Brexit: More questions than answers

Share Button

The UK, the world and financial markets have now had five days to digest the British electorate’s vote to leave the EU and its impact on UK and global asset prices.

So far Sterling and Japanese and European equity markets have borne the brunt of the initial shock, while the FTSE is down only 3.3% since Thursday and most major and emerging market currencies have been reasonably well behaved (see Figure 1).

But there are still far many more questions than answers and the situation remains extremely fluid.

For starters there is no precedent for a country leaving the EU and thus no clear-cut rulebook to rely on. The government has limited institutional capacity to start negotiations with the UK’s 27 EU partners until Article 50 of the Lisbon Treaty is triggered and no timeline has been provided for when this will happen (assuming it is triggered at all).

Perhaps unsurprisingly given the mammoth task ahead, the Leave campaign leaders have been very short on specifics regarding the mechanics and timing of the UK’s exit from the EU, the likely shape of future trade treaties and national policies such as immigration. Prime Minister Cameron’s de-facto resignation and wholesale changes in personnel in the opposition Labour Party are adding to the head-scratching.

Moreover, it is not one country seeking to leave the EU, but a union of four countries – England, Wales, Scotland and Northern Ireland – which further complicates matters as both Scotland and Northern Ireland seem intent on remaining part of the EU and potentially breaking free from the UK.

At this point in time, all we can do is take stock of what we know (or at least we think we know) and what we don’t know (but can tentatively try to forecast).

I would conclude, as I did in Europe – the Final Countdown (21 June 2016), that the many layers of political, legal, economic and financial uncertainty are likely to keep UK investment, consumption and employment, as well as Sterling on the back-foot for months to come. Financial market volatility is also likely to remain elevated in coming weeks.

In this context the US Federal Reserve is likely to keep rates on hold in coming months and the European Central Bank can probably afford to do little for the time being. The Bank of England is likely to seriously contemplate cutting its policy rate while the Bank of Japan will be under renewed pressure to curb soaring Yen strength.

Of course, British policy-makers and business associations have come out and said the right things in order to limit the carnage and contagion. But they have far more limited room to reflate the economy and fade gyrations in financial markets than they did during the 2008-2009 great financial crisis. They are not in control at this juncture and it is not obvious who is.

 

Olivier Desbarres - More Questions Fig1UK Economy

What we know

  • As I wrote in EU Referendum survey results (18 May 2016), there has been mounting evidence that in the run-up to the referendum domestic and foreign companies curtailed or delayed investment in the UK, with domestic companies also prone to freezing hiring.
  • UK gross fixed capital formation, seasonally-adjusted, increased only 0.5% quarter-on-quarter in Q1 despite a 1.1% contraction in Q4 2015 – the largest contraction in over three years (see Figure 2). Similarly, business investment shrunk a further 0.5% qoq in Q1 2016 following a 2% qoq contraction in Q4 2015 – the second and third largest quarterly contractions in six years which more than wiped out the growth in the previous two quarters (see Figure 2). Unsurprisingly business and consumer confidence remains depressed (see Figure 3).
  • Weak investment capped GDP growth at only 0.4% qoq in Q1 2016 (see Figure 4).
  • A number of UK-based domestic and foreign companies publicly stated in recent days that they had already activated contingency plans to move some operations abroad.
  • More positively, improved currency competitiveness had seemingly already contributed to a recent rebound in UK exports (see Figure 5). Even prior to Sterling’s collapse in the past 72 hours, a weighted basket of Sterling’s exchange rates against the currencies of its main trading partners – its nominal effective exchange rate (NEER) – had weakened about 7% since mid-August.
  • S&P on 27th June downgraded its AAA-credit rating one notch to AA with a “negative” outlook and Fitch also downgraded Britain’s credit rating to AA from AA+. Moody’s on 25th June cut the outlook on its Aa1 credit rating to “negative” from “stable”, often a precursor to a full credit rating downgrade.

