Now that Boris Johnson’s Conservative Party has won a decisive parliamentary majority, negotiations on the actual terms of Brexit put us into uncharted territory. For the first time in the post-WWII period, a country is negotiating a free trade agreement with a trading partner many times its size in an attempt to diverge economically and gain competitive advantages.

A Landslide Victory

In the December 12 general election, 52% of the vote went to parties pledging another referendum on Brexit, and 48% to Johnson’s Conservative Party and three other groupings advocating immediate withdrawal from the European Union (EU). This translated into an 80-seat majority for the Conservatives—365 seats for Tories versus 202 seats for Labour and 83 seats for all other parties.

The immediate effect of this Tory win is two-fold. First, it removes the risk, however remote, of a sharp hard-left pivot toward the nationalization of entire swathes of the UK economy and wholesale wealth redistribution. Second, it cements the UK’s departure from the EU within a month or so.

The pound sterling duly rallied by 2% to touch 1.35 briefly on the news. And we can expect Parliament’s passage of the EU Withdrawal Agreement Bill by the end of the year. Beyond that, what happens next becomes hazy.

What Happens Next?

Even with a bare-bones free trade agreement, the disruption to the UK economy in the short term is likely to be substantial.

The Conservative Party’s pledge that the government “will not extend the implementation period beyond December 2020” suggests a path to a de-facto hard Brexit, as only a bare-minimum post-transition trade agreement can be reached and ratified by the end of next year.

Specifically, the UK and the EU would just have time to agree to a zero-tariff, zero-quota free trade agreement in which the UK agrees to zero dumping. In other words, the UK would have to commit to adhering to the EU’s rules on state aid, which bans subsidies in the form of grants, loans, tax breaks, or pricing that selectively benefits UK companies or threatens competition and trade in the European Economic Area.

But Johnson has already said that he wants to revoke EU state aid rules to make it easier to bail out failing industries while simultaneously proposing a “buy British” approach to public procurement.

In other words, the goals of a free trade agreement with the EU by December 2020 and independent industrial policy for the UK are irreconcilable on any timeline that is not measured in decades.

Even with a bare-bones free trade agreement, the disruption to the UK economy in the short term is likely to be substantial.

Outside the EU’s customs union, goods will become subject to clearance procedures and will lose their rules-of-origin benefits, which are important for goods that are finished in the UK using imported parts. UK-based companies in auto, aerospace, chemical, food, life science, and financial services industries would face severe disruptions to their businesses under a bare-bones free trade agreement.

Out of Options?

The option to seek a two-year negotiation extension may be more constrained than the massive parliamentary majority suggests.

The option to seek a two-year negotiation extension may be more constrained than the massive parliamentary majority suggests. Some commentators have assumed that when faced with the prospect of a substantial economic disruption, Johnson will renege on his word and request a transition extension of two years, past the current December 2020 deadline.

With the parliamentary majority of 80, he is no longer captive to the European Research Group (ERG) of Tory Eurosceptics, and will have the freedom to act as he sees fit. This analysis assumes that the ERG will remain a minority within the new parliamentary majority. But with Johnson’s recent purge of the Tories’ leading centrists and with hard-right Brexit parties back in the Conservative fold, the ERG may have a greater say than at any time before the election.

Further, a transition extension will imply a continuation of UK transfers into the EU budget, which were around 8.5 billion to 8.9 billion pounds in 2018, not the 17.4 billion pounds claimed by Brexiteers. The longer the UK remains in transition, the longer it will take to reach meaningful trade agreements with other powers, such as the United States.

Finally, there is the issue of the territorial integrity of the UK.

Winning 48 to the Tories’ 6 seats in Scotland, the Scottish National Party (SNP) has already begun what may turn into a relentless campaign for another independence referendum. This demand may gain further momentum if Johnson stays on the path to “hard Brexit” at the end of 2020. Northern Ireland also took a step toward Irish unification: for the first time, a majority of Irish-unity members of parliament were elected.

Watching the Situation

As economic constraints of the possible choices become more obvious, the UK economy and pound sterling may face substantial downward pressure past the first quarter of 2020.

Olga Bitel, partner, is a global strategist on William Blair’s Global Equity team.

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Any statements or opinions expressed are those of the author as of the date of publication, are subject to change without notice as economic and markets conditions dictate, and may not reflect the opinions of other investment teams within William Blair Investment Management, LLC or the Investment Management Division of William Blair & Company, L.L.C.

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Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Investments are subject to market risk. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Statements concerning financial market trends are based on current market conditions, which will fluctuate.

William Blair does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax questions and concerns.

Distributed by William Blair & Company, L.L.C., member FINRA/SIPC.

The William Blair Funds are available to U.S. residents only. Non-U.S. residents, please click here.

Copyright © 2020 William Blair & Company, L.L.C. "William Blair” is a registered trademark of William Blair & Company, L.L.C. No part of this material may be reproduced in any form, or referred to in any other publication, without express written consent.

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