After the referendum
After the historic referendum vote to leave the EU, Stewart Robertson and Michael Grady discuss the implications.
Initial market reaction
In the wake of the unexpected UK referendum result to leave the EU on 23 June, the initial market reaction was severe but broadly in line with our expectations. Developed market equities tumbled by 8.0-10.0 per cent before bouncing a little off lows. Most are still down by 2.0-6.0 per cent from pre-referendum levels. The FTSE-100 Index, the main UK market, is actually about flat, likely reflecting the large share of overseas earnings for many companies in the index. However, the more domestically-focused UK companies in the FTSE 250 Index are down by considerably more – around 8.0 per cent compared to before the vote. As expected, the pound also fell sharply, suffering the largest one-day fall since it was freely floated. It is presently around 10.0 per cent lower than before the referendum. Sovereign yields have also fallen in the UK and across the world, while financial markets have moved to price out rate hikes in the US and price in the probability of lower rates in the UK. Credit spreads have widened by about 10-15 basis points for investment grade and 50-60 basis points for high yield.
It is far too early to make any definitive conclusions on the longer-term economic or political consequences of the referendum decision. There is considerable uncertainty regarding who will be the party leaders in the UK, about when, or if, Article 50 will be triggered, about the situation in Scotland and Northern Ireland (both of which voted to remain in the EU) and about the model that will be adopted regarding the UK’s future relationship with the EU. Some of that uncertainty will persist for a considerable period, given negotiations on the terms of exit could last two years (or potentially longer). In these circumstances it would be rash, reckless even, to jump to make any major decisions that rest on particular outcomes. Given the extended period of uncertainty that has now begun, it is a particularly difficult backdrop for business and investment decisions.
Economic impact – UK
Again it is too early to say with any certainty, but consistent with our prior analysis, we continue to expect that the vote to leave the EU will push the UK economy into recession by the end of the year. The depth and severity is of course unknown, but we anticipate a hit to UK output in the range of 2.5-4.0 per cent over the next 18 months relative to what it might otherwise have been. This is significantly less than that seen during the global financial crisis of 2008/09, but, at the more severe end, is comparable to the economic downturn seen in the early 1990s. The path of gross domestic product (GDP) thereafter depends on many things including the policy response, a better understanding of our future position in Europe and the EU and a growing acceptance of the new order. The most significant factor will be the terms of any future relationship with the EU. If access to the single market is not secured on favourable terms, then we expect the long-run negative impact could be as much as 10.0 per cent on UK economic output. A more pessimistic view would be that reduced foreign direct investment and a smaller and less productive workforce would slow trend growth on a permanent basis. If more favourable terms were secured, perhaps akin to the Norwegian model, then the economic impact would likely be much smaller.
Economic impact – elsewhere
Economically, the UK is a relatively small player on the world stage, accounting for around 3.0 per cent or 4.0 per cent of global GDP at most. Post-war history shows that recessions generally affect several countries at the same time because they have a common cause or clear and obvious knock-on effects from more idiosyncratic sources of stress. The current situation is very much made in Britain. This does not mean that the impact will not be felt elsewhere, rather that the linkages need to be identified and understood in order to reach such an assessment. The most obvious candidate for contagion is, of course, the euro zone and individual countries within that region. As far as trade connections are concerned, an estimated 16.0 per cent of euro-zone exports go to the UK and exports make up about 40 per cent of euro-zone gross domestic product. So if the UK economy declines by 2.0 per cent, then the impact on euro-zone exports might be 0.3 per cent to 0.4 per cent, implying a hit to growth of 0.1 per cent to 0.2 per cent. Significant, but far from disastrous. Of course there can be lots of other second-round effects too such as from currency moves.
For other areas, trade linkages are less close, suggesting a reduced effect compared with that in Europe. But of course many countries that have greater trade with the UK will be adversely affected. Ireland is probably the clearest example.
The impact on other countries is thought to be progressively smaller – the UK is simply not big enough to have a major impact, at least with regard to direct trade linkages. The US is a relatively closed economy, with exports making up only around 13.0 per cent of GDP, of which less than 4.0 per cent goes to the UK.
Indirect economic impact – political contagion
The phrase “political contagion” can encompass many things. But it seems clear to us that this is the way in which Brexit could potentially have far more damaging economic effect on other countries. There are several dimensions to this. Probably the most important is if Britain’s exit (or more specifically just their vote to exit) encourages other countries within the EU or, more worryingly, within the euro zone to flex their rebellious muscles. It was noticeable that after the UK decision became known, many populist or right-wing parties across Europe applauded the outcome and intimated that the UK might just be the start of an anti-EU or anti-euro movement. This is far from certain – an alternative reaction might be exactly the opposite, with EU or euro-zone countries moving closer together. But this is a dynamic situation that could ebb and flow in various ways. It will be influenced, among other things, by the UK’s negotiations with the rest of the EU on the terms of their exit. It is not in the EU’s interest to give the UK an ‘easy ride’ for fear of setting a dangerous precedent. As an example, if the UK was favoured (or perceived as being favoured) in terms of the trading status it is given in a pro-Brexit world, then others (both euro-zone countries and others such as Norway) might demand something similar.
