Paresh Upadhyaya is Director of Currency Strategy, U.S. at Pioneer Investments.
The UK’s vote to leave the EU will have global economic and financial consequences. During the initial days of uncertainty, global financial markets sold off sharply as markets were determining whether Brexit was a regional or global shock to the world economy. The indications so far are that this should be a regional shock contained within the UK/Europe area and, as a result, global financial markets are so far successfully riding out temporary volatility.
- The UK voted 51.9% vs 48.1% to exit the EU.
- Greenland was the first state to leave the EU in 1984 but the UK is the most significant exit to date.
Broad Implications from Brexit
- To end further globalization. The underlying forces behind Brexit, such as rising income inequality, stagnant wage growth, the loss of high paying manufacturing jobs and concerns about immigration, were key catalysts behind Brexit. These factors are also pervasive throughout the world. The appetite for further trade agreements is diminishing, as seen in Japan and the US. The eventual passage of the Trans-Pacific Partnership trade agreement is now likely below 50%.
- Global growth is likely to slow. The UK/Europe region should be affected the most. The IMF is forecasting global growth to take a 0-0.2% hit from Brexit. Not surprisingly, the UK will be the hardest hit and risks falling into recession during the second half of 2016 and the first half of 2017. Economists project Brexit will carve out between 1.5-2.0% from growth. Despite being a relatively closed economy, the US is likely to see a 0.25% reduction in growth.
- Global financial conditions remain accommodative. The US Federal Reserve (Fed) is even more likely to continue this protracted tightening cycle as global growth feels the negative aftershocks from Brexit and the US dollar (USD) strengthens, potentially complicating the Fed’s inflation outlook. This reduces the likelihood of a Fed rate hike at the July and September meetings, with December the earliest they might consider one. The European Central Bank (ECB) will likely increase monthly purchases, extend the quantitative easing (QE) program beyond March 2017 and potentially cut the deposit rate. The Bank of England (BoE) has already announced a 250 billion pound assistance package for the banking sector. The BoE will likely cut interest rates from 0.50% to 0.25% in the next three months. It is also likely to resume QE.
- Political and constitutional crisis in the UK. British Prime Minister David Cameron resigned, leading to a Conservative leadership contest to be settled in October. The opposition Labor Party is in disarray, with most of the shadow cabinet resigning in protest of Labor leader Jeremy Corbin’s leadership of the “Remain camp.” It is not out of question that a leadership contest could develop in the Labor Party as well.
- Possible disintegration of the UK. Scotland voted overwhelmingly in favor of remaining at 62% vs 38% and so did Northern Ireland at 55.8% vs 44.2%. Scotland has always been strongly pro-EU and the likelihood of another independence referendum has risen dramatically. Polls taken after the Brexit verdicts indicate a solid majority is now in favor of independence. While there may be a clamoring of support to hold an independence referendum, given the volatile and combustible nature of Northern Irish politics, tensions may rise between the Unionists who favor ties with the UK and Nationalists who favor a union with Ireland.
- Potential unraveling of the EU. The Brexit verdict could embolden anti-EU parties in France, Italy, Germany and the Netherlands. The immediate focus will be the French presidential elections in 2017, where the anti-EU party, National Front, is favored to make it to the second round. From here, the EU can go in many directions, ranging from further fragmentation to stronger integration.
What’s Next for the UK?
The UK government is in turmoil and there are many possibilities. Credit Suisse published an interesting schematic showing many different scenarios, ranging from a relatively quick Brexit resolution to a complete reversal of Brexit and decision to remain. For Brexit
to occur, Prime Minister Cameron will need to trigger Article 50 of the Lisbon Treaty to start negotiations on its exit from the EU. This is not likely to occur until after he is replaced by a Conservative successor sometime in September or October. The political
situation remains highly fluid.
For a more detailed discussion of Brexit implications, see Paresh Upadhyaya’s full summary: The Dawn of Brexit – Implications for Fixed Income and Currencies.