As a Londoner and a “remain” voter Friday was a very sad turn of events for me. It is important to know however that the final outcome does not necessarily have to be as bad as the initial headlines have made out. What the UK was actually voting on was whether to remain a member of the European Union. Membership of the EU is, in economic terms, a non-event. What is far more important is access to the common market, a large free-trade area, larger in fact than the EU itself. Countries like Norway and Switzerland are part of the common market, but are not part of the EU. If the UK can maintain access to the common market, then the actual impact will be quite mild.
For an optimistic scenario this brief paper from the Adam Smith Institute is worth reading. In a world where cool heads prevail and a path towards a sensible new arrangement is set out soon, perhaps the country can avoid a tremendous mistake. With some hope I note that amidst all the anger from EU officials demanding a swift and punitive UK exit, Angela Merkel was quoted over the weekend as saying there was “no need to be nasty” in the negations and that she was not in favour of speedy talks.
Away from the hopeful “ifs” however, at a minimum there will be many months of great uncertainty hanging over European economies and this will clearly exert a cost on economic activity, both here in the UK and in the EU. Economists suggest that a UK recession is now likely while in the rest of the EU GDP growth could be lowered by c. 0.5%. The depth and severity of the economic impact to both the UK and the rest of EU will depend on how long negotiations last and what path they start to take. Nobody is going to be investing or hiring until there is a lot more clarity than there is today.
In terms of the potential future risks to financial markets, I believe these now hinge on how likely markets perceive a ‘Brexit lite’ vs ‘Brexit full’ outcome to be, as more information is made available over the coming weeks and months. Under a Brexit full path - i.e. a rapid enactment of article 50 and a strong likelihood of curtailed access to the single market, the areas that worry me greatly are the EU peripheral economies. It will be grim in the UK, with the county likely experiencing a recession and lower future trend GDP growth. But the UK is in far better shape than much of Europe. Currency depreciation, an independent central bank and full employment all provide the UK with at least some buffer. Outside of Germany, the EU is suffering from chronic unemployment, low or no growth and dangerously persistent deflation. For highly indebted EU economies this is a toxic mix and there is little or no buffer to fall back on. If, say, Italy, Spain or Portugal were to fall back into recession their outlook could start to become very worrying. The market is already moving to price these risks in. I believe it is noteworthy that while on Friday the UK share market, the FTSE index, fell by 3.1%, the pan European share market index, the EuroStoxx index, fell by 8.6% and the Spanish and Italian equity markets fell by 12.4% and 12.5% respectively. Indeed the FTSE was actually one of the best performing global equity markets on Friday, with the S&P500 off 3.6% and the Nikkei off 7.9%.
Probably more importantly than the equity market moves, the debt markets on Friday saw a significant widening in credit spreads between German bunds and peripheral yields. The 10 year German bond yield fell 14bp while Italian, Spanish and Portuguese 10 year yields rose 15bp, 16bp and 25bp respectively. The Greek 10 year yield rose 77bp… What I will be watching most closely going forward will be changes to the yield spread between German bunds and these peripheral economies. The spread has already increased significantly and future moves will hang on how the ‘Brexit lite’ vs ‘Brexit full’ future path unfolds.
Outside of the EU and the UK, I do not believe Friday’s vote should herald a broader systematic risk event. It may, but in essence this is just an act of economic self-harm between these two regions, it will lower global GDP for sure, but I don’t believe at this time we need fear a Lehman bankruptcy or Greek debt crisis moment. Outside of a very messy Brexit scenario, this should hopefully remain a European problem not a global issue. Time will tell. As will sober leadership.
Great piece and insightful Balanced view.
Having spent the month leading up to the vote travelling around England and Scotland I was surprised at the strength of the exit feeling and came to understand the call for self sovereignty. England was the jewel in the EU and I have no doubt they will prosper as an island trader like NZ and AU have. In 20 years time they will look back and celebrate their decision to be in control of their own destiny. The self-interested will naturally complain about their short term financial losses.