A change of tone
In agreeing to modify the post-Brexit trade arrangement for Northern Ireland, the UK and the EU hope to end years of acrimony.
Northern Ireland represents a mere two percent of UK GDP, but this deal to amend the Northern Ireland Protocol (NIP) is significant, in our view, and not only because it holds the promise of a smoother customs process. It substantially minimizes the risk of a UK-EU trade war. Unhappy with the arrangement it had negotiated in 2019, the UK government had threatened to scrap it unilaterally, a move which could have triggered sanctions from the EU, and a possible trade war.
Importantly, the deal marks a change of tone in the UK-EU relationship. It’s the fruit of a more constructive, pragmatic approach by the UK to its differences with its neighbor and major trading partner. Since becoming UK prime minister, Rishi Sunak has worked to dial down tensions with the EU. A more conciliatory approach on the EU’s part might have helped seal the deal as well.
For the UK, the economic cost of leaving the single market is increasingly obvious as its economic growth lags that of its G7 peers. But a more practical approach with the EU could herald more cooperation overall between the regions from a geopolitical, regulatory, and societal point of view.
Reducing the discount
UK equities have underperformed international peers since the 2016 Brexit vote. Investors feared political instability and regulatory uncertainty as the UK government pursued sovereignty at all cost.
Today, UK equities trade at a steep discount relative to both its history and other developed markets. The MSCI UK Index trades on 10.4x forward consensus earnings estimates, compared to a historical median of 12.5x and versus the MSCI USA Index at 18x. The MSCI UK Index’s dividend yield is a generous 3.5 percent, one of the highest in the developed world.
A discount to U.S. equities is warranted, in our view, due to differences in sector bias and a more resilient outlook for the U.S. economy. Yet the UK is home to several global leaders, such as those in the Energy sector, which trade at substantially less than U.S. peers, even though they derive their revenues from as much of an international base as their U.S. brethren.
A more constructive tone to UK-EU relations could contribute to reducing the UK equity market discount.
The NIP: An unworkable arrangement
The NIP, though negotiated by the UK government and approved by the UK Parliament, has proven unworkable, causing delays and frustration. At stake is the issue of goods moving between Northern Ireland, the UK, and the EU.
Northern Ireland is the only region of the UK which shares a land border with the EU. Both sides of the border, Ireland and Northern Ireland, want to avoid checkpoints, such as border posts—which risk reigniting hostilities between the two.
While negotiating the NIP in 2019, the UK and the EU agreed that protecting the peace between Northern Ireland and Ireland was a priority. They settled that checks would be conducted at Northern Ireland’s ports, while Northern Ireland committed to following EU rules on product standards. The EU requires border checks when goods arrive from non-EU countries to ensure that its strict rules are observed and its consumers protected.
Yet the NIP didn’t work. Northern Ireland felt an internal border with the rest of the UK had effectively been raised, as goods it received from elsewhere in Britain came with the burden of costly checks and paperwork. Brexiters were not happy that part of the UK still had to observe EU laws and regulations and refer any dispute to the European Court of Justice.
Sunak’s proposal, to which the EU agreed, aims to create two lanes for goods to go through: a green lane for UK goods destined to Northern Ireland which would not be subject to checks; and a red lane for UK goods destined to Ireland with checks.
A less acrimonious future
While the deal has been agreed to in principle, it still needs to be approved by both sides. That Keir Starmer, the leader of the opposition Labour Party in the UK, has stated that he would support it makes UK approval likely.
The challenges the UK faces remain notable. The economic damage wrought by Brexit uncertainty cannot be undone, and the cost of living crisis in the UK shows scant signs of lifting. Moreover, regulatory uncertainty remains as the UK government mulls over the disentangling of UK and EU laws. But a more constructive approach by the UK to its relationship with its main trading partner could go some way to start to restore investors’ interest in the UK’s undervalued equity market.