Focus on ‘will of the people’ misses bigger Brexit picture

Former UK prime minister Tony Blair recently warned that a non-aligned UK, after leaving the European Union, would have little trade or military influence in a world increasingly dominated by three powers: the US, China and India.

Speaking at the same summit, the Yalta European Strategy Forum in Kyiv, Ukraine, eminent Peruvian economist Hernando de Soto suggested wars are typically caused by failure to create solid trade deals. Most international military conflicts can be avoided if we enter closer trade arrangements with neighbours and potential rivals.

This was the strategy behind the establishment of the European Coal and Steel Community in 1951, precursor to today’s EU. It was promoted by French foreign minister Robert Schuman with the aim of making another war between France and Germany “not only unthinkable but materially impossible”.

During the wall-to-wall coverage of Brexit in today’s media, especially in the UK, there is little talk about this vitally successful geo-strategic aspect of European integration. Most talk relates to immigration, “sovereignty” and a daily call for governments to listen to the “will of the people”, however self-destructive this may be. Even long-term effects on international trade are not discussed in any depth.

The lasting peace in Northern Ireland, monitored by the EU, saving countless lives and creating a vibrant regional cross-border economy, is considered a distraction by ideologically-driven Brexiteers.

Despite recent political unrest in eastern regions and disquiet about the country’s leadership succession, Germany’s perspective on Europe is very different and the wartime experience still feels fresh. 

“After the experience of the 1930s, there is no possibility of a referendum in Germany,” says Christoph Schon head of applied research at Axioma, which helps investment managers with portfolio construction and risk measurement. “It is simply unthinkable for Germany to leave the EU.”

Axioma has modelled scenarios for concerned clients among investment houses and private banks. Mr Schon believes the only two serious options are a “no deal” Brexit or second referendum, with the latter most likely, and a feeling the UK will now vote in favour of remaining in the EU.

The probability of a “soft Brexit” agreement with the EU is calculated at 60 per cent by James Bevan, an economist and head of investments at CCLA, which manages assets for foundations and charities. He gives the hard version a 30 per chance and no deal 10 per cent. That said, Mr Bevan expects a final deal to be rejected by parliament, leading to a second referendum or a general election.

In either case, the inverse relationship between the pound and the FTSE100 index of leading shares will finally come to an end, believes Mr Schon, with both set to surge if the UK remains in the EU and falling if no deal is reached before a disorderly Brexit.

In a hard Brexit scenario, Axioma expects sterling to drop up to 15 per cent from current levels, resulting in a 12 per cent UK stockmarket crash, according to recent stress tests.

The firm ‘s analysis of recent stockmarket drivers concluded the global economy was powered by three engines during 2018: China, the US and the EU. However, inward-looking trade policies in the US and a developing US-China trade war, plus other geopolitical risks in the Middle East, Russia and Korea, could play a dominant role and cause cross-asset correlations to continuously swing from side to side during 2019.

There appears to be more optimism for European markets than the US, which has largely finished its love affair with president Donald Trump’s protectionist policies. As we enter 2019, markets appear ready to punish those moving from global co-operation towards isolationism. “The populists have no credible alternative,” says Mr Schon. “They feed on discontent but do not offer a better model.”

Yet there is a fear from Mr Schon and other economists that the isolationist movement has further to run. The Centre for European Reform (CER), a think-tank devoted to reforming EU institutions and practices, warns UK financial services exports to the EU could plunge by more than 50 per cent if the government carries out plans to leave the single market.

“Any deal short of single market membership would see UK-based services exporters to the EU facing new barriers,” says Sam Lowe, senior research fellow at CER. This would lead to businesses moving operations to within the EU, taking high-skilled jobs and tax revenues with them.

Despite this bleak prognosis, private bankers at Coutts expect London and the UK to prosper, even if there is an inevitable recession following the unlikely possibility of a no deal Brexit.

London and the UK remains a place superior to most competitors when it comes to conducting business. “From a financial sector viewpoint, the leading role of London in asset management will remain untouched,” believes Alan Higgins, chief investment officer at Coutts & Co. Delegation of fund management responsibilities from EU states to London will still be possible after Brexit and the UK’s capacity for innovation and digitalisation are not in question, he believes.

Other economists see potential for longer-term power shifts away from London to Asian cities. Trade routes have historically been development axes for large cities and the main source of wealth creation.

These routes are being redefined in the 21st century under the influence of capital mobility and globalisation, believes Patrice Gautry, chief economist at Union Bancaire Privée. Government stability, the fiscal environment and size and accessibility of domestic markets have also played a key role. 

“Brexit creates constraints as the UK domestic market would be relatively small without access to the European single market,” he says.

Over the long term, this suggests European financial hubs will lose influence, while the US and China dominate. Although China has relatively small equity and bond markets compared to the US, the Chinese authorities will prioritise the growth and development of their financial system, so that their markets will be better placed to serve their growing economy. “Competition among financial hubs will probably increase as a result of these developments,” predicts Mr Gautry.

Where the UK will be placed in this new Great Game could have serious ramifications in both financial and security terms. For populist politicians, the “will of the people” can be the most dangerous tool to bargain with.