The United Kingdom’s surprise vote to leave the European Union (EU) has cast a shadow of uncertainty on the global economy and financial markets. While global equity markets have rebounded after the surprise referendum reverberated across equity, fixed income, and currency markets, the medium-to long-term political and economic trajectory is uncertain, with many potential twists and turns.
Early anecdotal evidence points to an economic slowdown in the U.K., as additional investment is put on hold. In addition, the U.K.’s twin fiscal and current account deficits are made more difficult by uncertain leadership in the coming months. As a result, incremental U.K. consumer spending and corporate capital expenditures/indirect investment may be impaired over the intermediate term.
As the reality of the referendum outcome has begun to set in, the focus has quickly shifted to the U.K.’s formal withdrawal from the EU under Article 50 of the Lisbon Treaty, a process complicated by Prime Minister David Cameron’s resignation. The Conservative Party has publicly committed itself to producing a new prime minister by early September, while moving the exact date three times in as many business days. It is widely expected that the new U.K. leader and cabinet will then formally invoke Article 50 and begin exit negotiations, although the timing is unclear. Current estimates are for late 2016 to early 2017.
Beyond the summer months, the economic impact of the June 23 vote will depend largely on the kind of exit the yet-to-be-named U.K. government will seek.
At the same time, the EU has stated that no discussions will take place until Article 50 is invoked. From that day, the U.K. and EU will have two years to negotiate a new bilateral relationship, and the U.K. will have to disentangle and replace 40 years of EU legislation with its own. Failure to agree on a new contract would result in the U.K. reverting to trade under current World Trade Organization rules while it tries to negotiate bilateral trade deals to replace 53 such arrangements it enjoys as part of the EU.
Beyond the summer months, the economic impact of the June 23 vote will depend largely on the kind of exit the yet-to-be-named U.K. government will seek. Should the U.K. wish to join the European Economic Area (EEA), which would be similar to the current arrangements of Norway and Switzerland, the U.K. economy would likely suffer few disruptions and confidence would return relatively quickly.
However, in order to join the EEA, the U.K. would need to accept the four freedoms of the EU’s single market: free movement of goods, services, people, and capital. Doing so would ignore every referendum promise of the “Leave” campaign. Beyond a relatively swift resumption of business-as-usual for U.K. and European companies, this new arrangement would be unlikely to deliver any economic or political benefits for the U.K. relative to EU membership.
In the event the new leadership chooses to honor some of the commitments that were made during the referendum campaign, an entirely new relationship with the EU would have to be negotiated. This path is more likely to result in a protracted decline in domestic demand—both investment and consumer spending—in the U.K. and potentially slower growth in the EU, as companies postpone investment decisions or seek new suppliers. In this case, the pound sterling is likely to resume its decline, and companies earning in euros or U.S. dollars are likely to fare relatively better.
From a political perspective, it is convenient to draw parallels between the U.K. and other EU countries such as the Netherlands, Spain, France, and Italy, where populist parties have fueled anti-Brussels sentiment. A recent Pew Research survey found that only 38% of French respondents hold a favorable view of the EU—six points lower than in the U.K. A European Council on Foreign Relations study noted that extreme “insurgent parties” are calling for a total of 34 public votes on issues ranging from EU membership to refugee policy.
The next referendum to be held in the EU will take place in October, although it is not about the union: Italians will be voting on changing their country’s constitution, which has produced a gridlocked legislature and notoriously unstable governments over the years.
Looking beyond Europe, there are similarities with the United States in terms of intensifying antitrade, anti-immigration sentiment, which has helped solidify the candidacy of the presumptive Republican presidential nominee. These trends are real and should not be downplayed, but they likely also represent a more basic repudiation of establishment leadership. Regardless, these events may precipitate additional market uncertainty.
Market Outlook and Strategy
In addition to the negative overhang of Brexit uncertainty for Europe, the prospect of prolonged weakness in pound sterling is a concern for relatively exposed countries like Ireland, the Netherlands, and Belgium, where exports of goods and services to the U.K. comprise a higher share of their respective gross domestic product totals. June economic survey data for the euro area pointed to slowing but continued modest growth, with the Markit Purchasing Managers’ Index for manufacturing and services still in expansionary territory.
Amid the Brexit fallout, however, there is increased risk to European business investment and consumer confidence that could lessen the positive effects of quantitative easing, stable energy prices, and euro weakness.
Major central banks around the world are focused on maintaining financial conditions as stable as possible.
In response to this uncertainty, major central banks around the world are focused on maintaining financial conditions as stable as possible. As a result, the impact on interest rates is lower for longer. While recent U.S. and European consumer spending statistics were robust on a year-over-year basis, it will be important to evaluate the changes over the next several months as Brexit developments affect sentiment and potentially flow through to economic activity.
What this likely means is that negative interest rates will broaden globally and the Federal Open Market Committee (FOMC) will maintain its dovish stance for longer than previously expected, as developed market growth prospects outside of Europe are mixed.
The near-term outlook for Japan has been adversely impacted by Brexit-driven safe haven flows into the yen, further complicating the government’s efforts to weaken the currency and stimulate growth through negative interest rates and ongoing quantitative easing.
In contrast, U.S. growth prospects remain well underpinned by healthy consumer demand and an improving corporate earnings backdrop. We have become more optimistic on the outlook for U.S. equities, which will be supported by more favorable year-over-year comparisons in the second half of 2016 as the negative effect of dollar strength on reported profits over the past three quarters begins to reverse. That said, we are increasingly mindful of the potential for elevated volatility as the U.S. presidential election approaches, in what promises to be a divisive fall campaign.
Emerging market equities and currencies have broadly stabilized in 2016, benefiting to varying degrees from the pause in U.S. dollar strength, FOMC inaction, improved commodity price outlook, and China credit-growth resurgence. Economic and reform prospects continue to vary widely across geographies and sectors in emerging markets, but we have been encouraged by stable-to-accelerating earnings trends and supportive valuations relative to developed markets.
This blog post was based on insights and input from the William Blair Global Equity team.
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