The UK has voted to leave the EU with a resultant shock to financial markets, which beforehand had moved significantly towards a “remain” outcome. The exit procedures under Article 50 of the EU treaty could involve up to two difficult years of negotiations before the eventual ratification of the final exit agreement. There are going to be adverse impacts across Europe and, to a much lesser extent, the world at both the economic and political levels. We are likely to downgrade our Eurozone GDP growth forecasts by around 0.5% points per annum over the next one to three years. However, the UK and the Eurozone account for only 6% and 28% respectively of global GDP so the impact on the world economy should be relatively modest. That said, the overall economic impact will ultimately depend on the resilience of consumer, business and financial market sentiment, which is impossible to accurately forecast.
At the political level, BREXIT illustrates the growing disenchantment of “ordinary people” with the mainstream political parties in Europe and globally. We expect further growth in the populist trend towards protectionism, nationalism and isolationism and, in Europe, perhaps some copycat exit referendums.
In response to BREXIT, the various central banks are likely to provide even further monetary policy support, albeit they have much less scope to act than usual in this post GFC environment: • The European Central Bank could lower interest rates yet again and the US Fed could delay any further lifts in interest rates. • Various liquidity support measures could be launched as and when required. The immediate reaction of global financial markets the day after BREXIT has been “risk off” because uncertainty has risen and, therefore, volatility will now be more elevated.
This heightened global risk aversion resulted in an orderly rather than a panic sell-off of global equities accompanied by the safe haven buying of government bonds, the US dollar, and gold on Friday:
Share markets — European (Stoxx 600) ↓7% (322) USA (S&P 500) ↓ 3.6% (2,037) Australian (ASX 200) ↓ 3.2% (5,113) Ten year bond yields — German ↓ 14bp (-0.05%) USA ↓ 19bp (1.56%) Australian ↓ 24bp (2.01%) Currencies — Euro/USD ↓ 3.0% (US$1.11) USD TWI ↑ 2.1% AUD/USD ↓ 2.4% (US74.0 ¢) Gold (spot) — ↑ 4.7% (US$1,315/oz.)
So what does all this mean for Australia? We expect some limited adverse impact on the economy and the outlook for commodities, except gold, has deteriorated. The Reserve Bank is now much more likely to reduce the official cash rate to 1.5% over the next month or so. The Australian share market will suffer some collateral damage from the global “risk off” but, in this regard, it should be noted that only around 5% of aggregative earnings are derived from the UK and Europe. At the individual company earnings level, there are many moving parts including the negative impact of a stronger Australian dollar against the UK pound and the positive impact of a weaker Australian dollar against the US dollar. We will have a closer look at individual company impacts over the coming days.
What should investors do? BREXIT is a political crisis with some adverse economic consequences, especially in Europe, but it is not a global financial crisis. So investors should “let the dust settle” and start preparing themselves to “buy the share market dip”.