“If you can’t join ’em, beat ’em” – Uffe Ellemann-Jensen, Danish Foreign Affairs minister, when the Danish football team won the European Championship after Denmark’s voters rejected the Maastricht Treaty in a referendum (June 1992).
Brexit – Stormy weather
The UK has voted in favor of leaving the European Union. The reasonably clear result – which unfolded appropriately perhaps against a backdrop of thunderous showers and transport disruption in the South East – does not however reduce uncertainty:
- The British Prime Minister has resigned, and a change of administration (and possibly a general election) will happen within months;
- He or his successor has to decide if and when to invoke Article 50 of the Lisbon Treaty, and then to negotiate, over a period that could extend to two years (and possibly longer), the terms of the UK’s likely exit;
- As he/she does so, a sovereign (ironically so, perhaps) UK parliament has to decide whether its democratic mandate in this matter is one of representation or delegation (the referendum has no legal status);
- At some stage, the UK’s own Union may be questioned again by demand for another referendum on Scottish independence;
- Perhaps most importantly for global markets, the EU partners have to decide how best to respond to the UK vote, and to any damage done to the stability and coherence of the wider EU project, and to the credibility of the euro;
- More generally, if populism is really on the rise, and voters on both sides of the Atlantic increasingly “stick it to the man”, the risk of protectionism and confiscation will increase.
When the facts change…
There is little point here in analyzing the result closely: it’s happened, there are plenty of inquests on offer elsewhere, and markets look forward, not backward. We should also be wary of detailed game plans. This is an unprecedented situation: nobody can know what will happen in the months ahead.
We offer instead some general thoughts on how best to try to separate signal and noise in this changed world. We try to distinguish rhetoric and politics from business and investment.
Politically, the referendum is of course a big deal, the biggest this analyst can remember having to comment on. The stakes could hardly be higher. The UK chose to turn its back on the EU project almost exactly 100 years after the start of the Battle of the Somme, a poignant reminder of why the EU exists to begin with.
The piecemeal progress towards “ever closer union” had already faltered, and may now cease or become more explicitly multi-speed. And with apologies to Sweden, Denmark and peers, the departure of the UK will make the single market and the single currency much more congruent, with any strain in the one being visited more completely on the other.
But while things could go very badly wrong for the global economy and markets, they needn’t. The EU project need not descend into protection and fiscal anarchy – it could even become more successful, if its ambition is re-focused (and we’d suggest France, not Italy or Spain, holds the key to reform). The fragmentation of the euro would be a major loss of global liquidity – but need not happen. The Brexit vote is not likely to stop the US economy in its tracks. China continues to slow, not collapse.
And we think that the UK, after the initial setback, will likely remain one of the more dynamic economies in Europe. If you can’t join ’em, beat ’em economically perhaps? As investors, we are inclined to face this uncertainty on the front foot, looking for opportunities.
Market response so far
The result was not expected by markets, which were moving to price in a “remain” vote. This was not financial “short-termism” – the long-term outlook changed overnight.
As a result, the pound fell sharply, particularly against the yen and dollar, and stock markets fell markedly (Japan especially). Safe haven assets such as gold and government bonds (gilts included) rose strongly (figures 1 to 3).
However, if there can be such a thing as orderly volatility, this is how it seemed, even as the pound saw its biggest ever intra-day fall against the dollar. Most assets remain inside relatively recent trading ranges (the 10-year gilt yield, which hit an all-time low, and cable, which hit a 31-year low, being two very visible exceptions).
Currency moves muted the practical impact for many investors. The fall in the pound was bigger than the decline in stock markets, and so sterling-based investors actually saw their global stocks rise in value. There has been a huge variation in UK stock moves: domestically-focused and financial stocks were hit hard, but many UK-listed multinational stock prices have risen, and as we write, the main UK market indices have more than made good their fall (but not of course in dollar terms).
Implied volatility itself spiked higher, but not sensationally. Interbank spreads – which reflect tension in the banking system – rose modestly (figure 4).
However, the sheer scale of political uncertainty – the UK has a lame duck government until September at the earliest, while political contagion may infect the rest of the EU – suggests it is way too soon to take this measured response for granted.
What is the economic impact?
Increased uncertainty, and the additional friction introduced to trade and investment, is bad for the UK economy (and on a smaller scale for the wider EU and global economies too), which is why markets moved in the directions they did.
On the UK:
- Leaving (eventually) the biggest single market (in terms of customers) on the planet, without replacing it with improved trading arrangements elsewhere, is likely to damage trade and inward investment. The scale of the bad news, however, is unclear.
- Outside agriculture, EU tariffs are small enough (low single digits for manufacturers) not to represent a major competitive hurdle. Renewed tariffs on UK exports to the EU could of course be matched by tariffs on UK imports from the EU, but even Brexiteers suggest this is unlikely.
- Investment is most immediately at risk, particularly in service businesses. Both domestic investment and foreign inflows are easily frightened. We have spoken to overseas companies whose UK plans have been put on ice, but none who’ve suggested they would invest more.
- For financial companies in particular the issue is not tariffs, but the ability to transact some forms of cross-border business, period. Some euro-denominated business will migrate to a eurozone center – encouraged by eurozone politicians and regulators.
- Set against these costs are the saved budget contribution (a one-off boost to growth of roughly 0.5% of GDP, when it happens) and the cyclical stimulus provided by cheaper
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