Olivier Desbarres - More Questions Fig2and3

Olivier Desbarres - More Questions Fig4and5

What we don’t know

  • The net impact on the economy cannot yet be quantified with any degree of certainty. But the political, legal, economic and financial uncertainty currently prevailing is likely to have a negative impact on UK domestic investment, consumption and employment near-term. The longer this period of limbo extends the greater the likely damage to the UK (and EU) economies.
  • Foreign direct investment and capital inflows into the UK are also likely to fall further until there is greater UK policy certainty and it becomes clearer whether asset prices have stabilised. This does not preclude tactical investments by foreigners attracted by a cheaper Sterling.
  • A more competitive currency could buoy tourism and further drive UK exports particularly to non-EU countries. But the Sterling cost of imports has already ticked up (see Figure 5) and UK exporters are still likely to face an uncertain trading environment with the EU and weak global demand. Therefore any narrowing of the UK’s trade deficit in goods and services is unlikely to be significant near-term.
  • The likely decrease in receipts from direct investment and portfolio investment abroad and increase in payments to foreign direct investors is also likely to limit any significant narrowing of the record-high 7% of GDP current account deficit recorded in Q4 2015 (see Figure 6).
  • The fall in UK and global equities and bond yields is likely to put further pressure on UK pension funds.
  • Beyond the effects of Brexit, the government still needs to address the residual problem of low productivity growth, tepid wage growth despite a low unemployment rate (see Figure 7), still-high levels of household debt and fiscal deficits.
  • There is limited room for interest rate policy to stimulate growth as the BoE policy rate is already at an all-time low of 0.5%.
  • Similarly, there is limited room for fiscal policy reflation as the Treasury, which remains for now committed to fiscal prudence, is likely to be hampered by weaker economic activity and lower fiscal revenues. Chancellor Osborne has warned that the interim budget to be announced in October may have to include tax increases.
  • The recent credit rating downgrades will at the margin likely entail higher borrowing costs for both the government and businesses, putting further pressure on government finances.

Olivier Desbarres - More Questions Fig6and7

Bank of England monetary policy

What we know

  • The governor of the Bank of England (BoE), Mark Carney, said in a statement on Friday 24th June that the BoE “was “well prepared for this” […]. The Treasury and the Bank of England have engaged in extensive contingency planning and the Chancellor and I have been in close contact, including through the night and this morning. The Bank will not hesitate to take additional measures as required as those markets adjust and the UK economy moves forward. […]. The Bank of England is also able to provide substantial liquidity in foreign currency, if required”.
  • There have been various reports in recent weeks that the BoE would either have to hike its record-low policy rate to curb imported-inflation or cut rates to support growth in the event of an economic downturn. Carney in his statement said that “In the coming weeks, the Bank will assess economic conditions and will consider any additional policy responses”. The BoE is currently scheduled to hold policy meetings on 24th July, 4th August, 15th September, 13th October, 3rd November and 15th December (see Figure 8).

Olivier Desbarres - More Questions Fig8

What we don’t know

  • The BoE has not confirmed whether it has intervened in the FX market to support Sterling or at least smooth its path. But Sterling’s seismic collapse since the referendum result suggests that the BoE has so far stayed on the sidelines (or less likely that the intervention was modest and/or ineffectual). The BoE will have learnt its lesson from 1992 when it used up billions of FX reserves to unsuccessfully defend Sterling and keep the UK in the Exchange Rate Mechanism. Moreover, all other things being equal, the BoE may welcome a degree of currency weakness to the extent that it boosts UK exports and tourism revenues and may in time encourage foreign investment in the UK.
  • The BoE will likely first want to assess the referendum result’s impact on the UK economy before deciding whether to cut, hike or stay on hold. However, I would argue that the risk is tilted towards the BoE cutting its policy rate by 25bp or 50bp given the likely negative shock to the UK economy, including to consumer and business confidence, investment, consumption, employment, housing prices and fiscal revenues. The BoE also has the option of another round of quantitative easing but this is still likely to be a measure of last resort.

Sterling

What we know

  • Sterling is currently trading around 1.34 versus the US dollar, off its recent 31-year low but still down about 10% since it became clear at about 2am on Friday 24th June that the Leave vote had won the referendum.
  • The Sterling NEER has depreciated about 8% since Thursday and 15% from its multi-year high recorded in August 2015 (see Figure 9), with similar losses against the Euro and other currencies (see Figure 10), according to my estimates.

 Olivier Desbarres - More Questions Fig9and10

  • Indeed Sterling’s collapse since Thursday has been pretty uniform as Figure 11 shows, although the Yen’s rally has led to a 13% collapse in the GBP/JPY cross since the referendum.

Olivier Desbarres - More Questions Fig11

 

What we don’t know

  • Assuming ongoing legal, political, economic and financial uncertainty, capital account outflows from the UK are likely near-term to continue to overwhelm any modest competitiveness-driven narrowing of the large UK current account deficit. The risk is therefore that Sterling remains under pressure in coming weeks, interspersed by short-lived bounces.
  • Medium-term, a weaker currency may well drive a rebound in UK growth – assuming that the political and economic outlook has started to clear – in turn attracting capital inflows and investment into the UK. This could be the turning point for Sterling but picking the timing of this turning point at present is akin to playing the violin on the Titanic – laudable but risky.

