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. Calibrating these effects is difficult. However, we expect a marked impact on growth and see a strong possibility that the economy moves into recession. This will be disinflationary for the domestic economy, although this will not show up in the data immediately. Instead the sharp adjustment seen in sterling will push inflation artificially higher as import prices rise. However, beneath the surface this shock will open up more spare capacity, even taking into account a weaker potential growth rate after exit.
The Bank of England’s (BoE) first response has been to offer liquidity support for the financial sector. It has not yet loosened monetary policy, although this can’t be far off. The shock to the economy justifies easier policy and the BoE is unlikely to be deterred by a short-term pickup in inflation as sterling depreciates. Indeed, it looked through a similar inflationary bump after the financial crisis (see Chart 4). We expect the Bank to cut rates at its upcoming meeting in July. However, the scope to loosen through this channel is limited and the BoE has already flagged its reluctance to use negative interest rates given the impact these have on the financial sector. Therefore, the MPC is likely to restart quantitative easing to provide further stimulus, potentially as soon as August. There is a caveat here. The Bank will only be able to loosen if the depreciation in sterling is orderly. The UK is running a large current account deficit and if we see a more abrupt freeze in external financing then the BoE may have to take steps to support the currency, potentially by increasing interest rates (see Chart 5). This is not our base case, but it cannot be ruled out. Finally, we also expect fiscal policy to loosen over coming months. In the first instance, this will come through automatic stabilisers and a less rigid adherence to budget targets. However, we expect a new Conservative leadership to unveil a more explicit stimulus programme in a bid to try and soften the impact of Brexit.
James McCann, UK/Europe Economist
Europe – A canary in the coal mine?
It became quickly apparent on Friday that the UK’s decision to leave the EU had reverberated right across the Channel. Indeed, a number of European equity markets fell more than the FTSE, although in part this was driven by currency shifts rather than fundamentals. Brexit raises a number of questions for both the European Union and smaller Eurozone block. The first of these is how the recovery will fare in the face of another unhelpful headwind. The UK represents a major trading partner for the Eurozone and uncertainty over the post-exit trade relationship will hurt firms with close ties. However, these direct trade effects should not be overstated. The UK accounts for around 14% of EU exports, well below the 45% of UK exports that go in the other direction. Instead, it is political uncertainty raised by the referendum result that has triggered jitters. Most European countries have experienced an increase in Euroscepticism/Europhobia since the financial crisis. Brexit is not the cause of this trend but, rather, a continuation of this theme. Markets are therefore worried that developments in the UK could represent a sign of things to come; at best, scuppering the further Eurozone integration required; at worst, prompting additional exits.
One way of measuring these market jitters is by looking at the spread between Eurozone government bond markets. The difference in German and peripheral governments’ borrowing costs has widened markedly since Friday’s announcement as investors become more nervous (see Chart 6). Certainly, there are reasons for market concern and, ironically, Germany is far from immune despite its safe-haven status. Europe’s largest economy is under pressure to hold the EU together alongside a migrant crisis at home. The latest figures suggest that AFD (the populist right Europhobic party) holds approximately 15% of popular support (compared to 2% in the previous election), making it the joint third-largest party. If it delivers this support at the 2017 elections, it will be in a position to influence policy. In the Netherlands, the Dutch Party for Freedom (a populist right Europhobic party), which boasts 37% of public support in the latest polls, has called for a referendum after the March 2017 election. So has Marine Le Pen of the Front National (far-right Europhobic party) who is polling at 28% in France, although the electoral system there works against more radical candidates. Finally, the 5 Star Movement (the populist anti-establishment Eurosceptic party) has echoed these demands in Italy, where it is currently the second most popular party.
The European Central Bank is likely to take action to try and ease some of these market jitters. It is likely to use liquidity in the immediate aftermath to try and calm markets and will signal a willingness to do more. Triggers for further action would include severe stress in the banking sector, pronounced peripheral spread widening and signs of weaker growth (see Chart 7). The central bank could announce a small cut to deposit rates, front load its asset purchases or increase the duration/intensity of these. These steps should help support activity, but do not fully address the underlying issues. If Europe cannot find a way to generate stronger, broadly distributed increases in living standards, with much lower unemployment, it will remain highly vulnerable to political ruptures of the type we are seeing today.
James McCann, UK/Europe Economist
Japan & Developed Asia – Brace position
The Abe administration has set itself some big targets: inflation at 2%y/y, nominal GDP of ¥600trn, capex of ¥80trn, and a birth-rate of 1.8. These are ambitious by design; as much aimed at influencing future expectations as to be realised. Unfortunately, the credibility of these goals has been seeping away, making the Abenomics project increasingly vulnerable to an external shock. At this stage, there is considerable debate as to whether the UK referendum result is significant enough to represent such an action. One of the biggest points of contention is whether the magnitude of an event that is primarily political, such as Brexit, is the same as an economic or financial one. In reality, the three factors are intimately entwined, with each likely to impact Japan in important ways. Starting with the political implications; the LDP has deliberately sought to avoid the institutional issues that have underpinned political dissent in the Europe. This is partly an issue of migration, with the overseas workforce restricted to just 1.4% of the total versus 16.7% in the UK. The country has also sought to limit unemployment, which peaked at 5.5% in 2002 compared to 8.5% and 26.3% in UK and Spain respectively. Finally, Japan’s gini co-efficient is the lowest in the G20 (see Chart 8). Consequently, there is little prospect of political contagion in the July elections. If anything, the Brexit result is likely to be seen as an endorsement of Japan’s legacy policies, potentially strengthening resistance to labour market deregulation and immigration reform – two areas where the government’s growth strategy had already been lagging.
