U.K. Exit Is Different This Time

Last break from Europe was in 1992; ‘Brexit’ decision raises risks for the pound, real estate and economy

By Paul Davies

Freed from the shackles of Europe, many who voted for a British exit expected the U.K. to prosper. The pound may fall, but this and a slashing of EU regulatory restrictions should only add to the country’s competitiveness. Stocks should rally.

That didn’t happen. The FTSE 100 finished more than 3% lower, which in dollar terms is closer to 10% down. Many companies—especially banks and home builders—did far worse.

The most worrisome, though expected move, was in the pound, which fell 6% versus the dollar.

That highlights the U.K. economy’s major vulnerability—it needs to borrow from abroad to fund its day-to-day spending. A decision by foreign investors to stop that funding or make it more expensive could be damaging to the economy and the Banks.

The hopeful might look back to the last time the U.K. made a break from Europe. In 1992, another Conservative government pulled out of the Exchange Rate Mechanism that linked the continent’s currencies due to massive pressure on the pound.

But the differences between then and now are striking and help to explain why not only U.K. share prices are falling but also why the outlook for property prices might take a bleak turn, too.

Back in September 1992, the FTSE 100 had fallen by 15% over the previous five months and house prices had been drifting down from recent highs, according to Credit Suisse. CS -16.11 % Interest rates were at 10% and in one day the government had said it would lift rates to 12% then 15% before it capitulated and quit the currency regime.

Over the next six months after the pound’s fall, the U.K. stoked the economy by cutting rates to less than 6%.

Today, U.K. stocks have been held up near historic highs by ultraloose monetary policy. House prices are at all-time highs and affordability is stretched to precrisis extremes.

The U.K. economy is very likely to suffer a slowdown as a result of the uncertainty. This break with Europe is far more significant than in 1992 because the whole trading relationship with the country’s biggest export market has to be renegotiated.

The willingness of foreign investors to fund the U.K.’s large current-account deficit was already waning in the run-up to the vote, weighing on capital flows. U.K. government bonds have rallied a little on the result, but Bank of America-Merrill Lynch analysts reckon this won’t last.

Bearish sentiment will come to dominate.

And that is the other big difference between 1992 and today. Back then the U.K. current-account deficit was running at less than 2% of gross domestic product; now it is closer to 7% of a bigger economy.

Mark Carney, governor of the Bank of England, highlighted the risk in one of his early interventions in the “Brexit” debate. Speaking to British politicians at a committee hearing, he warned it would be dangerous for the U.K. economy to find itself “relying on the kindness of strangers” to fund its borrowing and spending in what would be more volatile markets after a vote to leave Europe.

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