After 43 years of membership in the European Union, the United Kingdom has voted in a referendum to withdraw.
The market impact has been great. Within one week (from the reporting of the referendum’s result to the morning of 30 June), the GBP lost almost 8% to the EUR (and -12% on the year to date). Meanwhile, European equities fell 5% (as measured by Eurostoxx) and safe havens like Bunds or US Treasuries posted sharp gains. Ten-year Treasuries and 10-year Bunds are now yielding, respectively 1.50% (-19bp) and -0.12% (-18bp). Corporate bond spreads have widened but this was offset at least partially by the interest rate impact. Bank securities (equities and debt), however, have dropped sharply, (-12%, for example, by the MSCI EMU financial index). As for sovereign spreads, the widening was held in check thanks to the ECB's QE. The Italian spread returned almost to its pre-Brexit level (+13bp, or 150bp above the 10-year Bund), while the Spanish spread actually narrowed a bit (by 5bp) to 138bp).
It is worth reviewing the political and economic impacts on the one hand, and the impacts on the financial markets and asset allocations on the other. The purpose of this research note is to address the main current concerns.
QUESTION # 1 Can the UK stay in the EU despite the approval of Brexit via a referendum?
Is it possible to imagine that a democratic country like the UK would not adhere to the outcome of a vote as important as this one and with such a high turnout? It seems unlikely. And yet, despite the referendum’s clear verdict, this option seems to have been put on the table. Yes, of the 650 MPs in the House of Commons, 479 came out in favour of “Remain”, but it’s hard to see how the government and Parliament could act against the wishes of almost 17.5 million voters. The lawyers are now going at it. Some are calling on the people’s representatives to decide, instead of the people themselves; in other words, MPs should vote before triggering the exit process. Others acknowledge that this is possible in theory but impossible in practice, as the people’s representatives must adhere to the decision of the voters, as in any democracy.
Under the current procedure, any country wishing to pull out of the EU must invoke Article 50 of the Lisbon Treaty (see box below). This opens the path to negotiating an exit from the EU (this is the only legal way out of the EU). To do so, it must serve notice of its decision to the European Council, which would take note of this decision. That is when negotiations would begin. That would be a challenge indeed, as this is shaping up as the most complicated divorce in history. This is no doubt the reason for the UK government’s stance (“Only the UK can trigger Article 50. In my judgement we should only do that when there is a clear view about what new arrangements we are seeking with our European neighbours”, in the words of George Osborne, Chancellor of the Exchequer). Moreover, David Cameron would rather leave this (burdensome) task to his successor and play for time. Remember that negotiations will begin as soon as the procedure is triggered and will last for up to two years if an agreement is reached and longer if necessary on the unanimous vote of EU member states. Baring unanimous agreement to extend the negotiations, the UK will be out of the EU with no trade agreements and no free-circulation agreements. Some feel that it is possible for the UK to never invoke Article 50 and to remain de facto in the EU. We see this as highly unlikely. But one thing is sure: EU member-states are not displaying much cohesion. Some (like France) want the Brexit procedure to begin as soon as possible, while others (Germany) are not in as much of a hurry. The final agreement with the UK must be approved by the 27 member-countries at a qualified majority.
QUESTION # 2 Could there be a second referendum?
In theory, anything is possible. But do not expect the situation to bog down, leading sooner or later to a second UK referendum. True, the pro-Brexit British press has softened its tone and some pro-Brexit politicians are now proclaiming their fondness for Europe, but foot-dragging is out of the question (European countries are obviously against doing so), as is preparing a second referendum. However, a second referendum is entirely possible… but in Scotland alone. This would be a referendum on whether to pull out of the United Kingdom. Nicola Sturgeon, the Scottish prime minister, has already announced that if the polls are favourable, she will call for a referendum and, if it’s successful, to apply to join the EU. A Scottish pull-out would be very bad news indeed for the UK from an economic viewpoint, as the UK would lose the North Sea oilfields, which are located in Scottish territory.
QUESTION # 3 Is a petition enough to reverse the process?
A petition with more than 100,000 signatories can also have consequences: in such a case, Parliament may debate the issue (but is not legally required to do so). There is currently a petition circulating for a new referendum and stating that if one camp wins less than 60% of the votes and voter turnout of less than 75%, a new referendum must be held. This is the case, and the petition now has 3.9 million signatures. Keep in mind, however, that the petition was initially launched by a Brexiteer, before the referendum, at a time when “Remain” was ahead in the polls. This petition does not appear to be serious. An investigation has found that some signatories were minors, some were not British, and others were simply made up: 39,000 signatories from the Vatican’s 900 inhabitants, 23,000 from North Korea, whose people have no Internet access, and so on. In short, not only do certain aspects of the petition invalidate it, it would not be enough to reverse the outcome of the referendum, but merely to lead to a Parliamentary debate. Not enough, then to go against the referendum’s verdict.
QUESTION # 4 Will the coming negotiations between the UK and EU be decisive in Brexit’s economic impact on the UK?
