Hell is empty and all the devils are here
- William Shakespeare
True to their literary heritage, the United Kingdom (U.K.), in voting to leave the European Union (EU), has reenacted Shakespeare’s The Tempest replete with political drama, strange alliances, fantastical promises and intriguing magic.
One would hope that this unfolding play would have a similar ending …when sailors arrive and announce that the ship hasn’t been wrecked after all, but is safely anchored off the island, everyone is forgiven and there is a final celebration of their reunion.
Decision Economics is willing to put chips on this outcome.
The first thought was that Brexit was a mere tempest in a teapot, another tantrum of the kind the Brits are famous for, especially when dealing with their neighbors across the Channel. Judging by how quickly the markets rebounded after the “Leave” vote, this would not have been a bad call. Since the plunge on June 23 and for a few days after, equities across all major developed equity markets have recovered most of the lost ground, while the U.S. equity market has rebounded to repeated new record-highs, a DE strategic view.
Key Takeaways:
- Brexit will be a long journey over many years without an obvious final destination.
- Undermined business and consumer confidence will weaken growth prospects in the U.K. but the economy will stop short of full-blown recession this year or next.
- To maintain market stability in the face of uncertainty, central banks will keep official interest rates “low-for-longer.” This is also to backstop the banking system on possible increasing credit problems.
- The fallout from Brexit will not trigger a domino-like contagion in the EU.
- Immigration and the refugee crisis in Europe, rather than economic and monetary tensions, might prove the Achilles’ heel of EU efforts toward further integration.
- For DE investment strategy, Brexit does suggest some Country Global Regional shifts in allocations. Mainly, however, the strategic Strong Overweight, the asset class Equities stays, although now at 75% (vs. a Neutral 55%) rather than 85%. The Eurozone and Europe are downgraded some, the U.S. upgraded, and tactically the U.K. is Neutral. Longer-run, however, the U.K. is an Overweight. Modest increase in emerging markets in both equities and bonds is warranted.
Dismissing Brexit, however, as simply a parochial non-event would overlook potentially significant macro consequences.
The actual logistics of Brexit will make it a long, drawn-out process spanning years, creating considerable uncertainties. Former Prime Minister Cameron, who gambled his tenure by calling for the referendum, had no plan B in place if the “Leave” won.
Also, the British civil service is inadequately staffed to tackle the enormous task of trade negotiations that lies ahead. Having relied on the EU to carry out trade agreements in the last 40 years, Whitehall purportedly has only about 40 experts in trade negotiations vs. 450 in Brussels. Ironically, tiny New Zealand offered to send some trade experts to help out.
For the divorce to proceed, this one looks thorny, the new Prime Minister Theresa May must invoke Article 50 of the Lisbon Treaty that sets in motion a two-year process of disengagement. It has been reported that she does not plan to do so until early next year. Importantly, the Parliament must vote to give the Prime Minister the authority to proceed. The outcome of the vote is not a foregone conclusion in the face of the narrow margin of the “Leave” win, and with some “buyers’ remorse” among Leavers according to polls. Then, too, adding more intrigue, Prime Minister Cameron’s authority to call for the referendum in the first place is now being challenged in the British courts. Presumably, only Parliament has that authority as the ultimate arbiter of English law.
Growth Setback, But No Recession
Increased uncertainty in the outlook is bound to take a toll on business investment, on some consumer spending, and bring a weak pound-sterling that will generate considerable asset instability. But DE expects any setback in growth to stop just short of a full-blown recession this year or in 2017. With a deteriorating fiscal balance, the government will find it difficult to deploy fiscal stimulus. But the Bank of England can be counted upon for an aggressive easing of monetary policy. A hesitation in growth, yes, but recession no!
The loss of froth in the real estate market, especially in London, is also likely to dampen private consumption. This leaves exports as the main engine for growth. But with the EU UK’s main export market, struggling with tepid growth itself, it is unlikely this would be a growth area for British exports. In all, despite the very small downward revision of world growth by the IMF to 3.4% from 3.5%–hardly a noticeable change—the setback in U.K. growth will not become a catalyst for a global recession. The size of the U.K. is not significant enough in the world economy. The U.S. economy will continue to grind forward on the back of decent wage and employment growth, with strong consumption and stronger housing, and Europe is continuing to show signs of growth supported in part by a pickup in lending. The Developing economies have stabilized recently in the face of firmer commodity prices.
No “Lehman Moment”
Brexit did not morph into a “Lehman Moment” for the markets, because major central banks immediately stood ready to provide whatever amount of liquidity must be necessary to keep markets from seizing up.
