Chris Darbyshire, Chief Investment Officer.
30 March 2017.

It has been a busy week for Brexit. Over the weekend, the Labour Party flexed its muscles for the first time since the EU Referendum. With Article 50 imminent, and no longer in danger of being accused of frustrating the “will of the people”, the Shadow Secretary of State, Sir Keir Starmer, declared that any Brexit deal must pass six tests of worthiness in order to earn Labour’s parliamentary support. One of those tests is decidedly ‘soft’: does Brexit deliver the “exact same benefits” that we currently have as members of the Single Market and Customs’ Union? This test will not be passed in the event of a hard Brexit. Finally, therefore, Labour has put its cards on the table, coming out in favour of a Brexit that looks very much like our current arrangements with the EU. It remains to be seen how much leverage the Labour Party will have but, at the very least, it’s a first sign of assertiveness.

The Government already knew it wasn’t going to have everything its own way following the Scottish Parliament’s vote in favour of a second Independence Referendum. With this move, Nicola Sturgeon has done what she can to plant her foot on the neck of the Government’s Brexit strategy. This may not be a terminal threat, but it makes life less comfortable for the Government. Given that the Scottish Parliament has already made it clear that membership of the European Single Market is its top priority, this also creates pressure for a softer Brexit.

“The Government already knew it wasn’t going to have everything its own way following the Scottish Parliament’s vote in favour of a second Independence Referendum.”

Liberated from the shadow of last June’s referendum, a group of pro-EU Conservative MPs are supposedly now willing to block Brexit legislation if negotiations with Brussels go badly. This tactic could, at some point, dramatically weaken Theresa May’s negotiating power given the Tories’ slim majority in the House of Commons. Moreover, the conditions are now in place for May to circumvent the ‘European Research Group’ of 60 hard Brexit Tory MPs. Her argument would be that the UK is simply not ready to leave, and won’t be at any time in the next two years. A softer Brexit is therefore necessary to reduce the potential risks of Brexit but, importantly, the Prime Minister can dress this up as being bureaucratically convenient rather than the fault of the process itself.

Yesterday, the Prime Minister sent the UK’s resignation letter to the European Union and it was decidedly conciliatory in tone when compared with earlier pronouncements. Gone was the threat to walk away from negotiations, gone the “no deal is better than a bad deal”, gone the anti-European Court of Justice language and gone the threat to turn Britain into an off-shore, low-tax competitor. In a letter clearly written for a domestic as much as a European audience, there were no fewer than seven references to the “deep and special” relationship Britain hopes to have with the EU. We also saw the first explicit commitment to protection for Ireland and the peace process in Northern Ireland. Also new was an acknowledgement that British industry must conform to European standards in order to trade with Europe, but that we will have little say over those standards. Manifest within the text (though already flagged in the Brexit white paper) is the acceptance of some form of an exit payment, the benefit of a transitional phase (rather than striving to complete a deal within the two-year timeframe), plus the promise of significantly enhanced powers for regional UK parliaments. Reading between the lines, the letter implies that the size of the exit payment could be used as a negotiating tool to accelerate discussions on a new trading relationship.

Also yesterday, incidentally, a provisional response to Article 50 (drafted by the European Parliament) was conveniently leaked. It provided a useful summary of the European Parliament’s negotiating strategy, though the parliament represents only one of the bodies within Europe that will contribute to the negotiating process (and one of the more aggressive bodies, at that). This document warns that no discussion of the free-trade agreement will take place until a number of exit-related issues have been agreed via a Withdrawal Agreement: principally the exit payment, the legal status of expats, a resolution of the UK-Irish border issue and, most controversially, that the European Court of Justice will be the ultimate authority for interpretation and enforcement of the Withdrawal Agreement. Of most relevance to the Brexit process, however, was an admission in the document that Article 50 is revocable, though it is revocable only on terms that would be unanimously agreed by the remaining 27 EU states.

This latter point is of great significance, because it means that the parliamentary vote to be held prior to exiting the EU would effectively become as powerful as a second referendum – this time the vote would be between leaving the EU on the terms agreed by the Government or not leaving at all on terms to be decided by the other 27 EU states. In order to ensure Brexit happens at all, therefore, the Government will have to plot a course that commands a majority in Parliament. This is highly likely to be a soft path.

