In his July 2016 Ahead of the Curve, Group Chief Economist Neil Williams discusses how the UK’s vote to leave the EU has global implications. Markets must now assess the path that a new political line-up will eventually choose to go down. All of this will take time, and even a ‘soft exit’ – akin to matching Norway, Switzerland or Greenland’s associate membership - may take years just to get us back close to ‘square one’.
While the result was a surprise, the reaction was not, with the initial pressure releases being falls in the pound, UK and, rightly suspicious of the ripple effects, Continental European equities too. Large cap stocks have since found a floor, with global market volatility still relatively low. This early stabilisation is encouraging, but could yet be premature without further support from central banks.
A global issue...
The referendum outcome is only the latest chapter in a protracted story of lower for longer bond yields (see chart 1 below). The overriding force, QE, is global, and Brexit and its ripple effects are an extra incentive for central banks to keep the liquidity taps on. This should support growth assets. But, further QE would only intensify the pressure on pension funds.
In the rating agencies’ eyes, Brexit is also putting the UK’s creditworthiness back under the spotlight. S&P and Fitch have been quick to downgrade the UK’s sovereign ratings. Nonetheless, with the UK’s government debt being local-currency denominated, the BoE waiting in the wings, and the UK Treasury back in 2014 (into the independence referendum) pledging to honour all gilts should Scotland break away, UK sovereign default-risk in reality still looks close to zero.
UK economy will of course survive...
Once the dust settles, the UK economy will of course survive, given its entrepreneurial flair, increasing focus on non-EU trade, and likely policy loosening by the BoE and the UK Treasury. Also, comparisons with Brexit being akin to a ‘2008 moment’ are diluted at least by the fact that US and UK real GDP are each 8-10% up on their pre-crisis peaks, bank supervision looks tighter, and central banks, after a slow start in 2008-09, now have a proven track record of policy coordination.
Yet, getting to the end game on Brexit looks a long, drawn-out ‘can of worms’, offering uncertainty for UK assets and markets. The extent of the damage will probably rest on the manner of the exit. The mark-down on assets would surely be greatest in the case of a ‘hard exit’ - entailing acrimonious departure, lower trade, lower migration and recession - than the more probable ‘softer’ version.
Furthermore, with big elections elsewhere in Europe in 2017 (France, Germany and possibly Italy and The Netherlands), the potential erosion of the EU’s safe-haven status offers an additional brake for the US Fed to ‘peak out’ early on rate hikes. This suggests an ultra-short US rate-tightening cycle, akin to 1984 or 1997.
Staying close to the table...
The challenge now, in or out, is to remain at or close enough to the European negotiating table to secure the best possible trade and regulatory deals for the services sector as a whole. Services represent as much as 80% of the UK’s gross value added, and has been the heartbeat of the UK’s recovery from crisis.
Whichever route is taken, soft or hard, the deployment of UK civil servants to unwind membership risks pushing other priorities, such as infrastructure and environmental issues, down the line.
UK macro policy will thus be disrupted. BoE estimates in May suggested at least a 3.6% GDP-fall over two years, with 520,000 fewer jobs, house prices down 10% and £24bn extra government borrowing relative to plans. With GDP and tax-revenue plans inevitably revised down, the UK will have to forego returning to budget surplus by 2019/20. With growth hit, we doubt a future Chancellor will try to plug the gap. Moreover, delay in forming a new Cabinet until September offers just two months for a game-changing Autumn Statement.
The BoE will be watching to make sure a weaker pound doesn’t pump inflation. In our simulations, we struggle, even at the current GBP/USD 1.32, to get CPI inflation back up to its 2%yoy target before 2018, from its latest 0.3%yoy. Yet, further GBP weakness to parity lifts it to 2¼% by next May. But, we doubt this would force the Bank to raise rates, given the feared hit to growth. Conversely, it may be loath to cut rates if sterling is weakening.
As for the euro-zone, ‘helicopter money’ is considered a next step, via targeted fiscal give-aways. But, any deeper union may now come at the expense of a wider one. EU applicant countries may from hereon be treated more stringently, especially with the UK’s net £8-10bn per annum EU budget contribution in doubt.
Globally, the sluggishness of demand recoveries when monetary tool-boxes look bare may put increasing store on competing currency depreciations and other beggar-thy-neighbour policies.
Unless checked, these could unravel the globalisation of the past 25 years, and even re-erect the sort of trade protectionism that prolonged the 1930s depression.
So, the UK needs to quickly reassert its policy credibility - inside or out. Outside, we’ll probably have to compromise to retain Single Market access. After all, this is the second European ‘marriage’ we will have left, after the ERM in 1992. So, any trade tie-ups we agree to in the future may not be ‘without strings’ - just like EU membership then!
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