While everyone agrees that the British economy will suffer long-term damage from its decision to exit the EU (50% of its exports are sent to the EU, and they currently account for almost 70% of GDP, vs. 20% 40 years ago), negotiations with the EU will determine just how much so. There are several possibilities:
1st scenario: the UK retains access to the single market and its membership in the European Economic Area (EEA), as is the case for Norway, which, incidentally, contributes to the European budget and allows free circulation of goods and persons but is not bound by any free-trade agreements with the EU;
2nd scenario: the UK retains its membership in the European Free-Trade Association (EFTA), like Norway, but with trade agreements negotiated with the EU, like Switzerland. Keep in mind that Switzerland is subject to some restrictions, for example on access to the EU for its banking industry. This will
3rd scenario: the UK does not get any special trade agreements but does get tariff-free status between the UK and the EU, as is the case of Canada, for example. Some Brexiteers want to lift tariffs with the EU.
4th scenario: the UK renegotiates trade agreements with EU partners, one by one. Remember that it takes four to 10 years to implement trade agreements.
The impact on GDP is expected to be quite negative, especially as if trade agreements are not rolled over. The UK would “lose” between 2.5% and 9.5%
The British Treasury fears a 6% decline in GDP, a 4% decline in wages, and the loss of more than 800,000 jobs within two years. The Centre for Economics and Business Research nonetheless hopes that the UK will avoid recession, assuming a favourable policy mix (monetary and fiscal policy). No wonder the ratings agencies downgraded the UK (it has already lost its AAA rating).
We also understand better why the UK would rather reach an agreement (prenegotiated before triggering Article 50) giving it sole control over its migrant flows and allowing it to forego contributing to the European budget and to hold onto the current trade agreements. In a word, it wants to obtain even more than what it had been granted prior to the referendum. Any chance of that happening? Not really.
QUESTION # 5 How can (should) EU countries react?
European countries must now show cohesion, and two major issues stand out.
1st issue: get out of the stalemate that is emerging around the UK’s intention – or lack thereof – to invoke Article 50. It’s up to the UK to do so. Barring that, negotiations cannot begin. Although they do not represent all of the EMU or the EU, Germany, France and Italy do agree that there will be no pre-negotiations with the UK. But the European Council has no way to force the UK’s hand. Waiting for a new prime minister to take office (on 2 September) and for him or her to pull the trigger would leave Europe and its institutions in a stalemate. Who would have imagined that a country wishing to leave the EU would end up not following through? This once again raises issues on the Treaty’s content and governance.
2nd issue: show (soon) that Europe is not out of ideas. Among EU countries, interests sometimes diverge, and electoral calendars hinder joint decisionmaking, while lofty, broken promises feed extremist votes. Angela Merkel, François Hollande and Matteo Renzi presented four priorities early this week: security, growth, youth, and tax and labour harmonisation in the euro zone. Nothing new there. The hard part is not laying out objectives but meeting those objectives. All this is underlain by other basic issues, such as the debt burden in some countries, disenchantment with Europe, the rise of extremism (on the right in core countries and on the left in peripheral ones), reforms in France, foot-dragging on EU banking union, fears of a pick-and-choose Europe, and so on.
EU countries must now demonstrate their willingness to tackle these issues and head off temptations of a pick-and-choose Europe that the Britons have stoked.
QUESTION # 6 What are the political impacts of Brexit on the United Kingdom?
During the campaign David Cameron often said that, in the event of a pro- Brexit vote, Article 50 must be triggered promptly, as negotiations with the EU promised to be long and hard. Since the outcome of the referendum, his political agenda has changed. He announced he would resign in October but refuses – at least for now – to invoke Article 50 of the Lisbon Treaty, which would give the go-ahead to Brexit negotiations. He does not want to be held accountable for a political act that would most likely drive the British economy into recession, leaving this for his successor, probably a Brexiteer. Meanwhile, resignations are coming one after another within the Labour Party. All parties appear to have been shaken by the situation. We are therefore entering a phase of political instability that is blackening the picture a little more, especially as many Europeans want to get this over with as soon as possible.
On top of all these complications, the next prime minister will have to deal with a number of domestic splits:
In other words, the referendum’s outcome will have a lasting impact on British society. Moreover, the EU referendum may give way to a UK referendum. Scotland (where most oil is produced, among other things) has already announced that it wants to stay in the EU, which points to a new referendum.
We know the next prime minister will be a Conservative, and will be a woman. What we don’t know yet is whether she will be pro-Brexit or pro-Bremain. This will no doubt make a difference in negotiations and could also drive the financial markets in the coming weeks, through public statements and poll results. So there is more political instability to come in the UK. The start of the voting process within the Conservative Party has named Theresa May (Home Secretary, pro-Remain) and Andrea Leadsom (Energy and climate change minister, pro-Leave). The final verdict is set for 9 September.
QUESTION # 7 What are the direct economic impacts of Brexit on the European Union?
The EMU will now account for 86% of the EU’s GDP (vs. 71% previously, when including the UK). At first glance, Brexit will not have serious economic repercussions for EU countries, particularly as growth is driven mainly by domestic demand. However, a look beneath the surface shows that Brexit will have visible impacts, which will vary somewhat from one country to another.