With Article 50 out of the way, attention will now turn to the so-called Great Repeal Bill, the object of which is to formally bring EU law into UK law (EU rules having had a special status somewhat outside of the UK law-book up to now). Once this is done, this body of law can be adjusted to suit British purposes for which the government will issue a white paper on the subject today). The nature of the Great Repeal Bill, being the act of enshrining EU law first, and then asking, “do I need it?” will necessarily shed a great deal of light on the questionable economics of Brexit. For each clause of EU regulation (and there are many), lawmakers will have to consider if our domestic legislation should simply retain it to ensure continuity of British industry’s most important trading relationship. British industry will have its say in the Brexit process at this time, as any divergence from EU rules will create trade barriers and additional costs to doing business with the EU. While there will be the odd dissenting voice, the vast majority will be in favour of as little change as possible. Why rock the boat with so much else of economic and political consequence going on? At every turn, the path of least resistance will be to conform with EU law in the short term, which lays the ground for a softer Brexit and a continuation of existing ties with Europe.

Over time, regulatory divergence will occur as Britain chooses not to incorporate every change to EU legislation in our own laws. That is where ‘Henry VIII clauses’ will apply (special legislative powers were granted to Henry VIII in 1539 to change existing law without needing a vote in parliament). The sheer weight of EU law to be processed makes the normal parliamentary process difficult to follow, so a ‘Special Committee’ is likely to be convened to make adjustments without consulting parliament. The issue is, though, that the Special Committee’s powers will be constrained by MPs and the House of Lords, whose job it is to watch over the constitution. There is little doubt that MPs would approve of a mandate limited to retaining EU legislation in UK law. This is, after all, what parliament has been doing for the past 40 years. When it comes to allowing the Special Committee to diverge from European law, however, any progress will be more constrained. Legal systems, being products of the status quo, are naturally biased towards preserving the status quo.

Thus, there will be both a short term trend in favour of conformity to EU regulations and also a longer term trend in favour of preserving that conformity.

“The icing on the cake for soft Brexit would be if it actually improves May’s negotiating position with Europe.”

The icing on the cake for soft Brexit would be if it actually improves May’s negotiating position with Europe. And the reality is that a willingness to consider soft Brexit would make negotiations much smoother. It even makes sense as a negotiating ploy for the Tories’ hard Brexit camp. May’s opening gambit had been to be prepared to accept a hard Brexit or even ‘No Deal’. However, such an extreme position inevitably forces the EU to call her bluff, especially whenever negotiations break down. This will happen when the EU expects conformity with EU law that the UK is not able or willing to provide. With each disagreement, the deal threatens to lurch towards World Trade Organisation (WTO) status, increasing the probability that we end up there. However, if May can demonstrate relatively strict conformity with EU regulations from the outset, any demand for conformity by the EU is much less powerful. In fact, if conformity becomes Britain’s de facto position it removes a significant part of the EU’s leverage. The UK will be able to provide conformity, though it can still choose not to. We can still choose hard Brexit, but are not forced to go there.

The EU’s other principal negotiating lever, and perhaps the more formidable one, is simply the ability to delay negotiations. With the threat of WTO status looming, and UK businesses in the dark as to what degree of conformity would be required and what ‘No Deal’ really means, this would increase domestic, economic pressure on the Government. By being ready to conform, however, this threat is somewhat neutralised as the default expectation would be for ‘no change’.

Simply put, the UK has to be ready to conform in order to have any ability to manage how much it diverges. By ensuring conformity, divergence becomes an optional tactic. Without conformity, divergence is both necessary and inevitable, making the negotiation only a matter of ‘how hard?’.

Expectations for a softer Brexit would be perceived favourably by capital markets, especially the currency market. If our interpretation is correct, we would expect the Pound to rally. All of this will take time to materialise, however, and there are roadblocks that threaten Sterling in the shorter term. The first is the next two months: a period in which the UK will remain in an awkward limbo while the EU draws up its negotiating guidelines and sets out its initial negotiating position. During this period, the difficulty of negotiating with a supranational institution comprising many constituent parts will become apparent. The EU’s starting point (as outlined above) will disconcert many in the UK, particularly readers of right-leaning newspapers who have been led to believe that there will be nothing to pay, that Brexit only brings economic gains, and that the absence of EU red tape will liberate British business. How the press reacts may then influence the path taken by the Government.

How the public reacts will certainly influence the path of Brexit. We look to the local authority elections on 4 May for the next public judgement on the Government’s plans. Meanwhile, we remain overweight Sterling in our portfolios, anticipating a broad trend towards softer Brexit over time. The residual allocations to foreign currencies should preserve value in the event of Sterling hiccups along that way.