The UK has chosen to call time on its four-decades of European Union membership. There was a high turnout, and 51.9% of voters chose to leave the EU. During the campaign, economic arguments were overshadowed by immigration issues that polarised the debate.
Markets have clearly reacted negatively to the news on the back of the high level of uncertainty that has now arisen. European stock markets were down about 11% as they opened, and whilst markets are likely to remain volatile in the days ahead, it may be that the low point is already behind us. The pound sterling is under pressure, with an 8.5% fall against the dollar and 5% against the euro. Core sovereign debt rallied, with Bund yields falling from 0.09% to -0.15%, and risk premiums on peripheral Eurozone bonds are rising. However, leaving aside this knee-jerk reaction, what are the longer-term implications of this vote? It will take time for all of the economic and political consequences of this landmark decision to become clear, but here are our first impressions.
What will happen in the weeks ahead?
Initially nothing will change. David Cameron has declared that he will remain Prime Minister until October, when the Conservative Party will nominate his replacement. Boris Johnson is clearly one of the obvious candidates for the position, and it will be for the new Prime Minister to invoke Article 50 of the Treaty on European Union.
When will Article 50 of the EU Treaty be invoked?
Brexit advocates have argued for preliminary negotiations to take place, but Europe’s authorities had warned that a vote in favour of Brexit would require rapid activation of Article 50 for negotiations to begin. Constitutional experts see no other alternative for starting the exit procedure.
How will central banks react?
In the short term, they will provide financial markets with the extra liquidity needed to cushion the shock. The Bank of Japan and the Bank of England have already indicated as such. In the medium term, central banks are likely to carefully monitor the impact on the real economy. The probability of a Federal Reserve rate hike at the upcoming meetings has significantly declined, whilst the likelihood of more action from the ECB and the Bank of Japan is increasing. This is especially true for the BoJ given that the yen is likely to strengthen quite significantly, along with other safe-haven currencies such as the Swiss Franc. The SNB will most likely intervene.
Uncertainty and sterling’s weakness will weigh down the real economy
As discussed in our analysis ‘Risk, Uncertainty and Brexit’ (published June 2nd, 2016), no concrete changes will occur in the immediate term. It is chiefly via uncertainty and sterling’s weakness that this event will weigh on the real economy. In the UK, investment will most certainly fall, and more expensive imports will hamper consumer spending. Furthermore, the political backdrop will remain complex, particularly with the risk of a new referendum on Scotland’s independence. Given that exports to the UK only account for 3% of Eurozone GDP, direct consequences on the Eurozone economy will be relatively limited (probably in the order of 0.3-0.4% of GDP). However, the indirect consequences have still to be seen.
Political contagionv is the biggest threat
The UK’s decision may fuel the fire of Eurosceptic parties across Europe. It is easy to imagine countries such as Denmark, Finland and the Netherlands asking themselves the same question in the years ahead. This weekend, Spain goes to the polls for a second attempt at electing a ruling parliament. In Italy, Beppe Grillo’s 5-Star Movement, which has adopted a very Eurosceptical stance, won symbolic victories in municipal elections on June 19th, especially in Rome. In October, Italy will vote on the constitutional reform driven by Matteo Renzi, and it may become a ballot for or against the Prime Minister. Political contagion will probably take time to materialise and it is likely that the issue, although it will never be completely ruled out, will be less of an issue in a few weeks’ time. However, this outcome may serve as a wake-up call for European leaders and prompt them into reviving the European project.
Conclusion
Today’s falls are a knee-jerk reaction caused by speculators aiming to provoke and take advantage of volatility, rather than any reaction by long-term investors. However, the overall impact on the global economy and on firms’ profit-generating capacity does not, we believe, justify a shift of this magnitude. Some companies exposed to the UK market may lower their earnings forecasts, but within a few weeks the volume of news on the subject should subside, enabling the market to stabilise and even recover.
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