By Ruth van de Belt
The British people have spoken. Against all our expectations, a slim majority (51.7%) has voted to leave the European Union (EU). Although the referendum is technically not legally binding, the government will obey the will of the people.
The financial markets will react very strongly to the increased political risk in particular over the next few days. We believe that investors are currently over-reacting and this yields opportunities. Instead of participating in the subsequent round of selling, we will therefore seize this opportunity to buy more equities at a lower price.
The markets are responding turbulently to the news. Although we do not view this as a ‘Lehman moment’ (an event that causes a systemic risk to the financial system or economy), it will trigger a risk-off and subsequent flight to safe havens. ‘Safe’ currency, such as the Swiss franc, the yen, the US dollar and gold, are performing well. Effective yields on government bonds in the developed markets are falling as a result of a combination of capital flight and potential expansionary and/or liquidity injection measures by the central banks aimed at reducing tensions on the financial markets. The major central banks have already indicated that they are willing to intervene using the conventional means at their disposal.
More specifically, we anticipate a steepening of the UK yield curve, as investors are worried about inflation. Spreads on Southern European government bonds in the eurozone will widen, but the ECB’s purchasing programme could prevent extreme hikes in the short term. At the same time, the more risk-avoiding attitude of investors and the poorer growth outlook will squeeze equity markets. The British pound is under pressure, as is the euro, albeit it to a lesser extent.
The short-term outlook for the UK economy is not rosy. The huge level of uncertainty surrounding the conditions for leaving the EU will push down aggregated demand. Companies will not only curb their investments, but also scale back plans for taking on new employees. The depreciation of the British pound will push up inflation. In order to combat these negative growth effects, in the short term the Bank of England will announce a cut to policy interest rates and that it is prepared to implement further stimulatory measures.
As we have said before, the long-term consequences of this Brexit are trickier to predict. A great deal depends on the precise impact of the trade agreement the UK succeeds in concluding with the rest of Europe. We do not believe that the EU will be prepared to agree an advantageous deal with the UK: this would be an incentive to other member states to leave the EU. It is our belief that the long-term cost, in the shape of lower trade volumes due to trade tariffs, will be significant. The Brexit will also involve dynamic costs: lower productivity growth due to less trade and foreign investment and lower population growth. In other words, the growth potential of the UK economy will be affected.
The decision to leave the EU may trigger a period of political uncertainty. As expected, Prime Minister Cameron has announced his resignation. His successor will not just inherit a sharply divided party but also a divided country. Moreover, there are renewed calls in Scotland to hold another referendum on Scottish independence. The Scots want to remain a member of the EU. The ‘Remain’ camp also won in Northern Ireland, leading to calls for a referendum on an Irish union.
The Brexit will have a (limited) economic impact on the rest of Europe. Confidence will be affected, financial conditions will tighten, export volumes will fall and unemployment will rise slightly. Yet we do not think that the Brexit will cause a recession. An appreciation of the US dollar against the euro and the British pound, combined with higher market volatility and a lower risk appetite, will cause financial conditions in the US to tighten. The downward impact on growth is likely to be small. However, we do expect the Fed to shelve plans to raise policy interest rates further for the time being.
We are most concerned about potential political contagion. The deeply-rooted dissatisfaction expressed in the Brexit debate is not only a problem in the UK. There is growing dissatisfaction among the population in the rest of Europe and further afield. In the eyes of a growing portion of the electorate, only the elite has profited from the benefits of global integration and open borders.
Moreover, it is mainly the elite that has profited from the economic recovery of the past few years. The upper echelons of society largely ignore the feelings of a large portion of the population and this only serves to boost support for anti-establishment parties. Given the number of coming political events (including in Spain, Italy and the US, France and Germany), volatility will remain high. After all, anti-establishment parties can bring about a regime change that is difficult for investors to predict. On top of all this, there is a growing risk of the eurozone breaking up.
Ruth van de Belt is an investment strategist at Kempen Capital Management
