Blog Carsten Brzeski

Britain backs Brexit

Turbulent times ahead
The UK has voted to leave the EU by a margin of 52-48%. Financial markets have reacted very negatively with sterling collapsing and risk assets plunging globally. The economic and political implications are likely to be even greater for the UK and Europe with years of uncertainty ahead. The key question is whether the divorce will be amicable or become acrimonious while the prospect of a renewed Scottish independence push only adds to threats policy makers have to deal with. Europe will never be the same again…

Financial markets have swung violently through the night with sterling initially rallying on announcements from some polling agencies suggesting a narrow IN outcome soon after voting closed at 10pm. However, as the regional results came in it became increasingly clear that they got it wrong and risk assets and sterling have consequently collapsed.

David Cameron will be stepping down as Prime Minister with the aim of a new Conservative leader (and PM) being in place by the Conservative Party Conference in October. It will then be up to the new Prime Minister to decide when to trigger Article 50 of the Lisbon Treaty in order to start the negotiation process for departing from the EU. The key question will be whether the UK can achieve an amicable divorce from the EU, which will limit the economic pain, or whether it will break down in acrimony.

If it is the latter, a toxic political environment could lead to protracted negotiations, resulting in significant economic distress for the UK and Europe more broadly. We think UK growth in 2017 will be 1-1.5 percentage points lower in 2017 than would have been the case had the UK stayed in the EU. We will also have to wait and see if the Scottish nationalist movement launches a renewed push for independence.

This huge degree of political uncertainty is going to be massively disruptive for the economy. Trade gets the headlines, but nothing will change on this for two years and in actual fact the plunge in sterling could be beneficial in the near term. We are more worried about the hit to business sentiment given surveys suggested 75% of UK firms wanted the UK to stay in the EU. This suggests weaker investment spending and slower hiring, which ironically is likely to dampen migrant inflows. Foreign investors are also likely to take a dim view of putting money to work in the UK given the uncertainty over its future relationship with the EU.

The Bank of England will now have to decide whether it needs to step in and support the economy in some way. While the plunge in the currency is certainly a loosening of financial conditions, the Bank may be worried about domestic activity. We acknowledge that inflation will be pushed higher by sterling’s collapse, but we think the BoE will look through this, as they did in 2011 and focus on the growth risks, which will dampen inflation pressures in the medium term. As such, we see a strong probability of an interest cut in the near future.

The EU leadership will be in crisis. Sentiment and currency effects could knock 0.6% off GDP by 2017. Political contagion might even be bigger. With the emergence of anti-EU parties, the EU is facing an existential crisis. Mainstream parties will struggle to resist pressures to step back from further integration and the risk of further electoral rebellions is high.