Brexit implications: substantial, but unclear
Brexit is primarily about politics. The UK voluntarily deciding to leave the EU is arguably the biggest political challenge yet to the European Union. Not only is it a very big loss for the establishment to lose one of the largest member states, but it will further increase the uncertainty of the EU in several ways.
Firstly, it will create a big mess in UK politics. Prime Minister Cameron has already resigned and his successor, Theresa May, taken office. Several shadow Labour ministers have followed in PM Cameron’s footsteps. The decision may thus create deep splits — some are thinking it could lead to break-ups — within the two major parties, while populist UKIP gains traction. It will also lead to splits and a potential break-up of the UK, with Scotland contemplating leaving the UK and joining the EU.
Secondly, it is unclear exactly how the exit procedure will happen and how long it will take. Everything from trade agreements, visa regimes, education exchanges and utilisation of healthcare services has to be addressed. It may be relatively smooth (they can for instance adopt the Norwegian EEA or Swiss EFTA model), or lead to very lengthy negotiations on a bilateral basis. If, when and how the exit clause (the so called Article 50) is triggered — note that Cameron did not do it before he resigned — is likely to be a key factor in the short term.
Thirdly, the decision is also likely to open up a Pandora’s box of exit discussions. There have already been a number of populist parties in other EU countries saying they want to have similar referendums. It is going to be extremely difficult for the EU to move ahead with initiatives that deepen the cooperation in areas like migration, the single market, taxation and banking. Some think it could lead to a two-speed union, with a core moving ahead with monetary and political integration. Though I think that scenario is quite unlikely.
Fourthly, it places uncertainty on the enlargement process. It is hard to see the EU taking on more members — be they Serbia or Scotland — as long as there is any uncertainty over the UK exit. Enlarging the Union to the east is likely to meet opposition from countries with large populist parties, while including Scotland (and possibly Northern Ireland) could be blocked by members with their own break-away provinces. A key challenge in the coming months will be to assure the candidate countries in the Balkans that the process remains unchanged for them.
The main conclusion from a political perspective is that this is a major crisis for the UK, but also for the EU. The severity of the crisis for the EU and its financial implications are dependent on how the UK deals with its own crisis.
Economic consequences: negative but manageable
The economic consequences of Brexit are difficult to estimate, given that no one knows how the separation will happen. It seems reasonable to assume that the real economic implications will be sizeable for the UK (a few percentage points of GDP over the next few years), moderate for the EU (perhaps half a percentage point) and quite small for the global economy (a few tens of a percent). The above estimates are baseline scenarios from international organisations like OECD and the IMF. There is a risk that the consequences, especially for the UK, will be much larger, whereas some (Brexit-related organisations) hope the consequences will be positive.
There are several channels, but the two most important ones are trade and finance, given that the UK is an open economy with a very sizeable financial sector. The exit model will matter a great deal here though, with the UK joining EEA being the most benign. Negotiating bilateral deals would most likely be worse, and certainly more time consuming, while simply referring to WTO agreements would be the worst scenario from an economic standpoint, and the most narrow, although perhaps the easiest.
Financial consequences: asymmetrical volatility
The financial implications are not only manifesting themselves faster than the economic consequenses, but are also likely to be larger. The financial implications have so far been asymmetrical and volatile. Asymmetrical in that some assets moved sharply – currencies like the GBP and YPY moved sharply and equity markets in Japan and Southern Europe as well as bank stocks fell sharply – whereas others were relatively resilient; the EUR and many EM currencies and equities held up reasonably well and yields did not move all that much. The fact that many central banks intervened with liquidity and promised to intervene more if needed, not only helped to calm the bond markets, but will likely also help to avert a Lehman-style liquidity squeeze. A related consequence is that rates are likely to remain low for even longer. The FED may hold off until December (or longer) while the Bank of England and Bank of Japan are likely to wait even longer, or may have to cut.
EM assets may continue to outperform in a relative sense – as this is not about them or primarily about economics – at least those with little direct links to the UK and EU. But it is difficult to see EM and FM assets performing in an absolute sense in this environment. And some assets with EU exposure that did not move a lot on the result may “catch up” in the coming days and weeks, while some may have overreacted.
It is difficult to exaggerate the political consequences of Brexit for the UK and the EU. We are entering a period of great political uncertainty and this will most likely lead to continued financial volatility. The economic consequences are real and almost entirely negative but relatively limited and should not be the primary concern.
The fact that central banks were prepared and acted decisively limited the effect on the interbank and bond markets, while many EM assets proved relatively resilient, making comparisons to a Lehman-like situation misplaced. This is comforting — especially as rates will stay low for even longer now — but not a reason to become optimistic.
Peter Elam Håkansson is founding partner, chairman and chief investment officer at East Capital