Awaiting the data
After the shock of Brexit, the next test will be the economic impact
SHOCK, followed by frantic recalculation. That was how astonished financial markets reacted to the British vote to leave the European Union.
The initial phase saw a worldwide sell-off in riskier assets, such as equities, and a flight to safe ones, prompting further declines in government-bond yields. After the sell-off, equities started to bounce again on June 28th, in part because central banks may respond with easier monetary policy (or, in the case of the Federal Reserve, slower tightening); in part because Brexit may not have much of an impact on, say, the Chinese economy.
The biggest casualty of the vote was sterling, which was edging towards $1.50 on Thursday but on June 27th briefly dropped below $1.32, a 31-year low. In trade-weighted terms, the pound has fallen by 11% this year (see chart). Britain has a large current-account deficit (7% of GDP in the fourth quarter of 2015), which needs financing. A big drop in the pound, to make British assets more appealing to foreign investors and imports less appealing to Britons, is a necessary adjustment.
Equities have not suffered as much. Many companies in London’s FTSE 100 index—the oil and mining giants, for example—have little connection with the British economy. Since much of their income is in foreign currencies, sterling’s weakness will be good for profits. The more domestically oriented FTSE 250 index took the bigger hit, falling by 14% in two days.
Now the initial shock has passed, investors need to work out what the economic impact will be.
David Cameron, Britain’s lame-duck prime minister, did not immediately trigger Article 50—the provision in European treaties about a member state leaving the EU—bequeathing that decision to his successor. That will only prolong the uncertainty over what kind of deal will emerge from the negotiations between Britain and Europe.
One question is whether consumption will suffer because of the Brexit vote. A survey by Retail Economics found that more than half of consumers planned to reduce their spending on non-essential items. Shares in estate agents, housebuilders and budget airlines have all been hit.
However, this might be a short-term effect. The biggest risk to consumption was a crisis in the gilts market that forced up mortgage rates. But gilt yields have fallen, partly because of their risk-free status and partly because the markets anticipate further rate cuts from the Bank of England.
The bigger worry is investment. There have been lots of hints about jobs or corporate headquarters moving abroad, but nothing concrete so far. Many companies may be waiting to see whether Britain decides to join the European Economic Area, alongside Iceland and Norway, which would keep it in the single market. If it does, then the temptation will be to stay.
But since that deal would require freedom of movement, it seems unlikely that the next prime minister will accept it. In the meantime, of course, the uncertainty means that few businesses will be inclined to invest in new projects. And the longer it takes for a deal to emerge, the longer the hiatus.
Almost three-quarters of economists polled by Bloomberg think that Britain is headed for recession either this year or next. But the many anecdotal reports of cancelled contracts may not show up in the economic data until the third-quarter numbers are released; the more detailed estimate is not due until November 25th. Markets may get earlier indications of the trend in business surveys, such as the purchasing managers’ index. That will be the next big test for British equities.
In the longer term, some hope that the departure from the EU will turn Britain into a more vibrant economy. Chris Watling of Longview Economics is one of the few analysts to spell out what this might mean in practice. He suggests the immediate announcement of trade talks with the rest of the world, the abolition of corporation tax and the creation of new towns to ease the housing shortage.
The first would take a long time to achieve; the second would stir fierce political opposition; and the third, both. Again, investors will want to see some concrete plans if they are to believe the campaign promises of some Brexiteers of a more open Britain.
For the rest of Europe, the question is whether Brexit will encourage other anti-EU movements.
The indicator to watch is the German ten-year Bund yield, since it is the safest asset on the continent. It has dropped further into negative territory, hitting -0.12%. That yield needs to move well into positive territory before the risks of the British vote can be said to have been contained.