After the referendum, the UK’s most important existential event since 1945, a curtain has lifted to reveal a major political and constitutional crisis. It has only been just over a week since we heard that Britain voted to “Leave” the European Union, and for the time being we are in a vacuum. Quite who fills it, with what, and under what circumstances is unknowable, and it is all too easy to imagine possibilities that are deeply disturbing.
But for those expecting a rout in financial markets, there is precious little to write home about, at least so far. A number of City talking heads and several high profile commentators have mocked their gloomier brethren. The Daily Mail—not normally known for its financial and economic acumen—ran a lead story on 2nd July entitled Stop panicking and put the country first. It singled out the Financial Times as representative of City and industry leaders who, it said, had panicked about the aftermath of the Brexit vote like startled sheep. So, what can we deduce from the relatively sanguine performance of financial markets?
The straight answer is nothing. The FTSE 100 index did stage a significant recovery last week after referendum-related losses. But the FTSE 250, which comprises more UK-focused companies, didn’t, and ended up down six per cent over the week. The stock prices of a number of companies that have no export business recorded losses of up to 20 per cent.
“the Pound has been falling since it reached $1.71 in July 2014, and yet the UK’s trade and external payments position has gotten steadily worse”For export-oriented companies, the fall in the Pound is a mitigating factor in the outlook. It fell last week, ending at just over 1.3250 to the dollar, compared with about $1.45-1.47 before the night of the referendum. The optimists welcome the fall in the Pound, likening it to the big drop that ensued after it left the ERM in 1992, and even anticipating, as the Mail put it, “wonderful opportunities.”
There is no question a cheaper Pound will help some companies but it depreciation is most unlikely to offset other economic problems the UK is going to encounter. Unlike in the 1990s, when we had Black Wednesday:
- the Pound is not starting from a chronically overvalued position
- world trade is stagnating and there is no productivity miracle occurring, as there was then with information technology
- China and several major emerging markets have lapsed into a growth hiatus of unknown duration, when in the earlier period they were starting to make their presence felt
- global growth is weak and fragile, whereas it was accelerating quickly 20 years ago
- the UK’s balance of payments deficit is a large seven per cent of GDP, about three times as big as it was before the ERM debacle, and lack of confidence in the Pound could make financing the deficit more troublesome
If the FTSE still looks like it has weathered the initial shock, this is probably for two reasons: nothing much has changed so far, and these are early days.
The latest data we have suggest that in the run-up to the referendum, the economy was doing alright. A week or so on, the broad picture doesn’t look too different as far as company earnings and the economy are concerned. It is important to note that having lost the referendum on the 24th June, the Government did not invoke Article 50—the legal process for starting negotiations to leave the EU—the same day. In fact, since then, the timing has been put back. First, to September, and then to October. Although Andrea Leadsom, a candidate for both Conservative leader and Prime Minister, has stated she would like to invoke it as quickly as possible, the front-runner Theresa May has said it wouldn’t be invoked before the British negotiating strategy had been agreed, which would be very late this year at the earliest.
“I personally expect a recession to take hold”There could be further delays in 2017, caused by events that include the French and German national elections, to say nothing of the UK’s own position with regard to the role of Parliament, or a raft of constitutional and legal issues. Parochial financial markets are, therefore, no more able than anyone else to anticipate events and discount them. So they do little. But if and when the Article is invoked, the UK will lose all its leverage (it is widely thought that once Article 50 is invoked a two-year countdown begins: if nothing is agreed as the two-year deadline approaches, it harms the UK’s chances of landing a deal that’s any good at all). We can certainly expect markets to react at that time, though their reaction will depend on what they think our post-Brexit deal with might look like. There is also the possibility that no deal is struck, which would equate to economic suicide.
These are also early days. I personally expect a recession to take hold, starting with a slowdown in the third quarter of this year. Lending and spending decisions, especially when it comes to house purchases and investment, normally go on hold under conditions of uncertainty, of which we have more than enough. It matters, of course, whether we do experience a recession, not least to those who will lose their jobs, or have to weather wage stickiness. But it will also matter a lot to the Government’s fiscal position which would deteriorate sharply. The Chancellor has already said that his 2020 surplus target is a goner, and Theresa May has said that she wouldn’t respect it anyway. And it would matter for company earnings, which the FTSE markets would then discount (that is, reprice them to take account of expected changes) as expectations deteriorated.
But whether or not we go into recession is itself overshadowed by two things. First, all recessions end, so by 2017-18, the chances are that we would emerge from it, though at a cost we cannot as yet measure properly. Second, and more importantly, the real damage to the UK is impoverishment over the medium to long-term as a consequence of supply-side changes affecting trade, investment, and immigration that take time to materialise, despite decision-making processes having already started.
"Financial service companies can see the writing on the wall: regulatory uncertainty, recruitment issues, and restraints on business conducted inside the EU from outside"The Mail cited HSBC, Rolls Royce, Dixons and Toyota as companies that proclaimed their faith in a post-Brexit Britain. Yet all of these companies have issued warnings, including the shifting of jobs abroad, frozen investment spending, the critical significance of being in the Single Market for small businesses, and huge cost cutting (aka labour shedding) if we leave the Single Market, respectively. Other companies looking at moving jobs away from the UK include Easyjet, Goldman Sachs, Vodafone, and JP Morgan. The costs in terms of jobs and foregone tax revenues, as well as broader economic dynamic will be considerable and barely made up for by a weakened domestic economic base.
Financial service companies can see the writing on the wall: regulatory uncertainty, recruitment issues, and restraints on business conducted inside the EU from outside. They are already pondering which businesses and jobs to locate outside the UK. Don’t be surprised if people are going to be quite tight-lipped about all this for the time being. Weaker investment at home, lower foreign direct investment, a re-allocation of jobs abroad, a more restrictive immigration regime, and severe disruption to our trade relationships all speak to weaker potential growth and productivity at a cost to jobs, incomes and living standards, and a worsening debt profile.
The big worry, of course, is not just the adverse economic outlook itself, but how it interacts with political and policy instability and unpredictability. On the basis that the UK leaves the EU sooner or later, the most adverse outcomes could be mitigated by smart policy choices at home, and preserving as much as we could of our commercial relationship with the EU. As of now, being in the Single Market is inseparable from the free movement of labour. So there’s a strong case for doing nothing for quite a while, though this would of course increase economic uncertainty.
All this, though, is for another day. For now, no one is in fact panicking in the markets because there’s nothing to hand to panic about, not least because some of the ominous risks that loom large can’t really be discounted yet (it is too early for assets or currencies to be re-priced according to them.) This, however, does not mean that the City and industry are oblivious to the implications of Brexit for the economy. They are not so much panicking as preparing. The FTSE indices will respond in good time.
Prospect will be hosting a Brexit debate on Tuesday, 19th July at 6.30pm. Panelists will be: Anatole Kaletsky (economist), Rachel Sylvester (The Times Columnist), along with Anand Menon (Professor of European Politics at King's College, London). The event will be chaired by Duncan Weldon (former Newsnight economics correspondent). Click here to register your interest to attend.