 

UK equities and bonds

What we know

  • The FTSE-100 is down about 3.3% since Thursday with financial stocks among the hardest hit. Barclays and Royal Bank of Scotland yesterday suspended trading in their shares for five minutes as the 10% fall in the price of their shares triggered automatic circuit breakers.
  • The yield on UK 10-year government bonds fell to 0.93% – below 1% for the first time ever – as investors continued to sell shares in favour of safe-haven assets such as bonds and gold.

 

Major central bank monetary policies and FX

What we know

  • Developed currency markets have been reasonably well behaved (everything is relative). The exceptions of course are the contrasting Sterling and Yen, which have converged to the same level in NEER terms when April 2016 is used as the base (see Figure 12).
  • The Euro NEER has remained remarkably stable at the lower-end of its year-to-date 4% range.
  • The US Dollar NEER has appreciated about 2% since the referendum to a three-month high, while the Dow Jones is down 3.6% to a three-month low.
  • The Yen has been the stand-out performer in recent sessions, appreciating 13% versus Sterling and 5.2% in NEER terms (see Figure 12), in turn weighing on the Nikkei which is currently down 6.4% since last Thursday (see Figure 1).

Olivier Desbarres - More Questions Fig12

 

What we don’t know

  • The ECB, which holds its next policy meeting on 21st July, is likely to continue to allow markets to dictate the euro exchange rate. It may even tacitly welcome the small boost to the euro’s competitiveness to the extent that it supports sizeable eurozone exports at a time of still modest eurozone growth and global demand.
  • Yen and Nikkei price action is likely to accentuate the need for (and market expectation of) renewed Bank of Japan monetary policy easing at its next meeting on 29th July, in the form of rate cuts and/or beefed-up quantitative easing. As often the case in the past, the BoJ will likely have to deliver more than is expected in order to have any meaningful and lasting impact on the Yen and equities.
  • The Fed is very unlikely to hike its policy rate on 27th July, irrespective of the strength of US data (including June non-farm payrolls) in coming weeks. The Fed made clear in its June policy meeting minutes that the UK referendum presented significant event risk and the collapse in global equity markets and surge in volatility is likely to keep the Fed on hold in months to come.

 

Emerging Markets

What we know

  • A GDP-weighted basket of emerging market NEERs is broadl flat since Thursday (see Figure 13), with the majority of EM currencies (including the Chinese renminbi) up or down by less than 1%. However, the South African Rand, Mexican Peso and Korean Won are down 3.4%, 3.0% and 1.5% respectively.

Olivier Desbarres - More Questions Fig13

 

What we don’t know

  • The Bank of Korea (BoK) is likely to welcome the competitiveness-boost to exports and will not be overly worried about imported-inflation. It is therefore unlikely to dip into admittedly significant FX reserves to stop, let alone reverse, the Won’s recent and modest depreciation although it decreases the odds of the BoK cutting its policy rate from an already record-low.
  • With inflation still near 6%, the South African Reserve Bank may have an incentive to slow any further Rand depreciation but the modest size of its FX reserves may curb its appetite for heavy and/or sustained FX intervention.
  • The central banks of Brazil and Russia are unlikely to aggressively intervene against the still modest appreciation in their currencies as inflation remains stubbornly high in both countries.

 

