Caught leaning the wrong way, the financial markets were hit hard by the outcome of the U.K.’s referendum on EU membership. However, the decision to leave the European Union is not a Lehman-type event. A full-blown panic is unlikely and we should see the U.S. market settle down early this week. The outlook for the U.K. economy is not good. Meanwhile, back at home, investors will look to the calendar and collectively yawn. While a number of data releases have market-moving potential, none is going to alter the underlying picture of the economy – that is, until the June employment report arrives on July 8.
What were they thinking? The majority of economic studies on the EU exit impact pointed to severe consequences for the U.K. economy. Some voters recognized this and still wanted to leave. The desire for self-rule was a motivating force. As in the U.S., the economic recovery in the U.K. had passed many individuals by. The “elites” in London were seen doing well, but the “common people” struggled simply to maintain their living standards. Throughout the campaign, many felt that they were being talked down to by the powers that be. Much of the push for “leave” came from anti-immigrant feelings. The “leave” campaign misled on the impact of immigrants, suggesting that they were a drain on the National Health Service. UKIP leader and Brexit supporter Nigel Farage said that the “leave” campaign was “scaremongering” and described some of the advertisements (not his, of course) as “a mistake.”
There were significant differences in votes by educational attainment, with those with degrees most likely to vote “remain” and those with less education more likely to choose “leave.” Scotland voted strongly for “remain.” Scottish First Minister Nicola Sturgeon said that a second referendum for independence (from the U.K.) was “highly likely.” Northern Ireland may also move to leave the U.K. and rejoin the EU.
The key factor here is uncertainty. Prime Minister David Cameron has resigned (effective October), and his successor will face a lengthy negotiation (two years) with the EU on exit terms. This isn’t going to be pretty. It’s effectively a divorce with 27 wives all wanting some sort of alimony. Uncertainty is the enemy of business fixed investment. Even prior to the vote, there was evidence of firms pulling back on capital spending plans. Residential and commercial real estate transactions were being postponed. Consumers delayed big-ticket purchases. Economic growth in the U.K. will take a hit and there is a good chance of an outright recession.
The Bank of England has some room to cut rates, but the proper policy response isn’t clear. The weaker pound will boost inflation. The central bank will have to decide which problem, slower growth or higher inflation, is the greater.
The direct impact on the U.S. economy may be small. The U.K. accounts for less than 4% of U.S. exports and less than 3% of U.S. imports. Still, many U.S. firms do business in the U.K., so slower U.K. growth isn’t going to help (especially on top of sluggish global growth in general).
The referendum result sent global equity markets reeling. The pound fell sharply (to a 30-year low). A flight to safety pushed bond yields down. The 10-year Treasury note yield sank from 1.74% to 1.41% (briefly), before bouncing about halfway back. This seemed to be largely a knee-jerk reaction to a surprise, rather than an outright panic. Stock markets, bond yields, and the pound rose off their lows. The U.S. markets have had plenty at home to deal with in recent weeks, including three appearances by Fed Chair Yellen and a host of economic data reports. However, all of that was dominated by Brexit concerns.
The U.S. economic outlook should not change much following the Brexit vote. The U.S. economy was already not getting much help from the rest of the world, but domestic demand should remain moderately strong. Housing is in good shape. Consumer fundamentals remain sound, although low gasoline prices will provide less support for spending over time. Business fixed investment has been weak, but much of that has been tied to the contraction in energy exploration. Ex-energy, capital spending appears soft, but this is more consistent with a slow patch than an outright recession. Still, as Fed Chair Yellen noted in her Congressional testimony, “considerable uncertainty in the economic outlook remains.”
The pace of job growth is a key concern for the Fed. Job growth slowed into 2Q16. The May payroll figure was restrained by the strike at Verizon, but these workers will come back in June. Accounting for the strike, job growth was still lower than in the early part of the year, but it’s unclear why. Statistical noise may have been a factor. Firms may have reduced hiring in the face of uncertainty. Firms may have had a tougher time finding qualified workers (willing to work for what the firm is going to pay). The June employment report, due July 8, should help to answer many of these questions. Between now and then, the economic calendar is not very eventful.
With the Brexit vote out of the way, attention may return to previous worries, such as China and Greece. Financial market volatility may die down somewhat, but it’s not going to go away.
The bigger concerns are longer term in nature. In her testimony, Fed Chair Yellen said that “although I am optimistic about the longer-run prospects for the U.S. economy, we cannot rule out the possibility expressed by some prominent economists that the slow productivity growth seen in recent years will continue into the future.” Quoting one famous philosopher, “it just goes to show ya, it’s always somethin’.”