Brexit – The Vote Heard Round The World by Standard Life Investments
The collective decision of UK voters to leave the European Union by a margin of 52% to 48%, shocked financial markets that had priced in a remain vote in the days leading up to the referendum. On Friday sterling fell 8% against the dollar to hit a new 31-year low, and global equity markets fell 4.8% amidst a widespread retreat to safer assets (see Chart 1). Risk assets continued to sell-off at the beginning of this week as markets were still getting to grips with the full political, economic and financial ramifications of the decision. In times like these, we think it is important for investors to have an analytical framework that helps them separate the signal from the noise following political events. Ours begins by breaking political risk down into institutional and cyclical factors. Institutional factors are those that arise from the structure of a country’s political institutions; these are the cogs that determine the stability of the political backdrop to time-sensitive or cyclical events like elections and policy decisions. Political risk is usually lower and more stable in developed markets than in emerging markets because the underlying institutions are usually more fully-formed, entrenched and transparent.
The decision to leave the EU goes against that grain because it constitutes a major institutional change for the UK and its trading partners, both within and outside the EU. Empirical evidence suggests that as political uncertainty increases, firms delay investment and consumers put off spending on big-ticket items, weighing on economic growth and asset returns. The severity and duration of this drag will depend on the response of global policymakers. In the first instance, global monetary policy needs to become more accommodative, beginning with aggressive pre-emptive action by the Bank of England. The ECB will also need to take steps to reassure markets that banks and peripheral bonds are safe places to invest and the Fed should avoid hiking rates in 2016. Eventually, fiscal policy will also have to come to the party as the capacity and benefits of monetary actions reach their limit. This shift should be easiest to achieve in the UK as politicians recognise the futility and political dangers of austerity. Brussels will also need to become more tolerant of fiscal slippage to ward off anti-European uprisings in other countries.
United States – Brexit lessons for the US
Many Americans that were following the UK referendum campaign watched the events unfold with a mixture of curiosity and confusion. The seriousness of the result is clearer now after voters’ decision to exit the EU initially wiped 3.6% off the S&P 500 and sent the US dollar soaring (see Chart 2). As the world’s most powerful economy, it is tempting to argue that Brexit will have few implications for the US. That would be premature; the vote has important economic and political ramifications, as well as lessons that politicians and policymakers will need to heed as they confront their own challenges.
The most immediate consequence of the referendum result will be to reduce the chances of the Federal Reserve (Fed) lifting interest rates again this year. Fed officials had already been backtracking on their earlier intentions to lift rates following the recent deterioration in labour market conditions and will now want to see how economies, markets and other policymakers react to the sharp rise in political uncertainty before committing to tighter policy. Certainly, the abrupt rise in the US dollar will not have been welcome, while officials will also be wary of another bout of financial stress and a further moderation in global growth. Unless markets take Brexit in their stride over the coming weeks, December is now the earliest another rate will be considered. Brexit also has repercussions for diplomatic relations. The US has strong alliances with both the UK and the large continental European countries; increased tensions between them as they confront an array of serious geopolitical challenges over the next few years will not be welcome. In addition, Brexit has dealt another blow to the global trade liberalisation agenda already reeling from the backlash to the Transpacific Trade Partnership (TTP) within the US and further complicates negotiations over the Transatlantic Trade and Investment Partnership (TTIP), which were faltering even before the UK’s rejection of the EU.
There are also important lessons to be drawn from the Brexit vote. Like the UK and other advanced economies, US voters’ trust in political elites and the policy establishment has ebbed. After decades of widening inequality, the recovery from the financial crisis has been historically weak, leaving middle-class households more financially vulnerable and insecure. As the primaries have shown, many voters are attracted to populist candidates promising radical policy changes. Economically speaking, the optimal response to rising populist anger and disillusionment is to implement policies that address its root economic and social causes. For example, there is mounting evidence that, although trade liberalisation has boosted aggregate incomes, it has also undermined wages and job security for lower skilled workers more than its architects originally envisaged. Good policy would implement counteractive measures that compensate the losers from globalisation and make sure they are retrained for jobs that are now in higher demand. Neither of the candidates currently seem willing to engage with the complexity of this issue. Despite the populist turn in politics, measures of domestic political risk and policy uncertainty had remained at relatively subdued levels until the Brexit shock (see Chart 3). This could worsen as we approach the election in November.
Jeremy Lawson, Chief Economist
United Kingdom – Question time
The most searched question on google since the EU referendum result has been: what does it mean to leave the EU? Markets are asking themselves the same question, judging from the price action after the announcement. A vote to leave constitutes an economic shock. Indeed, we have experienced a foreshadowing of these effects over recent months, with growth slowing markedly as firms delay investment and hiring. The main channel for this shock is a huge increase in uncertainty. 45% of UK trade is carried out with EU member states and 7% of UK employees are EU nationals. Moreover, the UK financial sector is heavily integrated with the rest of Europe, as are a huge range of professional services. With no clear template for a post-exit relationship with the EU, businesses with ties to the continent have been left in limbo for at least two years during negotiations, but more likely longer.
We expect the impact of this shock to be pronounced. Investment and hiring plans for those companies sensitive to EU trade are likely be shelved, which will rapidly pass through to connected sectors of the economy. Consumer sentiment is expected to take a smaller hit in the first instance, although this is likely to increase as the shock feeds through to the labour market. We have already seen an increase in financial stress, and credit conditions are likely to tighten.