A hard Brexit is looking increasingly likely by the day, and it’s going to shake equity markets around the world as the March 29, 2019 closes in.
Practically, a hard Brexit means that the United Kingdom would crash out of the European Union without any trade deal to take its place. Sound scary? It is, and it will put astounding pressure on UK equities and bonds especially. ETFs like the iShares United Kingdom ETF (NYSE:EWU) may fall hard.
However, take comfort. We’ve seen this whole movie before with Greece, which threatened to crash out of the EU several times already, and never did. The UK might, briefly, but shortly afterwards a deal will be struck in the aftermath and probably ensuing market chaos. In the event of a bona fide hard brexit, buying the dip in UK stocks and ETFs will be scary and difficult, but it will be worth it. Here’s why.
When Greece threatened to crash out of the Euro, it was a very lopsided back and forth between Brussels and Athens. The EU did not really need Greece, but Greece needed the EU. Greek equities were of course crushed and many never recovered. The UK is different because compared to Greece, it is an economic powerhouse and it’s not bankrupt. While the EU could have afforded to let Greece crash out of the EU without a trade deal had a bailout not occurred, neither the EU nor the UK can afford a hard Brexit for any sustained period of time. In other words, a hard Brexit may happen, however briefly, but in the ensuing freefall, the two sides will quickly understand that they are both severely hurt by the lack of a deal. They will come together and hash out something. It’ll just take something scary to get there. From that point, European, and probably global equity markets, will breathe a huge sigh of relief.
Why must there by a deal eventually? Because total trade between the UK and the rest of the EU in 2016 totaled £560B, combining imports and exports. You can’t have that kind of trade come to a standstill and expect calm in the streets for long. The only questions are which side will hold out longer, how long will the brinkmanship last, and how long will a hard Brexit last without a deal,.
Here are a few things to consider. First, in Britain, companies are already starting to stockpile supplies in preparation for a hard Brexit. Sanofi (PA:SASY) for example is expanding its stockpiles to a 14-week supply over its current 10-week maximum. Novartis (NYSE:NVS) is doing the same, as is AstraZeneca (NYSE:AZN), expanding current stockpiles by 20%. That should put the maximum deadline for a hard Brexit without a deal at about 3 months. European leaders will simply not allow a situation that chokes off life-saving medications like insulin for diabetics. Brinkmanship can go far, but not that far.
As for which side will be more desperate, the quick answer most people assume is the UK, simply because it’s smaller than what will remain of the EU. But it’s actually not quite clear. The EU could actually be in worse trouble than the UK without a deal within that 3-month timeframe before a medical shortage ensues. Why? Because no deal will roil bond markets throughout the EU, which already has severe pressure points in Italy, Spain, and Portugal that are still raw and not ready for any sustained pressure. No deal could cause the festering sovereign debt crisis in the Eurozone, which has never been healed and which the UK is not a part of since it never joined the Eurozone, to reemerge quickly, putting severe pressure on Brussels to get a Brexit deal done before sovereign defaults become a significant threat.
Consider, Italian bonds spiked to nearly 3% on August 2 with no apparent catalyst causing it. Spain’s political situation is getting increasingly muddled and the Catalonia secessionist question could resurface on any new elections there. The EU is still coming apart at the seams, and the UK is not. This might be what the diehard Brexiteers are relying on as they have refused to compromise to the level that British Prime Minister Theresa May has. The hard line Brexiters have all pretty much left the May Administration, leaving her government extremely vulnerable.
It could be then, that in order to get a better deal, Brexiters in the UK government are willing to try out a temporary but hard Brexit, and see if Brussels will grant concessions if the fabric of the remaining EU comes under serious stress.
Either way, whichever side croaks first, a deal will be struck, and UK stocks will bounce back hard. The most volatile shares will probably be UK banks like HSBC (NYSE:HSBC) and UBS (NYSE:UBS). A hard Brexit will smash UK financials, and when a deal is finally hashed out, they will catapult back up just as quickly.
Disclosure: No positions in any stocks mentioned