Turning to the economic impact, the typical transmission channels between economies come through trade flows and financial linkages. The direct trade impact on Japan is likely to be moderate as UK and total European Union exports represent about 1.9% and 10% of Japan’s total exports respectively. In our base case scenario, where growth slows markedly in the UK but by less in the Eurozone, this represents only a moderate hit. Of course, weaker end-demand is only part of the story. The deregulation of capital flows has intensified spillover effects from macroeconomic fluctuations. The surge in the yen may have been driven by safe-haven flows but the consequences will be profound. The first thing to note is that the yen appreciation was against a wide basket of currencies, meaning that the country is likely to see a loss of competitiveness if the move is sustained. More short-term, there is likely to be a considerable hit to exporters’ profitability – hence the 8% decline in the Nikkei 225. In addition, a spike in financial stress proxies is likely to raise risk premiums and tighten financial conditions. This could hurt those parts of the economy that would otherwise be insulated from deteriorating trade dynamics. In aggregate, the potential for disruption is considerable, meaning the policy response should also be swift.
The economic case for monetary policy easing has already been made and implementation should now be easier post Brexit. However, the BOJ is unlikely, and we suspect increasingly unwilling, to put the Abenomics project back on track on its own. Arresting the currency rise may require intervention from the MOF as the foreign exchange channel has proven ineffective in boosting aggregate demand. Instead, the Bank may focus on portfolio rebalancing channel, where it still has some firepower – even deeper negative rates and purchasing risk assets. A fiscal stimulus, say ¥10 trn, may also be on the cards, although we continue to argue that raising growth potential is the best hope for Japan.
Govinda Finn, Senior Japan Analyst
Emerging Markets – Assessing the fallout
With Thursday’s referendum now behind us, it is necessary to assess the financial and economic impact on emerging markets (EM). The short-term effect of the vote has been market volatility, with emerging market assets weaker in the days following the result. Although EM assets were broadly down, there was notable differentiation between countries. EM FX performed broadly in line with the EUR, with the exception of Central European currencies, which saw considerable weakness, led by the Polish zloty and Czech koruna. The economies with the largest trade and financial linkages with the UK and Europe saw their currencies and markets weaken the most. Asian currencies, with the exception of Korea, saw substantially less weakness.
Looking past short-term volatility, the long-term impacts will be more important; however, like many issues surrounding the process of Britain leaving the EU, these are harder to measure. The long-term effects will depend on how the resulting political uncertainty impacts demand in the UK and, more importantly, broadly across Europe. As the largest export market for many EMs, weaker growth across the European Union will hurt an already subdued external environment. From a trade perspective, again it is the emerging European countries that are the most vulnerable. Regardless of whether weakness is localised in the UK or spreads more broadly across Europe; Hungary, Czech Republic, and Poland stand out as being amongst the most exposed (see Chart 10). Czech exports to the UK account for 5% of total exports (4.5% of GDP). Hungary is similar, sending 4% of total exports (3.5% of GDP) to the UK. Exports to EU ex-UK account for nearly 80% of total exports in both countries, measuring 72% of Czech GDP and 66% of GDP in Hungary. The impact on EM outside of Europe should be more contained but, again, it depends on how long the shock lasts and how badly Europe is affected. South Africa, Turkey, Malaysia, Hong Kong, and Singapore, have substantial trade linkages, the latter two slightly inflated because of their status as global trans-shipment hubs.
Beyond trade links, emerging markets will also be affected through sentiment spillovers and financial flows, namely banking claims, foreign direct investment, and portfolio flows. Although less exposed through trade, South Africa stands out as uniquely exposed through finance and investment channels. UK portfolio flows to South Africa account for 4.6% of GDP, inward FDI from the UK is approximately 18% of GDP, and bank lending from UK institutions is nearly 20% of GDP (see Chart 11). Looking to China, the economic impact should be minimal – exports to the UK accounted for only 2.6% of total exports. If Europe is more broadly impacted, the downside could be substantially more significant as the non-UK EU accounts for 13% of total exports. The current market shock also creates a difficult environment for the CNY. Policymakers will not want the currency to strengthen in line with the dollar, but FX weakness could trigger another bout of outflows and cause an involuntary tightening in domestic financial conditions. Therefore, the CNY will likely depreciate against the USD while policymakers attempt to manage a further unwinding of dollar-denominated liabilities. Luckily, attention will be off China – at least in the short-term – giving them some leeway to depreciate without causing a market panic.
Alex Wolf, EM Economist