27 Jun What’s next? Brexit commentary from Bevan Graham, Chief Economist of AMP NZ
Britain’s decision to exit the European Union (“Brexit”), followed swiftly by UK Prime Minister David Cameron’s resignation, creates considerable economic and political uncertainty. It will be some time before we know all the answers. The negative market reaction to the narrow victory (52% vs 48%) for the “Leave” camp has been exacerbated by markets going into the referendum expecting exactly the opposite outcome, a narrow “Remain” victory.
It’s important to note that nothing changes immediately for the UK. For a start the referendum is not legally binding. Parliament needs to pass legislation to start divorce proceedings and a majority of the Parliament support remaining in the EU. That said it would be only politicians with a desire for short political careers that would vote against the will of the people.
With the passing of the necessary legislation therefore a virtual certainty, the UK will then begin negotiations with the EU over the rules governing trade access for goods and services and the mobility of labour. The two parties will have a minimum of two years to negotiate the terms of the separation and new access arrangements. It’s conceivable this could take longer than two years. In the meantime nothing changes but uncertainty about future arrangements will prevail.
Implications for the UK economy
While current arrangements remain in place the UK will continue to enjoy unfettered access of its goods and services into the EU, so the immediate impact on exports will be limited. In fact given the significant depreciation of the exchange rate export competitiveness will improve, assuming the depreciation is sustained.
However, we are more concerned about the likely negative impact on business confidence of a long period of uncertainty around future trade access. A drop in business confidence will have negative implications for capital spending and hiring decisions. Indeed capital formation was already weakening leading into the referendum. Negative labour market developments, as well as the uncertainty around the legal status of the roughly two million EU workers who currently reside in the UK, could have a negative impact on consumer confidence.
And of course there is uncertainty about the future status of the City of London as Europe’s financial capital. It is questionable whether the City of London can retain this status if it doesn’t come under EU’s regulatory purview.
In short, the uncertainty and likely implications for capital investment and jobs could push the UK into a mild recession later this year. Key indicators to watch will be business and consumer confidence.
Broader Economic Implications
While it was a shock, it is important for investors to be aware that it is not a globally systemic one. The UK economy is only 2.5% of the global total. The global economy will not grind to a halt because of this. Global banks are not insolvent because of this. Economic estimates of the UK leaving the EU vary, with the average around a 4% cumulative loss of GDP by 2030.
Around 7% of Europe’s exports go to the UK. Even with the appreciation of the Euro versus sterling a mild UK recession should be manageable for Europe.
Of possible greater consequence is the widening in credit spreads. This represents a tightening in global financial conditions which, if sustained, could have negative implications for global growth. If that happens however we would expect a response from central bank’s in the form of further policy accommodation.
The implications for New Zealand are negative in the near-term but will be manageable. The UK takes around 3% of New Zealand’s merchandise exports (meat, wine, lamb) and 9% of services (tourism). The sharp drop in sterling and possible near-term recession will be an obvious negative for trade. Financial market volatility could be a negative for business and consumer confidence. Wider credit spreads and higher bank funding costs mean an August cut in the Official Cash Rate is more likely.
The Bigger Issue: Politics
At its most fundamental the “Brexit” debate is one of deep-seated dissatisfaction amongst the UK voting public about a whole range of issues including the general lack of lack of UK economic progress, stagnant real incomes, lack of job security, trade access, sovereignty and the most emotive of all, immigration.
The people of the UK are lucky enough to live in a country where they can make changes if they are not happy. And for a number of reasons a lot of them are not happy with the status quo. The “Remain” campaign has suffered because of this. Donald Trump is benefiting in the US because of this. Bernie Sanders, a self-proclaimed socialist. nearly secured the Democrat nomination for US president because of this.
That’s called democracy, which is something to be celebrated regardless of one’s view of the outcome.
The UK voting public have now had their say. The question has been asked and answered. The risk is they may not like the consequences. As Winston Churchill once said: “The problem with committing political suicide is that you live to regret it.”
Politicians world-wide are on notice to sharpen their ears to their constituents concerns. It is broadly similar issues to those facing the UK that led to the Scottish independence referendum, and has contributed to the rise of populist, nationalist, anti-integration and anti-globalisation political movements across continental Europe.
Conclusion and Implications for Investors
Besides uncertainty, nothing has changed except the level of the pound and other financial assets. As we all know, financial assets can be volatile for any number of reasons. Markets often make rash judgements so we should not read too much into recent moves.
However, volatility and uncertainty can have short-term impacts on global growth as consumers and employers delay spending and hiring. Expect central banks to stand ready to provide stimulus to offset this effect.
Only time will tell the true economic impacts on Britain but for the rest of the world the UK’s decision probably has greater political implications than economic ones.
Expect markets to remain volatile over coming weeks as we learn the next steps in the UK’s process and European nationalists look to exploit the news. As is normally the case, volatility will decay over time as investors realise the global economic and financial wheels just keeps on turning. As such, global equities should recover from levels determined by knee-jerk selling (though the knee could jerk for a little while longer yet!). For the same reason, global bond yields should also move higher but ever vigilant central banks will limit the rise.
Unless individual circumstances have changed, investors should not be selling assets at prices lower than they were a week ago given the fundamentals haven’t materially changed. Patient investors should be thinking about using the volatility to their advantage.
Bevan Graham and Keith Poore