One week ago the world was waking up to the UK’s decision to leave the EU. This opened up a world of uncertainty, with many questions about what would happen next. One week on, we take stock and try to evaluate what issues we have a better view on now, and what areas remain highly uncertain.
The starting point for the rest of Europe also makes the continent vulnerable to political contagion.
Nick Kounis Head of Macro Research
Evaluating the situation one week later
- One week after we woke up to the UK’s decision to leave the EU what have we learnt? What is still uncertain?
- It seems financial conditions may not tighten very aggressively…
- …while another round of global monetary easing looks likely
- In addition, the UK government will almost certainly go ahead and take the country out of the EU, though the process may not start until 2017…
- …in addition it will most likely be a tough and long negotiation
- Although we have downgraded our economic forecasts, we do not yet have evidence of the size of the uncertainty shock…
- …or the extent to which euro contagion will build in the coming period
Financial conditions may not tighten very aggressively
So what have we learnt? First, of all the market reaction of the first few days could be seen to be rather encouraging. Although there was an aggressive sell-off in equity markets in the immediate aftermath of the vote, major market indexes have recovered to varying degrees since then. This raises the hope that financial conditions will not tighten very aggressively, which would have been a major headwind for the global economy. Of course, it is perhaps too early to say that markets will not experience a further leg down going forward. However, it does seem reasonable to assume that the Brexit impact is not too far from being discounted, assuming a relatively benign scenario for the rest of Europe. Of course in an adverse scenario, where Brexit morphs into a full-scale euro crisis and investors fear euro/EU break-up, markets would have much further to correct. However, our base case – and that of the consensus it seems - is that contagion will be limited.
Another round of global easing
Something else which has become a little clearer is that central banks are set for a new round of easing, which is one of the factors that has supported investor confidence. Further UK easing over the summer has been explicitly signalled by BoE Governor Carney. There have also been reports that the ECB is considering changing the rules of its QE programme to give it room to make additional purchases. Indeed, President Draghi and Executive Board members Coeure and Praet have indicated they expect Brexit to be negative for eurozone economic growth. We expect further easing from the BoE, ECB and BoJ, while we continue to expect the Fed to keep interest rates on hold this year.
Brexit is Brexit, but it may take a while and will be tough
Since the referendum, the UK political scene has been a circus, with the Labour and Conservative parties looking to be in chaos and the Scottish national party looking to make moves to trigger a new independence referendum. However, we are seeing some clarity about who the next Conservative Prime Minister might be. After Boris Johnson decided not to put his name forward, current Home Secretary Theresa May has emerged as the front runner in the race.
Mrs. May has set out a number of key positions, which provide some early indications of the UK’s approach. First of all, she said there should be no second referendum, the public had given its verdict. Second, Article 50 should not be invoked before the end of this year. Third, there should be no new General Election before 2020. Finally, the government had no mandate to reach a deal that would maintain the free movement of people. This is crucial, as it will therefore make it difficult for the UK to have full access to the single market, given the EU's current stance. Indeed, French President Hollande has said that there will be no access to the single market without free movement. All this suggests that the negotiations will likely be long and difficult and that the period of uncertainty will be prolonged.
Uncertainty about the uncertainty
So there are a number of areas where there is a little more clarity a week on from the referendum. What is still uncertain? Well a major issue is what will the Brexit mean for the economic outlook. Earlier this week, we lowered our forecasts for economic growth, US, German and UK government bond yields, sterling and the euro (see Global Macro View – Downgrading our forecasts on Brexit). One of the main features of the scenario is that the prolonged period of uncertainty will lead to corporate caution and hence a scaling back of hiring and investment, especially of course for the UK. How big or small this effect will be is obviously intangible and highly uncertain. We will need to wait and see how business confidence indicators develop. Although we have seen some business surveys this week, they relate to June, so we have to wait for the data for July to get the first indications.
The other big issue is the extent of ‘exit contagion’ to other EU countries. In our base case, we assumed contagion will remain limited. However, political risk is elevated and there is clearly an anti-establishment and Eurosceptic tide sweeping through many countries. The Italian political reform referendum later this year and elections in Germany, France and the Netherlands next year are key events to watch in this respect. Certainly some of the polls make worrying reading. For instance, a poll this week showed that Italy’s anti-EU, anti-establishment 5 Star Party would win a General Election if held today. The risk of European contagion looks significant.