The Brexit negotiations may appear to be over, but it is merely the end of the beginning.

Four and a half years after the U.K. public voted in a referendum to leave the European Union, and with just days remaining until the transition period expired, the U.K. and EU negotiators reached a trade arrangement. But the skinny nature of the deal means crucial sectors such as financials services barely take up any ink in the 1,246-page document, and negotiations about the future relationship will rumble on into the future.

The U.K. will leave the customs union Jan. 1, 2021, but will continue to trade goods free of tariffs and quotas with the EU, avoiding defaulting to World Trade Organization rules that would have introduced customs duties. While in some sectors, these would have been negligible, in others, exporters would have been hammered, notably the automotive sector, where the tariff would have been 10%, processed fish 25%, and meat and dairy products 50%.

The U.K. Office for Budget Responsibility projected that a no-deal outcome would have cost the country 6% in lost potential GDP over 15 years. While that was avoided, the budget office's model for a thin agreement such as the one achieved still would result in a 4% reduction in output versus the status quo.

A new trading relationship

"The agreement means that the EU and the U.K. avoid a cliff-edge scenario but there will still be significant changes to the trading relationship starting on Jan 1, which may create some disturbances in the very near term at the borders," Mikael Olai Milhøj, senior analyst at Danske Bank, wrote in a research note.

Being outside the EU's single market means frictionless trade with the U.K. is over, with border checks for the transport of goods incurring time and expense, the cost of which will be "significant," according to the multinational law firm Baker McKenzie.

Meanwhile, the skinny nature of the agreement means companies offering services will lose their passporting rights, meaning they will have to establish a presence within the EU to continue to operate.

This is a particular concern for the U.K., where services make up 80% of GDP and made up 42% of the £294 billion in exports to the EU in 2019. Whereas the U.K. runs a significant deficit with the EU in the trade of goods — about £97 billion in 2019 — in services, the U.K. achieved a surplus of £18 billion.

The agreement does not remove licensing barriers that arose as a result of Brexit, a concern for the finance sector, which is the largest contributor to the U.K.'s surplus in services.

"The U.K. has prioritized regulatory autonomy over alignment in its negotiations with the EU over financial services arrangements, and instead of blanket market access mechanisms [the U.K.] is seeking regulatory and supervisory cooperation arrangements," wrote Mark Simpson, partner in the financial services and regulatory group at Baker McKenzie, noting that "this means that the U.K. has not negotiated bespoke EU market access arrangements, but will instead rely on assessments of equivalence."

The equivalence problem

As negotiations rumbled toward their conclusion, many of the headlines were made by the fight over fish, an issue more emotive than economic based on the sector's 0.04% contribution to U.K. GDP.

Eventually, the issue was settled by an agreement to cut the value of fish caught by EU fishermen in U.K. waters by 25% over a 5.5-year period. That left equivalence as the other major stumbling block, with the EU concerned that future divergence of U.K. regulations may give U.K. exporters what the EU may deem to be an unfair competitive advantage.

Assessing whether equivalence has been maintained or whether there has been divergence will be a unilateral decision not made within the terms of the trade agreement, with a rebalancing clause giving both sides the right to take steps if they perceive that the other has diverged from common standards that negatively impact the other side.

This does not give much security to U.K. services companies, with Prime Minister Boris Johnson himself admitting as much.

Brussels uses an equivalence system with other non-EU financial centers, but it does not cover all financial services, and rights of access can be withdrawn at 30 days' notice. London will begin its new relationship with the EU with fewer rights than other major financial centers New York and Singapore.

"The U.K. issued a number of decisions in November 2020 granting equivalence to the EU in 22 areas, based on the principle of equivalent outcomes underpinned by compliance with internationally agreed standards and not necessarily technically equivalent rules," Simpson said. "By contrast, the EU has not yet finished its equivalence assessments, and has expressed concern about the U.K.'s plans for its future regulatory framework and the degree of divergence from the EU regime this might entail. It is likely that the commission will continue its assessments well into 2021."

'Cautiously welcomed'

It is not all smooth sailing for the trade of goods, either, as tariff-free trade applies only to products manufactured in the region. This could be a problem for manufacturers of cars, a major U.K. export to the EU, with producers having to comply with rules on foreign content that limit the number of components produced abroad to 45% of the total car. This is less of an issue for EU producers, which have more of their supply chains located domestically.

Yet the deal was "cautiously welcomed" by the industry lobby group Make U.K., with Chief Executive Stephen Phipson commenting that the agreement "avoids the catastrophe of no deal." But he warned that the industry has not been given enough time to adapt to the new regime.

"It is in everyone's interest for the U.K. and EU to jointly agree that with the legal start of this deal significant easements and an adjustment period, with review clauses if necessary, are vital. This will ensure the new systems and processes which will underpin this trade agreement, and the companies that will rely on them, can acclimatize successfully," Phipson said.

Investors have also welcomed the deal, with sterling and U.K. stocks tipped to expect a surge of demand once investors return from the holidays, having been considered undervalued amid the potential for a no-deal outcome. The FTSE 100 rose from 6,502 on Dec. 24 to 6,602 on Dec. 29, largely on the strength of the announcement.

"The deal should see sentiment towards the FTSE indices recover just as the dividend payout ratio improves, vaccines are rolled out and overseas revenues accelerate," Sean Darby, global equity strategist at Jefferies, wrote in a market commentary.

The U.K. economy is still expected to feel a pinch; however, the avoidance of no deal, together with the rollout of a vaccination, is expected to accelerate investment, which has lagged since the 2016 referendum.

"We would not be surprised if the U.K. economy outperforms the euro area next year," Danske Bank's Milhøj said.