How big a Deal – Brexit and the US-China trade war

Last week proved unexpectedly eventful with the agreement of a limited US-China trade deal and the move towards a Brexit Deal. Global equities ended the week up 1.1% in local currency terms although, because of a bounce in the pound, were down 1.8% in sterling terms.

The US-China trade war has had many twists and turns over the past year and the latest deal in no way marks an end. All that has been agreed is that China will boost its purchases of agricultural goods and increase access for US financial services firms and in return the US will suspend the tariff increase scheduled for this week.

Further US tariff increases are still scheduled for mid-December and talks in November to stave off their implementation may prove problematic as they will focus on controversial areas such as intellectual property. We expect trade frictions between the US and China – and also between the US and EU – to remain a source of volatility over coming months. However, we continue to believe trade tensions will eventually diminish as Trump will be keen to announce a somewhat broader deal ahead of the Presidential election next November.

Brexit negotiations over the last three years have made US-China trade discussions look like a walk in the park. They too have been full of numerous twists and turns and last week’s turn of events was undoubtedly one of the more unexpected.

Boris Johnson has abandoned his proposal for a border across the island of Ireland, effectively replacing it with a customs and regulatory border in the Irish Sea. Northern Ireland would remain legally part of the UK customs area but in practice would be part of the EU customs area.

The new plan has met with a reasonably positive response from the EU although the latter is saying a lot more work still needs to be done. It now seems quite possible a Brexit deal could be agreed by the EU at the summit later this week, which would then be voted on by Parliament on Saturday. Whether or not Parliament would then approve the deal is far from clear. The Government is currently some 40 votes short of a majority and the result would probably hinge on the DUP and Conservative euro-sceptics.

The market reaction on Friday to the Brexit news was for the large part not unexpected and should be viewed as a template for things to come in the event of a Deal. The pound and UK mid-cap stocks both rallied strongly on Friday, gaining 3.3% and 4.2% respectively. By contrast the FTSE 100 – with the bulk of its earnings coming from overseas and now worth rather less in sterling terms – was up a more modest 0.8%. The one surprise lay in the reaction of UK small cap stocks which, despite their domestic focus and cheapness, were up only a modest 0.5% on the day.

All this left the UK market overall outperforming significantly with a gain of 1.4% on Friday, compared with a 2.0% decline in sterling terms for the rest of the world. Our assumption is that a Deal could very well take the pound back up towards $1.35. This in turn would lead to the UK outperforming other markets another 5-10% or so in sterling terms with mid cap – and also small cap despite their lacklustre performance on Friday – benefiting the most.

A Deal will be a very big deal but don’t make the mistake of believing it will mark the end of Brexit. Rather, it will just set the stage for no doubt interminable negotiations to seal free trade deals with both the EU and the rest of the world. Brexit related uncertainty will be reduced substantially but certainly not removed altogether.

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