International business has long been attracted to the UK's economic strength, low corporate tax regime, and pre-eminent financial, insurance, and legal services markets. Even if Brexit alters the UK's global orientation, we believe US aerospace and defense (A&D) companies should continue to see the UK as a key market central to their European entry and growth strategy.

Continued US footprint in a more competitive UK expected

Most major US A&D companies have continued to invest since the EU referendum, and the top ten North American A&D firms have just over 20% of their non-US headcount in the UK. Only a few major players have closed or consolidated UK sites recently, including GE, Raytheon, and Bombardier, but we see no evidence these were Brexit-related. Some US primes such as Boeing have been quite successful lately at winning more government contracts in areas such as maritime patrol. Such contracts often bring heavy offset commitments which will require more direct and indirect activity in the UK. Also, the United Kingdom will be more competitive than Germany and France, with their above-inflation wage increases and social program costs. The pound is expected to stay weak and this too will add to the advantage.

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Prepare for short-term risks of "no deal" exit

Despite these encouraging factors, global A&D firms have voiced public concerns about a "disorderly Brexit." Of the UK A&D sector's workforce, 5% comes from the EU and any reduction in this mobility would add risk in the provision of key skills. However, companies can offset this by applying for "trusted partner" status, which offers a simpler and faster employment permit application process. Companies can also turn to methods, as Bombardier Aerostructures in Northern Ireland has, in pressuring the Democratic Unionist Party to support the Brexit deal, leveraging the importance of the 10 DUP MPs in the government majority.

OEMs are prepared, but smaller firms may have work to do

R&D budgets could also be affected, creating risk to future growth. While the UK Government has committed to underwriting pre-Brexit bids to the EU Horizon 2020 research and innovation program, this likely won't be enough. The current government recognizes the need to fill the gap left by exiting European research programs, such as the Clean Sky carbon emissions reduction initiative, and is looking for alternatives to invest in. It's unclear whether the UK will be excluded from the European Defence Fund (EDF). We believe A&D firms, especially in the small and midsize (SME) segment, should create new R&D hubs to keep up with innovation.

Although tariffs on finished parts for civil aviation are less concerning given the UK's WTO participation, import VAT and tariffs on generic parts and raw materials could add significant costs—as much as 38% of sale value, according to ADS, the UK trade organization. Delays at European borders would affect just-in-time supply chains, potentially adding £1 billion in costs annually. The resulting need to stockpile inventory would put cash pressure on SMEs and the wider supply chain. These small and midsize enterprises should focus on cost management, plan cashflow carefully, and expand their customer base to reduce risk. This may be the silver lining of the Brexit turbulence for many SMEs—forcing them to examine their businesses more critically than ever.

Post-Brexit, the UK will lose full membership in the EU Aviation Safety Agency (EASA), which provides access to other markets. Some 200 UK A&D companies have applied to switch regulatory approval to the EU in case of a no-deal Brexit. All the Airbus sub-tier suppliers were approved by EASA by March 28, indicating a pragmatism on EASA's part. We believe the UK will end up in a "third country" status like Norway's.

Absorb the risk, and carry on

With leading airport passenger capacity and technical capability, the UK remains highly desirable in the aerospace sector. Defense spending in Europe is also set for continued growth with military budgets still below the NATO target of 2% of GDP, and the EU potentially seeking to avoid increasing dependence on the US for future conflict and defense investments. The UK defense industry will remain reliant on both EU and US firms to deliver major programs, and as such should remain a core market for the major US players. However, the UK defense industry cannot be complacent and strong leadership and competitiveness will remain a prerequisite.

The costs for the sixth-generation fighter—with its stealth-engine technology and advanced weapon systems—clearly need to be shared, and the UK volume will be important to closing the business case.

Strong M&A activity looks set to continue, fueled by US firms with healthy cash positions resulting from the 2017 US tax changes and the weaker pound. UK companies should still prove attractive to US buyers, with synergies potentially creating an advantage over other EU investments. UK-based firms could find benefit in acquisition by US companies, and a path to less EU-centric trade strategies.

The possibility of simplified UK public procurement procedures post-Brexit could even drive improved competitiveness, and a strengthening dollar may boost UK exports, especially with favorable future trade agreements with the EU and other major trading nations.

As a capital-intensive and long-cycle industry, A&D will unlikely feel any impact of Brexit immediately, beyond some potential short-term disruption. However, the final future trade agreements will be key and the next two to five years critical in terms of investment decisions that shape major A&D programs over the coming decade and beyond.