Reaching a mutually beneficial Brexit deal has so far been beyond the reach of UK and European Union (EU) negotiators. Now that COVID-19 has struck, can they avoid a damaging split?

COVID-19 has made the world a very different place from when we last wrote about Brexit. Back in January, we argued that the UK was likely to exit its transitional arrangement with the EU at the end of this year on either World Trade Organization (WTO) terms or with only a rudimentary trade deal—an outcome once called a hard Brexit. We thought this would make a recession in the UK more likely, leaving the pound vulnerable.

Several months on, the probability of a disruptive Brexit outcome has increased. Negotiations on the future trading relationship between the UK and EU have made little progress, and the deadline for extending the UK’s transition deal with the EU has passed.

While negotiations seem to be taking place in a more cordial atmosphere, there is little evidence of a meeting of minds on the most contentious issues: level playing field provisions, fishing rights and the role of the European Court of Justice. Moreover, the EU remains concerned about implementation of the Northern Ireland protocol to avoid a hard border on the island of Ireland (without which, there will be no agreement).

More Intense Negotiations in Prospect

We are entering a more intensive period of face-to-face negotiations. The UK would like to conclude matters by the end of the summer so it can continue preparing for the end of the transition phase—including, if necessary, reverting to WTO terms. But unless the negotiations break down altogether, a summer deadline looks wildly optimistic. It’s quite possible discussions will drag on into October, a hard deadline for the EU if it wants to ratify an agreement before the end of the year.

In January, we identified four scenarios for the end of the transition phase: no deal/WTO, limited agreement, close alignment and extension.

Disruptive Outcome Likely

We continue to think that the balance of risks is skewed towards one of the more disruptive scenarios—no deal or limited agreement—and more so than in January. That’s because any agreement that keeps the UK in close regulatory alignment with the EU would require one of two unlikely developments: either the British government would need to renege on its commitment to voters, or the EU would have to compromise the integrity of the single market. And while an extension of the transition phase might still be possible, the British government has shown no interest in pursuing this option, and it will be harder now that the July 1 deadline has passed.

But what about the other two scenarios? While it’s reasonable to assume that the British government and EU would prefer a deal, time is short and it’s still not clear how key differences will be bridged. With widespread misunderstanding of motivations and constraints on both sides, failure to reach a deal is therefore a real possibility. Indeed, the impact of COVID-19 has pushed Brexit well down the pecking order in both the EU and the UK. For the EU in particular, reinforcing the European project through its new Recovery Fund is now much more important than Brexit.

We compare our updated probabilities for the four scenarios with our January assessment in the Display above. We now put a higher probability on the UK exiting its transitional agreement with the EU at the end of this year with either a bare-bones trade deal or no deal at all. At this stage, we don’t think there is enough information to differentiate between these two disruptive outcomes—other than wishful thinking that a deal will be reached. And that hasn’t been a useful way of gauging Brexit outcomes.

The key point, though, is that either scenario would disrupt the UK’s trading relationship with the EU, with no arrangements to cover services and the reintroduction of customs and regulatory checks for goods. Yes, the UK will apply a light touch on its side of the border, but there’s no guarantee the EU will reciprocate. For this reason, both outcomes would have been considered hard-Brexit scenarios at the time of the 2016 referendum. In fact, a WTO-terms exit wasn’t even on the radar for most people back then.

Sterling a Likely Victim

So what does this mean for the pound sterling? That’s a more difficult call than it was back in January, but only because the pound has already fallen.

Indeed, it’s hard from a fundamental perspective to see much in sterling’s favor. Not only has the risk of a disruptive Brexit risen but the UK has handled COVID-19 poorly and is clearly lagging the rest of Europe as it emerges from lockdown (see Displays above). To be fair to the British government, its fiscal response has been impressive in recent months, but that’s also been the case elsewhere in Europe and the US—it’s not clear that this is a source of relative advantage for the pound. Even from a low starting point, the outlook is therefore biased towards sterling weakness.

Darren Williams is Director—Global Economic Research at AllianceBernstein.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. AllianceBernstein Limited is authorized and regulated by the Financial Conduct Authority in the United Kingdom.

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