Referendum result

What we know – which is a lot but somewhat counter-intuitively makes it harder

  • The British electorate voted to leave the EU in last Thursday’s referendum by 52% vs 48%, according to the official result published by the Electoral Commission. Turnout was 71.8%, with more than 30 million eligible voters voting. There was no legal minimum turnout threshold but it was the highest turnout in a UK-wide vote since the 1992 general election.
  • The UK Lower House of Parliament (the House of Commons) will most likely have to vote on whether to trigger Article 50 of the Lisbon Treaty which in effect starts the procedure by which the UK negotiates its exit from the EU[1]. There is no precedent of the House of Commons voting against a referendum result and the UK Parliament website states that “The UK public elects Members of Parliament (MPs) to represent their interests and concerns in the House of Commons”.
  • But the referendum was set up such that it is not legally binding on the UK government or parliament. The UK Parliament website states that: “The national result, once declared, will be final but it is not legally binding. The European Referendum Act 2015 does not include provisions to implement the result of the referendum; legally, the Government is not bound to follow the outcome. However, it would be very unlikely for the Government to ignore the outcome of the referendum”.
  • The House of Commons could legally vote in favour of remaining in the EU on the basis that it is in the best interest of the UK public. About three-quarters of the current members of the House of Commons are pro-EU (see Figure 14) and they could in theory easily win a simple-majority vote not to trigger Article 50. However, there is no such precedent and if the House of Commons went against the will of the majority of the electorate this could be seen as an attack on the principles of democracy and intensify popular pressure on parliament to hold new elections.
  • If the House of Commons does vote in favour of triggering Article 50, the UK government would then have to either verbally or in writing inform the European Council of its formal decision to leave the EU. No timeline has yet been put forward for when House of Commons may vote on Article 50 or when the government may officially notify the European Council. Cameron has only said that it would be a matter for his successor to contend with.
  • If the government did officially notify the European Council of its intention to take the UK out of the EU, at this point the European Council would have up to two years (or more if both parties agree) to vote by a qualified majority to approve the terms and conditions of the UK’s exit from the EU, as per Clause 3 of Article 50. So, even if the UK government and/or House of Commons triggered Article 50, in practise the UK would remain an EU member for up to two years or more. The European Council would be very unlikely to vote against the UK’s exit from the EU.
  • The UK’s exit procedure from the EU is in theory irreversible. The Lisbon Treaty does not allow for a member state to turn negotiations on the terms and conditions of its exit from the EU into negotiations on a new membership deal. In theory, if that member state changed its mind it would once again have to go through the complex process of re-admission to the EU.

What we don’t know

  • The leaders of the leave camp, Boris Johnson and Michael Gove, have stated that there should be no rush to start the UK’s exit from the EU. There are a number of reasons behind this tactic to delay.

 

First, from a practical perspective, Boris Johnson has limited executive powers as he is not a member of the Cabinet, the UK government’s decision-making body. Michael Gove, who is Lord Chancellor and Secretary of State for Justice, is one of the twenty one Cabinet members and will therefore in all likelihood have to translate the wishes of the Leave campaign to the Cabinet. Moreover, the FT points out that it is significant that Brexit policy has been delegated to the Cabinet Office – a small department responsible for supporting the Prime Minister and Cabinet with little weight domestically or influence abroad – not the Treasury or the Foreign Office. This highlights the lack of urgency.

Second, the Leave leaders presumably want to delay as long as possible in order to give themselves time to get to grips with the enormity of the task ahead. “Everyone has a plan until they get punched”, as former heavyweight boxer Mike Tyson famously once said. Recent statements from senior Leave leaders, including Ian Duncan Smith, suggest that at best they only have a very tentative outline of a plan for the UK’s exit from the EU and renegotiation of its trade deals with EU partners. Until there is clarity on these complex issues, the Leave leaders are also likely to remain very vague with regards to national issues such as immigration and how extra funds (if any) will be spent.

Conversely, EU leaders have stated that the exit procedure should start without delay, partly because of their fear that a drawn-out process could exacerbate the risk of other EU countries pushing for their own referenda on EU membership. But the EU cannot legally force the UK into triggering Article 50.

  • The longer this period of limbo extends, the greater the risk that of Article 50 not being triggered and an alternative path being sought in my view. This could include another Scottish independence referendum, another UK referendum on EU membership (less likely) and early general elections (see below). 

Olivier Desbarres - More Questions Fig14

Next General Elections

What we know

  • The next general elections are scheduled for 7th May 2020. The Fixed-term Parliaments Act 2011 states that a 2/3 majority in the House of Commons (434 votes) is required to dissolve parliament and trigger early general elections.

 What we don’t know

  • The probability of early general elections is low at this juncture. Conservative members who won a surprisingly large 330 seats in last May’s general election would likely be reluctant to vote for snap elections in which they may win a far smaller number of seats. Similarly, the 229 Labour members of parliament may be fearful that their leaders’ tepid backing of EU membership and recent personnel upheavals could see support from their mostly pro-EU voters dwindle and significantly cut their number of seats in a new parliament. Only the Scottish National Party (SNP), which has 54 seats, and a handful of smaller parties such as UKIP and the Liberal Democrats, which won only a small number of seats in the 2015 elections, would have a strong incentive to vote for snap elections.

 

Next prime minister

What we know

  • Prime Minister David Cameron announced on 24th June that he would step down before the next Conservative Party Conference in Birmingham on 2-5 October, effectively handing in his three-month notice. The executive of the 1922 Committee of backbench Conservative MPs is set to meet to draw up the timetable for the Conservative Party leadership contest.
  • Candidates must be nominated by any two Conservative Party MPs. A series of ballots among Conservative Party MPs is held until there are only two candidates remaining at which point eligible Conservative Party members elect the new leader[2].

