Brexit deal removes one potential brake on the recovery - Capital Economics
UK Economics

Brexit deal removes one potential brake on the recovery

UK Economics Update
Written by Paul Dales
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Today’s news that a UK-EU Brexit deal will soon be announced may not boost the financial markets by much more than it already has. But a decent economic recovery from the COVID-19 crisis in the second half of next year may mean that the pound rises from $1.36 now to around $1.40 by the end of 2021 and the FTSE 100 climbs from 6,500 to about 7,500.

  • Today’s news that a UK-EU Brexit deal will soon be announced may not boost the financial markets by much more than it already has. But a decent economic recovery from the COVID-19 crisis in the second half of next year may mean that the pound rises from $1.36 now to around $1.40 by the end of 2021 and the FTSE 100 climbs from 6,500 to about 7,500.
  • It’s been reported that, four-and-a-half years to the day after the UK voted to leave the EU and seven days before the end of the status quo transition period, a Brexit deal has been agreed and will be officially announced by the Prime Minister today. The deal will need to be voted into law by UK Parliament (probably next week) and by the EU (it may provisionally agree the deal and hold a proper vote early next year), so it’s not 100% in the bag. Indeed, the latest reports are there’s been a last minute “hitch”, which has delayed the official announcement. But it seems unlikely (famous last words?) it will fall apart at this stage.
  • There’s not much detail yet on what exactly has been agreed. It appears that a compromise has been reached on fisheries that involves the EU fishing quota in UK waters being cut by 25% over a five-and-a-half-year transition period with annual negotiations thereafter. And on the issue of the level playing field (i.e. fair competition), we suspect there will have been an agreement to not loosen regulatory standards from their current levels and to establish an arbitration panel to assess and resolve any future divergences. There’s been no word yet on whether the EU has granted “equivalence” for UK financial services, but since regulatory standards are the same right now, it would be odd if there’s not a separate agreement on that.
  • More generally, the deal will cover a wide range of issues from transport to law enforcement. And it means no tariffs or quotas will be imposed on goods moving between the UK and the EU, which maintains the current situation. Of course, there will still be changes on 1st January. Compared to the other options that the government could have chosen, this is still a relatively “hard” Brexit as the UK will leave the EU’s Single Market and Customs Union. The latter means that custom checks and procedures will be required on goods moving between the UK and the EU from 1st January for the first time since 1973. This will add to the major disruptions and delays at the UK-EU borders already caused in recent days by the COVID-19 crisis.
  • But, notwithstanding any further COVID-19 border closures, with time UK firms will become familiar with the new customs procedures. And the deal means businesses can now plan knowing the shape of the UK/EU relationship (although we doubt there will be any release of “pent-up” investment). Perhaps most importantly, the deal removes the risk of a “no deal” Brexit and the resulting hit to households’ real incomes from the inflationary effects of what would have surely been a sharp weakening in the pound.
  • And while more trade barriers and lower EU migration may trim the UK’s growth rates of productivity and the labour force in future, we suspect any such drag will be offset by faster productivity growth due to the digital revolution and the greater use of technology in the workplace. That means the UK’s potential growth rate in 15 years’ time may still be close to our current estimate of about 1.7%.
  • Of course, the COVID-19 crisis and the growing possibility that wide swathes of the country will remain under tier 4 restrictions for some months yet means that the near-term outlook for the economy is grim. But we are more optimistic than most in expecting the distribution of vaccines and resulting removal of COVID-19 restrictions to allow GDP to rebound rapidly in the second half of next year. We suspect the economy will climb back to its pre-pandemic peak in 2022. (See Chart 1.) And as long as both monetary and fiscal policy are kept loose for a few years yet, then it is still possible that in the second half of this decade the economy may be no smaller than it would have been if COVID-19 never happened. (See here.)
  • The news of a Brexit deal has already raised the pound from $1.33 (€1.09) on Tuesday to $1.37 (€1.11) today and lifted the FTSE 100. But since the markets have largely been expecting a deal for some weeks, there is limited scope for more Brexit-related gains in the coming days and weeks. Instead, it is the prospect of an eventual decent UK and global economic recovery from the COVID-19 crisis that explains why we think the pound will rise to $1.40 in 2021 and the FTSE 100 will climb to 7,500. (See Chart 2.)

Chart 1: UK Real GDP (Q4 2019 = 100)

Chart 2: FTSE 100 & $/£ Exchange Rate

Sources: Refinitiv, Capital Economics

Sources: Refinitiv, Capital Economics


Paul Dales, Chief UK Economist, +44 (0)7939 609 818, paul.dales@capitaleconomics.com