The decision by British voters on June 23, 2016 to leave the European Union (EU) triggered four years of political contortions. It cost two prime ministers their job and cast a corrosive cloud of doubt over the European economy. Current Prime Minister, Boris Johnson, finally settled the issue when he won a majority in December, and formally took the country out of the EU on January 31. Britain now faces a difficult task. It has one year to hammer out a comprehensive trade deal with the EU, while retaining the right to ink new trade pacts with other countries.

The difficult negotiations ahead

Currently, the EU consumes about 47% of all UK exports. Clearly, the most important priority of Johnston’s government is to negotiate a comprehensive trade deal that protects its export position and gains as much trade access as possible to the EU. But Johnson, who has the support of hard-Brexit MPs in his party, has made it clear that the UK (Europe’s second-largest economy) must leave the current customs union and single market, with or without an agreement by Dec. 31, 2020. If a deal cannot be struck, many of the same economic-dislocation fears that divided Britain, and undermined the European economy could resurface.

While Britain does have a year to prepare for its exit, the Bank of England has warned in the past that without a trade deal the country’s economy might contract by 8% over a 12-month period. As well, the UK may have to pay £20 billion in shared-payment liabilities with the EU.

Can a trade pact be reached by the end of the year? Only time will tell. But it could take months just for the EU, which must maintain the integrity of its own customs union, to agree to a formal negotiating mandate. As well, all 27 countries in the European Parliament have to agree to whatever negotiating strategy the EU comes up with – a consensus that may be hard to achieve.

Leaving without a deal

To satisfy a hard-Brexit supporters in his party, Johnson has insisted that if a new trade pact is not ratified by the end of the year, he will not ask for an extension. Without a deal, British exports to the EU would then fall under trade rules set out by the World Trade Organization. However, the EU would treat the UK as it would any other country when applying WTO tariffs and preclude the zero tariffs the UK enjoys now.

To ease fears that a hard Brexit could still take place, Johnson has argued that the UK is already aligned with EU customs rules, which will simplify negotiations. However, one of the reasons Britain left the EU was to gain the freedom to enter into trade deals with other countries. In so doing, that may require the UK to diverge from EU trade regulations – something the EU could see as a deal-breaker and attempt to block in whatever trade settlement it strikes with the UK.

The Irish border question

With the UK formally out of the EU, the border between the Republic of Ireland and the British province of Northern Ireland will become the only land border between the UK and the EU. However, as it currently stands, it will not be a hard border. Both sides have agreed that there will be no checks or controls on goods crossing the border between the two parts of Ireland.

For example, Northern Ireland will continue to follow EU rules on the import of agricultural and manufactured goods. But the rest of the UK will be excluded. As well, after the UK leaves the existing customs union, Northern Ireland will enforce the EU's customs code at its ports.

Other tough questions remain

It’s not just a trade deal that needs to be sorted out. The UK must agree to how it is going to work with the EU in the age of ISIS on a broad number of security issues. In another area, the UK has said that freedom of movement rules for EU citizens entering the country will change with stiffer checks at the border. And the rights of EU citizens living in the UK and visa versa have yet to be determined.

Our approach in the Sun Life Granite Managed Portfolios

While there is still some distance to go, with the increased clarity surrounding Brexit we may begin to see some improvement in the European economy as capital spending potentially increases. We are also more optimistic about the European banking sector, which may lead an economic recovery. Equity valuations are also generally lower in Europe than in other markets – particularly the U.S. Hence, late in 2019 we moved from a underweight to a slightly overweight position.

This commentary contains information in summary form for your convenience, published by Sun Life Global Investments (Canada) Inc. Although this commentary has been prepared from sources believed to be reliable, Sun Life Global Investments (Canada) Inc. cannot guarantee its accuracy or completeness and is intended to provide you with general information and should not be construed as providing specific individual financial, investment, tax, or legal advice. The views expressed are those of the author and not necessarily the opinions of Sun Life Global Investments (Canada) Inc. Please note, any future or forward looking statements contained in this commentary are speculative in nature and cannot be relied upon. There is no guarantee that these events will occur or in the manner speculated. Please speak with your professional advisors before acting on any information contained in this commentary.

©Sun Life Global Investments (Canada) Inc., 2020. Sun Life Global Investments (Canada) Inc. is a member of the Sun Life Financial group of companies.