 

What we don’t know

  • Boris Johnson and Theresa May, the Home Secretary, are currently the two front-runners vying for the leadership of the Conservative Party and become the new prime minister, according to recent opinion polls and bookmakers’ Michael Gove, State Secretary for Justice and co-leader of the Leave campaign, has endorsed co-leader and former mayor of London Boris Johnson.

 

Scotland and Northern Ireland – The politics of devolution

What we know

  • Nicola Sturgeon, First Minister of Scotland, has said that Scotland wanted to remain part of the EU and she would start preparing legislation to enable another referendum on Scottish independence, despite having lost such a referendum two years ago. She would then seek for an independent Scotland to (re) gain EU membership.
  • All 54 SNP MPs are reportedly in favour of the UK staying in the EU (see Figure 14). All 32 Scottish regions and about 62% of the eligible Scottish electorate voted in favour of Remain in last week’s referendum – the highest regional percentage according to the official count.
  • The President of the Northern Irish Sinn Fein party has hinted at a new bid to re-unify Northern Ireland (part of the UK) and the Republic of Ireland (an independent state which has the euro and will continue to be an EU member).
  • Of the four Northern Ireland parties represented in the British Parliament, only the DUP, which has 8 MPs, is in favour of the UK exiting the EU (see Figure 14). The other three parties – Sinn Fein, the SDLP and UUP (with a combined 9 MPs) are in favour or the UK remaining in the EU. The Northern Ireland electorate voted in favour of Remain by a majority of 56% to 44%.

What we don’t know

  • Scotland and Northern Ireland may have a number of sources of leverage. For starters, the 54 SNP and 9 Northern Irish pro-remain MPs could threaten to vote in favour of remaining in the EU if they are not granted referendums on Scottish and Northern Ireland independence. Moreover, some legal experts believe that while the Scottish and Northern Ireland Parliaments have no explicit veto, by convention they would have to be formally consulted and effectively give their consent to measures which take Scotland and Northern Ireland out of the EU[3].
  • But should either Scotland or Northern Ireland be granted a referendum and vote in favour of independence, this could conceivably raise questions about the legitimacy of last week’s EU referendum.
  • The Leave leadership is therefore likely to try and stall any talks of a Scottish or Northern Ireland referendum on independence for as long as possible while trying to get support from Scottish and Northern Irish Parliaments and House of Commons MPs.

 

Labour Party

What we know

  • Labour Party leader Jeremy Corbyn today lost a motion of no-confidence vote triggered by two Labour MPs. The vote is not binding and the Labour Party will have to hold a formal leadership contest in order to replace Corbyn as party leader. Labour MPs, who in their large majority favour the UK remaining in the EU, have been very critical of Corbyn’s tepid support for the Remain vote in the run-up to  the referendum. Twenty members of the shadow cabinet and a number of ministerial aides have so far resigned.

What we don’t know

  • The final make-up of the Labour party leadership could change in coming weeks. The direct impact on UK policy-making is likely to be negligible but if a new Labour leader with stronger pro-EU credentials is elected, this could add weight to the risk of parliament voting not to trigger Article 50.

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

 


[1] The UK Parliament concludes that “Should the UK decide to withdraw from the EU, the UK Parliament should have enhanced oversight of the negotiations on the withdrawal and the new relationship, beyond existing ratification procedures”.

[2] If only one candidate stands (as happened in the 2003 leadership election) then they are elected uncontested. If two candidates stand, then the election immediately proceeds to a ballot of all members of the party. If more than two candidates stand, then MPs first hold a series of ballots to reduce the number to two. In each round, the candidate with the fewest votes is eliminated. Candidates may also withdraw between rounds (as it also happened in the 2001 contest). The series of ballots by MPs continues until there are only two candidates remaining. At this point the all-member ballot begins; this lasts for some weeks. The candidate who tops the poll is declared the leader. To be eligible to vote, an individual has to have been a paid-up member of the party for at least three months.

[3] Sir David Edward, a former Judge of the Court of Justice of the European Communities, in a UK Parliament Command Paper which lays out “The Process of withdrawing from the European Union” argues that “the Scottish Parliament would have to give its consent to measures extinguishing the application of EU law in Scotland. Such measures would entail the amendment of section 29 of the Scotland Act 1998, which binds the Scottish Parliament to act in a manner compatible with EU law”. He adds that he “could envisage certain political advantages being drawn from not giving consent”. This is admittedly an interpretation of the law.

Share Button