The Fed’s decision to postpone lifting of interest rates in July was a clear sign of its determination to avoid market turbulence. Large money center banks in New York and London should also be given credit for keeping markets calm. They had doubled up on staff and added extra shifts working 24/7 as if Brexit was a “Y2K Moment.” The markets recovered quickly from the spasm, but not before a spike in volatility inflicted serious losses to some investors, especially leveraged hedge funds, which were caught on the wrong side of the vote’s result.
Interest Rates—“Low-for-Longer”
The cloud of uncertainties overhanging Brexit has reinforced central banks’ commitments to easy money policies. This, in the face of anemic global economic growth and restrained inflation, will keep interest rates low well into 2017, and possibly longer, though some upward creep in U.S. yields is likely. Incoming data suggest that the U.S. economy will continue to chug along underpinned by strong employment and wage growth and solid consumption. Modest rises of interest rates will keep the U.S. dollar firm without undermining economic prospects.
Further aggressive easing by the ECB (in response to Brexit) and the BoJ (occasioned by continuing Japanese deflation), however, could produce renewed yen/euro weakness, leading to a U.S. dollar rally. In such an event, Fed policy would stay on hold, while the political uncertainty of the U.S. Presidential election dampen dollar exuberance.
The “low-for-longer” interest rate scenario is a double-edged sword: it gives access to cheap credit for borrowers and lessens debt service burdens, but can create asset price bubbles, push investors further out on the risk curve, and penalizes those in need for higher yields, such as insurance companies and private and public pension funds, many of them struggling with seriously underfunded liabilities.
Sterling’s Plunge is Data Dependent
So far, since Brexit, as was to be expected, the pound has plummeted, now near 1.31 to the U.S. dollar from a pre-Brexit level of nearly 1.60.
Some pundits have blamed Brexit for the steep drop. To be sure, there were some knock-on effects as investors searched for safe havens. But it is fundamentals that ultimately lowered the boom on sterling. The currency had become overvalued on the back of favorable interest rate differentials and strong capital flows, fed by foreigners’ appetite for London properties.
And, a deep budget deficit, coupled with a steep 7% current account deficit relative to GDP, were enough to cut the props from under sterling. And further weakness compared to the dollar/euro lies ahead as the currency collapse leads to higher inflation down the road. Having stayed put at the July policy meeting, it will be interesting to see how the Bank of England in the August 4th Meeting navigates the conflicting goals of price stability, defending the currency, and the need for further monetary accommodation to support a sagging economy.
Contagion and Falling Dominoes?
Contagion causing domino-like exits across the EU and the disintegration of the Eurozone has been viewed by some as the biggest threat of Brexit.
Though this is possible, the odds are against widespread contagion. Brexit has encouraged muscle-flexing by political parties on the extreme right and the extreme left in several countries, but the political majority at the center seems immune to this threat. The “Leave” vote cut across the political spectrum, both Conservative and Labor. It was an opportunity for Englanders to vent their frustration against the “London” elites, globalization, the loss of jobs, and rising income inequality.
Though similar conditions exist in several EU countries, it would be hard to form such “coalitions of the angry” given deep philosophical differences among political parties. Furthermore, mounting a referendum requires an enormous effort and takes considerable time. And many country constitutions prohibit referendums on international treaties. Then, too, many of the countries contemplating an EU exit are net recipients of funds from Brussels, and they would be hard pressed to replace these revenues. Greece is a good example: having voted “OXI” or “No”, the majority quickly fell in-line adopting the terms of a debt bail-out.
At the end of the day, it was the fear of immigration that clinched the “Leave” victory. The free movement of people within its members is a fundamental tenet of the EU treaty ratified in the Schengen Agreement in 1985. When the EU started its enlargement effort in 2004 to include countries of the former Soviet Bloc, nobody had anticipated, least of all Britain–instead of a projected tens of thousands of immigrants, the country was flooded with hundreds of thousands mostly from Eastern Europe–the massive wave of migration. And, clearly few foresaw the Syrian civil war and the refugee waves washing over Europe.
In addition to the daunting task of holding the EU together in the face of tepid growth and disparate economic performance among its members and the need to cut to size the gargantuan bureaucracy in Brussels which has outgrown the organism that feeds it–often a key complaint of “Brexiteers”–it is immigration and the refugee crisis that pose the bigger risk to political stability and efforts for further integration. Immigration might turn out to be the EU’s Achilles’ heel.
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