While we think it is unlikely that another EU government would put the question of membership to the people, there are political parties with significant following in the Netherlands, France and Italy who have advocated leaving either the euro or the EU. The Spanish election on 26 June was probably too soon after the Brexit vote to gauge any reaction – and there is no major political force there campaigning to exit the EU - but the populist Podemos party saw one million fewer votes than in December 2015. At this stage we think there is a greater risk around the upcoming the Italian referendum (on constitutional reform note) in October. The latest polls are not encouraging for prime minister Matteo Renzi, who has staked his political future on the outcome. Should it fail to pass, a general election would likely be triggered and with the rising popularity of the Five Star Movement, could once again raise concerns about the future of the euro and the EU. Looking further ahead, the general elections next year in the Netherlands (March) and France (May) will also be critical tests.
Policy response – UK
We still expect the Bank of England to reduce UK interest rates in 2016 – August seems to be the most likely candidate when, it is hoped, things will be a little clearer. A 25 basis point rate reduction to a new low of 0.25 per cent looks plausible. Thereafter, any subsequent policy decisions are likely to be influenced by how well or how badly negotiations are going – if indeed they have begun – and by whether any clarity emerges on domestic politics. An additional 25 basis point rate cut – to zero – cannot be ruled out, but we do not anticipate the UK central bank t o follow the European Central Bank (ECB) in heading into negative interest rate territory. A restart and extension of the UK’s QE programme is also possible, including the potential for a broader set of assets to be purchased, including investment-grade corporate debt.
Before the referendum official plans were for a modest fiscal squeeze (0.5-0.75 per cent of GDP a year) between now and 2020. This would be sufficient to move the UK back from a 4.0 per cent of GDP budget deficit back to close to balance. If we are right that the UK slips into recession in 2016, then this will change. Firstly, the automatic fiscal stabilisers will kick in: welfare and social expenditure will pick up and tax receipts growth will fall, probably pushing the deficit higher again. Whether outright and deliberate fiscal expansion follows in future years will depend on the severity of the recession. At this stage we do not expect such an overt expansionary fiscal policy, but this view is not held with any great conviction, especially given the political uncertainty.
Policy response – elsewhere
At the margin, the impact of the UK’s decision to leave the EU suggests a looser policy backdrop in most geographies, especially those with the closest ties to Britain. In the case of the euro zone, we do not expect the ECB to react by reducing rates further, but depending on the state of the economy (UK and euro zone) later in 2016, they might well decide to extend the deadline of their current asset-purchase programme beyond March 2017. A three or six-month extension (at the current pace of purchases) would be no great surprise.
There may be minor implications for euro-zone fiscal policy and again they would be in the direction of ‘looser for longer’. After a long period of austerity, the area had permitted looser fiscal policy to be adopted in many countries through a more relaxed (alternatively long-term) approach. A modest fiscal expansion overall was actually set to emerge in 2016, much to the annoyance of some fiscal hard-liners in the euro zone. But with growth persisting and political storms seemingly dying down, it had been hoped that a gentle lean on the fiscal brakes would return. It is possible that the recent UK events may mean that this change in policy direction just takes a little longer.
In the US, the uncertainty that Brexit has introduced will probably be sufficient to dissuade the Federal Reserve from raising interest rates again this year. It gives any doubters on the Federal Open Market Committee enough reason to pause. Eventually US policy will have to respond to domestic circumstances, but for now there is justification to wait and see, a mode of operation that policymakers seem very comfortable with.
In Japan, the Bank of Japan is likely to announce a new package of QE measures in late July – something we had expected even in the event of a vote by the UK to remain in the EU – followed by a major fiscal stimulus package.
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Approved for Austria, Belgium, Denmark, DIFC, France, Finland, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden, Switzerland and the UK.
- Initial market reaction: Sharp initial falls in equities and sterling lower yields and wider spreads. Some recovery since. US rate hikes priced out in near term
- Implications: Negative, but huge uncertainty – which is unlikely to be resolved soon – makes decision-making difficult
- Economic impact – UK: Mild recession by end of year, future path of GDP dependent on policy response and the details of the deal that is struck
- Economic impact – elsewhere: Mildly negative for Europe because of trade linkages; less so elsewhere
- Indirect economic impact: Political contagion: Potentially very significant – EU and euro area will be keen to contain it if possible
- Policy response – UK: Interest rate cut(s), possible restart of Quantitative Easing (QE). Fiscal stance may be loosened if economic weakness continues
- Policy response – elsewhere: Minor unless contagion is significant