By Philippe Ithurbide and Didier Borowski
The 23 June referendum saw British citizens vote by a large majority (51.9% with more than 1 million votes uncounted) for the UK to leave the European Union (EU). This vote, which puts an end to 43 years of membership in the EU, will have economic and political consequences not just for the UK but also for the EU.
There are many unknowns at this stage. This choice by UK citizens opens up a period of uncertainty in both the UK and Europe, resulting in short-term volatility for the financial markets. The political agenda remains heavy for the rest of the year with general elections in Spain on Sunday (26 June), a constitutional referendum in Italy in October and the presidential elections in the US in November.
Article 50, the legal basis of a UK withdrawal. In accordance with the commitment made during the referendum campaign, David Cameron should invoke without delay Article 50 of the Treaty of Lisboni which sets out exit conditions. However, he has no obligation to do so. Once proceedings are opened, the UK will have to renegotiate trade agreements with all of its trading partners (including those outside the EU) if he wants to avoid falling back on the minimalist rules of the WTO. For this purpose, paragraph 3 provides for a two-year period during which the UK remains a full member of the EU. This period can be prolonged but the unanimity of the European Council is required to do so.
In economic terms, the impact will be asymmetric. Brexit opens a period of uncertainty that will weigh on UK domestic demand and may precipitate the economy in recession. However, this crisis of confidence has no reason to endanger the economic recovery currently underway in the eurozone as it is mainly driven by internal demand (EU exports to the UK are not high enough to make the difference). The Consensus estimates the impact on UK growth at 1.4 pp in 2017 vs 0.3 pp on eurozone growth. However, this impact is highly uncertain. The total lack of visibility may in the short-term lead to: 1) an increase in the household savings rate (precautionary savings); 2) heightened caution among companies regarding their investment and hiring programmes; and 3) a slowdown in capital inflows. A risk premium on UK financial assets may also appear and increase the negative impact on activity. In the longer term, most studies point to a lasting negative impact on GDP and forecast by 2020 a loss of activity of between 3% and 9% in the UK.
In political terms, the shock however is symmetrical. The decision to leave the EU applies to the UK as a whole. However Scotland, which was largely in favour of remaining in the EU, is highly likely to ask London’s permission to organize a new referendum on its independence in order to stay in the EU1; a request which London could hardly refuse. This referendum would pave the way for similar demands in Northern Ireland and Wales which, despite being highly unlikely to secede, would exacerbate national political tensions. Moreover, the Conservative party which was extremely divided over this vote has come out weaker which may make the next government more fragile. Not to mention that, by leaving the Union, the UK’s weight on the international stage has decreased. The “Europe à la carte” theme may destabilise the EU. The UK’s exit is game changing in that it shifts the EU’s centre of gravity towards continental Europe. France and Germany in particular will need to reinforce their cooperation. Although it is not in the interest of any of the eurozone countries to withdraw from the single currency, certain EU countries (outside the eurozone) may demand similar advantages to those granted to the UK2. The “Europe à la carte” theme – which is contrary to the founding principles of the EU – may exacerbate the centrifugal forces related to the crisis and weigh on foreign investors’ confidence. To avoid this shift, EU governments must present a united front.
The beginning of a lengthy period of negotiating new trade agreements. The UK has several options: join the European Economic Area (EEA), draw on the existing model for certain countries (Switzerland, Norway or Turkey) or conform to the rules of the WTO (the most costly solution for the UK as it is the furthest from the current situation). None of these solutions will please both parties at this stage3. We are therefore heading towards “made-to-measure” agreements with the EU, possibly supplemented by bilateral agreements. The timescale for negotiating these kinds of agreements are very long: on average, between four and ten years to complete. At the end of the day, it is likely that the UK will remain part of the EU for more than two years.
Financial services: a major hurdle in negotiations? During the negotiation period, governments will seek to minimise the impact on confidence by guaranteeing that trade between the EU and the UK are not greatly affected. Negotiations on goods should not be a cause for concern in as much as the interests of both parties are largely convergent. However, negotiations over financial services promise to be long and difficult as they are strategic for both the UK and the EU. The UK is the EU’s leading financial centre: it accounts for almost 25% of the EU’s financial services and 40% of its financial service exports. Financial services represent 8% of UK GDP. Although no financial market is likely to replace London, the loss of a “European passport” for UK banks is likely to lead to the relocation of certain business segments (to Ireland or certain EU markets). The UK’s services trade surplus (5% of GDP) could therefore plunge in the future, making funding the external deficit, which is at an all-time high (-5% of GDP on average over the past two years), complicated.
Financial turmoil may provide investment opportunities. In the very short-term, we are possibly looking at a weakening of the pound and a fall in stock markets. By contagion, the sovereign bond yields of peripheral eurozone countries should increase and liquidity should worsen significantly on the credit market, in both the UK and the eurozone. In this case yields on safer government bonds (Germany, US) are declining and gold is gaining ground (flight to quality).The Euro has weakened given doubts about the cohesion of the European Union.
Central banks are capable of intervening, if necessary in a concerted manner, to guarantee access to liquidity and maintain financial stability. Following the surge in the yen and the fall of the Japanese Stock market (7.9% downturn), Japanese authorities have indicated they are prepared to intervene. The ECB and the BoE have already made it known that they would increase their cooperation to guarantee the banks access to liquidity in both currencies. In case of very significant turbulence, coordinated interventions with other major central banks (specifically the Fed) are likely. The ECB could temporarily accelerate its securities buying programme. For the BoE, all options would be on the table if financial stability were threatened. Governments, for their part, can reassure investors by showing their cohesion or by guaranteeing that they will offer the UK the time it needs to negotiate new trade agreements. Against this backdrop, we believe that any turmoil may provide interesting tactical investment opportunities across all asset classes (credit, equities, peripheral sovereign, currencies), especially if markets overreact by sending asset prices to levels that have no connection to their fundamentals.
Conclusion
The UK leaving the EU is a major clap of thunder and creates challenges for both the UK (avoiding a major recession, negotiating new trade agreements without exacerbating factors of uncertainty) and EU countries (stemming the centrifugal forces that could lead to further disintegration of the EU). However, a large chunk of this chapter remains to be written. Neither the governments nor the central banks are helpless during the transition phase. Within the EU, the political response will come through close cooperation to align governments’ positions and obtain an “orderly exit” of the UK from the EU. Until now, EU countries have always managed to benefit from periods of stress to consolidate their institutions. Without a doubt, the Franco-German couple will find itself playing a key role, in particular to strengthen the European Union’s federal dimension. But the challenge is considerable for Europe as the road ahead will be long and full of pitfalls.
Philippe Ithurbide (pictured) is global head of research, strategy and analysis and Didier Borowski is head of macro-economics, both at Amundi
