to a slightly less accommodative monetary stance, these moves are likely to be supportive of the USD and EUR at the expense of the Pounds (GBP). At the same time, the UK continues to run a wide current account deficit around 5% of GDP. With Brexit, issues surrounding passporting arise. This is the right for financial services companies registered in the European Economic Area (EEA) to do business in any EEA state without needing further authorization in each state and could threaten the UK services surplus which currently stands around 5% of GDP. On balance, the Pounds (GBP)'s historically cheap valuations prevent Citi analysts from becoming overly bearish on the currency although they feel that significant upside is unlikely. Citi analysts expect the GBPUSD to move towards 1.20 in the next 6-12 months.

Key takeaways:

  • With the European leaders likely to be distracted by the Germany and French elections and the need for the future trade deal to have the unanimous approval of all EU member states and their parliaments, Citi analysts believe that the time is too short for a full settlement by 29 March 2019.
  • While the UK economy is likely to be weighed down by weak business sentiment and rising inflation, the outlook for the Pounds (GBP) and UK equities is not overly bearish.

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