Two factors are supposed to underpin U.K. stocks next year. The first is the post-pandemic economic recovery, to which the commodities-heavy FTSE 100 and the midcap FTSE 250, with its bevy of domestic-focused services companies are both heavily exposed in different ways. The second is the return of international portfolio managers to equal weightings for U.K. equities after years of being underweight due to the lack of clarity about Brexit.
The first theme is still intact, despite the likelihood of some setbacks along the way. The announcement on Friday by GlaxoSmithKline (NYSE:GSK) and Sanofi (NASDAQ:SNY) that their vaccine hadn’t proved effective in stage 2 tests is one example of that. The pair now say they will re-engineer the drug and try again but don’t expect it to be available before the fourth quarter of 2021. GSK stock was unmoved by the news, though, not least because it seems that the race to get vaccines to market is already lost. GSK was up 0.7% by mid-morning in the U.K., helped by sterling’s weakness and by the comforting knowledge that it doesn’t matter whose vaccines return the world to normal if it means that all of GSK’s other drugs can be return to pre-pandemic sales levels when the intensive care wards are cleared again.
But the second theme looks to be in more danger. The unending nightmare of Brexit looks as if it may yet stretch out into the new year, albeit in mutated form. European Commission President Ursula von der Leyen told journalists after a meeting with EU leaders that “No Deal” as of January 1st, when the current post-Brexit transition agreement lapses, is more likely than a deal of any sort. That the EU leaders spent all night haggling (with some success) over their budget and the 750 billion-euro Recovery Fund, and only 10 minutes (according to various newswire reports) talking about Brexit, suggests very strongly that no-one sees a deal on the table worth discussing.
The chance of agreement has been effectively scuppered by the EU inserting, at the last minute, additional requirements that would force the U.K. to follow any future tightening of regulatory standards in the EU if it wanted to maintain full access to the Single Market. This is not a demand that lawmakers in Prime Minister Boris Johnson’s Conservative Party will willingly accept.
U.K. officials are complaining that the demands are unfair, but that is to miss the point. Negotiations are about what you feel you can get away with, not what is fair or unfair. The addition of fresh demands at the last minute comes only three days after the U.K. gave ground by withdrawing the offensive parts of its new Internal Markets Bill to placate the EU. That makes it very clear where the balance of power in the negotiations lies.
That all suggests that the EU is calculating that the impact of No Deal in January will be harder in the U.K. than in the EU. The U.K. will have to levy tariffs on imports from the EU (equivalent to around 13% of U.K. GDP) under World Trade Organization rules, with direct impacts on the cost of living. Given that imports from the U.K. constitute only 4% of EU GDP, the EU’s calculus seems well founded. However, it does assume that the EU is willing to compensate Ireland for the particularly heavy impact that it will suffer from the disruption of trade, especially since much of Ireland’s exports are perishable and need to avoid delays at the border.
Assuming that the new year starts with disorder and recriminations, the likeliest way forward is that the chaos is only mended slowly and in piecemeal fashion. That is not a scenario under which international portfolio managers are likely to return to U.K. equities, however good the post-pandemic rebound looks.