Where were you in the early minutes of 24th June 2016? Undoubtedly, the referendum result will be remembered as one of those defining moments in the history of the United Kingdom. As we look forward, in the immediate aftermath of the vote, all we see is uncertainty: over our future relationship with the EU, over the economic consequences of withdrawal, over the domestic political consequences (including new challenges to the Union), over the implications for the EU itself, and, of course, over the outlook for financial markets. Markets react badly to uncertainty, and the nature of the uncertainty we currently face is unprecedented in our working lifetimes. For how long this mood will pervade the financial markets is impossible to predict.
There are no real instances of similar events in the past to provide a guide. Naturally, people will think back to 1992… To the extent that the ERM crisis1 was also a defining moment for the UK, it marked the start of a 15-year growth surge in the economy, which was accompanied by a prolonged rally in the equity market. It is much harder to see a similar path ahead from where we stand today: the uncertainty we face now is much greater, in all aspects, and will take significantly longer to resolve. What this is not akin to is the financial crisis of 2008, which was the result of a worldwide implosion in market liquidity.
When faced by uncertainty, financial markets tend to overreact: risky assets become too cheap and safe assets too expensive. Quite often this reflects a price setting process whereby market makers and traders try to take prices away from expected buying or selling pressure (making it difficult or less attractive for investors to transact). This can provide opportunities for investors – the difficulty being, of course, in judging when any overreaction has finished. The important aspect of the current situation is that, in the near term, nothing will change vis-à-vis the source of the uncertainty – our relationship with the EU. On that basis, while the current crisis of confidence will gradually dissipate, once the process of negotiating our exit terms with the EU has started there will almost certainly be further bouts of heightened anxiety.
Just as financial markets overreact, we can sometimes exaggerate the likely consequences for the real economy of an unexpected event. Once again, however, there is no real precedent against which we can assess the likely impact on the real economy of the referendum result. Households, like financial markets, tend to react adversely to uncertainty. One area in which this can be expected to become immediately apparent is in the housing market, particularly in the London market. Turnover can be expected to decline, especially at the high-end (which has already been hit by stamp duty changes) and a more general stall in prices would not be surprising. A weaker housing market would have a negative impact on consumer confidence (which had been improving) and that would likely feed through to softer high-street spending. What is more difficult to gauge is how long a softer period might last.
Household spending accounts for almost two-thirds of aggregate demand (or GDP), and is thus very important to the overall performance of the economy. Short-term indications of the impact of uncertainty on consumer behaviour will come through relatively quickly in the monthly retail sales data and also in figures direct from retailers – such as the weekly John Lewis sales figures. This should help us estimate both the extent of the overall ‘uncertainty’ hit to the economy, and the persistence of the impact.
At the time of writing, sterling has not fallen as much as might be expected, although this does not rule out further subsequent weakness. Currency depreciation tends to be inflationary, initially as a result of the direct consequences of a rising sterling cost of oil, and then reflecting a more general rise in import costs. On the other hand, were sterling to remain weaker, this should give a boost to exporters and domestic industries competing with imports. However, these positive effects can take a while to come through, before which a weaker currency is likely to cause a deterioration in the trade balance as a result of higher import costs. A further concern in this area is the UK’s prevailing current account deficit, which is already the worst in our history. In itself, this might be expected to put downwards pressure on the currency – and this will remain a continuing risk.
The most obvious way that companies will react to uncertainty is by putting hiring on hold and by suspending capital investment decisions and programmes. At the current time, the level of job vacancies in the economy is very high (higher than at the peak of the cycle before the last recession). Were vacancies and hiring to drop back significantly, this could undermine consumer confidence and household spending. While an outright reduction in employment levels seems unlikely at the moment, it would clearly have more serious consequences were it to occur.
There is already evidence that companies have scaled down capital investment. To some extent, this is probably a reflection of global over-capacity in manufacturing. Nevertheless, it probably also reflects uncertainty in advance of the referendum, and in the short term, this weaker investment trend can be expected to continue. Longer term, the reaction of the corporate sector (particularly larger companies) to EU withdrawal will depend on trading and other relationships that the UK is able to negotiate with its former EU partners. Some companies may choose to relocate headquarters and trading/manufacturing bases, but it is impossible to assess now the extent to which this might take place.
One area of the economy that is particularly exposed to a change in our relationship with the EU is financial services, particularly those with international exposure. Inevitably, this will prove an anxious time for people employed in this sector and associated businesses. The eventual outcome will be highly dependent on the exit terms that are negotiated, but the UK has one major factor in its favour – by far the largest pool of labour specialising in financial services in Europe.
The reaction of the authorities is another important influence on confidence in the wider economy and markets. This is an area in which, in the short term, words can be almost as important as deeds. The Governor of the Bank of England has already spoken about making additional liquidity available, should it be required. It will also consider whether a further policy response might be appropriate. In our view, we are not currently in a situation in which lack of liquidity is likely to be a significant problem. Nor do we believe that cutting short-term interest rates or carrying out additional quantitative easing would have a directly positive impact on the economy. However, statements that show the Bank is willing to act are helpful to short-term confidence.
Were the economic impact to be harsher or more protracted than we currently anticipate, then monetary policy would probably not prove a particularly effective counter-measure (this is one reason why we have previously argued that policy normalisation should already have begun – to provide the authorities with more policy ammunition in circumstances such as now). This would put pressure on the Treasury to provide a fiscal stimulus. The current rules allow the Treasury to suspend its deficit reduction programme (and other fiscal rules) if growth falls below 1% – which is not inconceivable, although not our central case.
In the end, we will not be able to escape entirely the impact of a protracted period of uncertainty. However, our overall assessment is that the economic cost of leaving the EU will not be as significant as many claims made during the Brexit campaign – either in the short or longer term. Equally, we are unconvinced that leaving the EU will provide the extent of growth stimulus that other forecasters have suggested – predictions that we will now be able to test.
So, the bottom line for the UK is that the impact of uncertainty on confidence is the main near-term concern, in the context of both the financial markets and the real economy. Reassurance may come from evidence that the real-economy impact is more muted than feared. It may also come from businesses beginning to assert that they see a changing relationship with Europe as providing significant future opportunities.
For the EU, the period ahead will also provide significant challenges, particularly on the political front. Developments in southern Europe will be most closely watched, although there may be wider implications of the UK vote. As ever, the most sensitive barometer of concerns will be the currency, which has already weakened against the dollar.
1 On 16th September 1992 the British Conservative government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism (ERM) after it was unable to keep the pound above its agreed lower limit in the ERM.