By Andrew M. Baron
I dislike the term “Brexit.” Some of you may agree with me, for a variety of reasons that may include the fact that the term has bombarded readers of the financial press over the last two months. My reason is simple: there appears to be a constant need to create a nickname or acronym for events that shape financial markets, economics and geopolitics (Global Financial Crisis becomes the cute “GFC”) and this phenomenon diminishes the seriousness with which one should be considering the effects.
Nicknames notwithstanding, the United Kingdom is in a position that most people frankly did not anticipate that it would be in. In fact, the British people themselves have reacted with palpable shock as the implications of the path the country has put itself on become more focused.
There is, of course, no way of knowing whether “Leave” voters understood the legal and political implications before arriving at the ballot box, but anecdotally we would guess that they did not. Indeed, as we write this, the situation in Whitehall is fluid. The U.K. has a new Conservative prime minister, with David Cameron having resigned in the wake of the referendum defeat, but the opposition is in a state of disarray. It is fair to say that there exists a vacuum of power that extends to both sides of the Commons, despite the reshuffled government.
At present, the best answer that Prime Minister Theresa May has been able to give regarding the timing of Britain’s exit plan is that she is “in no rush” to trigger negotiations with the EU. Thus far, politicians in the rest of the EU and the bureaucrats in Brussels have been unimpressed by that answer.
Lastly, there is a material risk that Scotland and Northern Ireland could call referenda to secede from the United Kingdom in favor of a Scottish attempt to remain in the EU and Northern Irish attempt to unify the isle of Ireland (the latter not particularly interesting to the Republic of Ireland itself!). One could be forgiven for being slightly confused by the political theatre of it all.
With all of these contingencies, it is exceedingly difficult to predict the real effect of the exit vote on the U.K. economy. There will likely be a dampening effect on growth, but a slowdown will not necessarily be transmitted through trade channels, which should exist in a status quo environment for at least two years after the U.K. formally notifies the EU of its intention to leave. The main channel through which a decline in growth in the U.K. is likely to progress is via a prolonged period of contraction in business investment. However, as business investment represents 10 percent of GDP in the U.K. and contributed exactly 0.0 percent to annual GDP growth in Q1 2016, it will take a severe contraction to push GDP negative in isolation.
A measurable increase in the personal savings rate and a shift to lower consumption is possible, but only possible as opposed to a certainty, contrary to the dire forecasts by the “Remain” camp. We do not believe that a two- to three-year process to negotiate withdrawal from the EU will have a permanent dampening effect on the consumer in the U.K. in the absence of actual large-scale declines in employment, which appear unlikely at present. Crucially, there is a high probability of further support from both the Bank of England and fiscal channels in the event that the U.K. economy enters a technical recession; avoiding a deeper downturn will be paramount.
We say all of this with a word of caution. No one has ever tried to do what the U.K. is going to attempt. Reversing 40 years of economic and social integration with the Continent has completely unknowable consequences, and assuming it will be easy (a la Boris Johnson) is not an informed assessment of the situation.
In terms of spill-over to the rest of the global economy, there is some good news. The U.K. may be the fifth largest economy in the world, but it represents only 4 percent of global GDP. It punches above its (GDP) weight in influence as a permanent member of the U.N. Security Council, a nuclear power and a “special” friend to the U.S. However, its influence on actual U.S. and global growth should be marginal. The U.S. is growing at a trend-like pace, is a relatively closed economy and is not showing many signs of fatigue at close to full employment. In short, consensus U.S. real GDP growth forecasts of 2 percent look attainable for calendar year 2016. The odds of continued tightening by the Fed indicate that only one increase (December) is possible in this environment, but is handicapped at only a 44 percent probability at present.
The not-as-good news is that the European economy can only properly be categorized as “in recovery” and is decidedly more fragile than that of the U.K. or the U.S. While Europe is growing at trend, or even slightly above trend presently, the ECB has pushed the limit of its monetary accommodation. Any weakness that is transmitted to Europe from the U.K. has the ability to expose further cracks in the union and renewed economic weakness. We do not believe that the vote changes the immediate fundamental economic climate in Europe, but the political landscape must be closely monitored for anti-establishment uprisings. Populist political uprising in Europe has an unpleasant history, and the economic and currency union only holds if the citizens in the EU are supportive of it. The baseline expectation is not instability, but one would be remiss not to consider the existence of emboldened fringe political leadership and populism’s potential for economic disruption in Europe.
Andrew M. Baron, CFA, is the chief investment officer at Butterfield Bank. The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The bank accepts no liability for errors or actions taken on the basis of this information.