There are three main angles:
Angle #1: impact on exports: Ireland, Malta and Cyprus, as well as the Netherlands, Belgium and Norway would be affected the most;
Angle #2: impact on direct foreign investment: Malta, Ireland, Luxembourg, Cyprus, Switzerland, Belgium and the Netherlands would be affected the most;
Angle #3: impact on the financial sector: Luxembourg, Switzerland and Malta would be affected the most.
All in all, Ireland, Malta, Cyprus and the Benelux countries would be affected the most by Brexit, and Austria, Italy and Finland the least, as they are the least connected with the UK. All in all, we believe Brexit will have little impact on euro zone growth. We estimate euro zone growth at 1.5% in 2016 (vs. 1.6% previously) and 1.3% in 2017 (vs. 1.5% previously).
Lastly, remember that the UK contributes 200 million euros each week to the European budget, an amount that will have to be taken over by EU countries, prorated to their current contribution. That shouldn’t be insurmountable at this point.
QUESTION # 8 Could Brexit alone cause a global economic slowdown?
The British economy will no doubt sink into a recession in the next two years. Even if its growth stays in positive territory in 2016 and 2017, it is very likely to suffer at least two consecutive quarters of contraction. Will this be enough to send the global economy into a general slowdown? Probably not. As the world’s fifth largest economy before the drop in the GBP, the British economy is not big enough to cause a global economic slowdown. Growth in other developed economies is solid enough to head off a new collapse in global growth. Keep in mind also that growth in many countries is currently being driven more by domestic demand than exports (especially exports to the UK). As for “emerging” economies, the impact will be too weak to make any radical change. All in all, global growth will remain at about 3%, and dangers will come from elsewhere: China, the United States, geopolitical risks, etc., and these are the risks to global growth, not the consequences du Brexit:
QUESTION # 9 Does Brexit jeopardise banking systems in continental Europe?
European banks are nothing like the banks of 2008 or 2011. Not only have they raised very heavy amounts of equity, but the ECB’s anti-crisis mechanism is now well established, with bank supervision, stress tests and so forth. Moreover, for more than one and a half years they have had access to ECB liquidity, something that has reduced specific and systemic risk considerably.
Banks nonetheless remain weakened by the fall of interest rates into negative territory and the stubborn relatively high cost of capital.
And yet, falling interest rates were effective at first. Banks were given immediate access to very low financing costs and, more importantly, without relation to their real risk level. True, some banks early in the crisis had a hard time securing funding on the interbank market and all banks’ share prices collapsed, but in the US and Japan as well as in Europe non-conventional policies at first boosted bank profitability. QE programmes sent bond yields down sharply, while deposits are of a far shorter duration than bank portfolio assets. Abundant liquidity and persistently low interest rates in some cases allowed banks to put off shoring up their balance sheets. In a second stage, lower yields and the flattening of the yield curve led to an outright collapse in the interest margin and profitability receded. In other words, the interest rate gap between (short) liabilities and long (assets) almost vanished.
Meanwhile, banks’ cost of capital did not decline, for several reasons:
The British financial sector – and banks in particular – will be weakened by Brexit, due mainly to their loss of European passports, the potential impact on the London financial market, and the prospect of a UK recession. If European banks are being undermined, that is due to the inability to make distinctions between different banking systems and additional squeezes on short- and longterm interest rates. But there’s no point in betting on a collapse of European banks. Rather, attention should be focused on their excessive undervaluations.
QUESTION # 10 Will Brexit have repercussions on the London financial sector?
The London financial market will not be left unscathed, and that’s why the City (and the Bank of England) was against Brexit.
All in all, the London financial market is likely to lose some influence, as long as the Europeans, led by Germany and France, can be bothered to take over.
QUESTION # 11 What is the risk of a series of referendums in Europe?
Brexit has revived expectations of referendums in other EU countries, backed by a number of opposition parties who see an opportunity to reject ruling parties. There have been referendums in many countries in recent years. Slovenia, Slovakia, the Czech Republic, the Netherlands, Malta, Luxembourg, Lithuania, Latvia, Ireland, Hungary, Spain, and Estonia have held referendums on a European constitution, the Lisbon Treaty or their membership in the EU, while Portugal and Poland cancelled theirs. Scotland is a special case: it wants to get out of the UK and stay in the EU, and a referendum there has become highly likely. Many people in Scotland feel greater affinity with Europe than with Great Britain and would like to create an independent and European Scotland. But things are not that simple. For one thing, the UK Parliament would have to green-light a referendum. For another, the transition period would be highly complex. First of all, Brexit includes Scotland. So not until the outcome of negotiations on the official exit of the UK would Scotland be able to request membership in the EU, assuming that it had become independent. This would be a long and uncertain process, involving the introduction of a national currency – not the GBP and probably not the euro, as Scotland would no longer even be in the EU. A real conundrum. Things are not necessarily any simpler in the other countries. In Germany, the fundamental law does not provide for referendums except to change the borderlines in the Länder, merging or dividing them. Any referendum would be held in the states concerned. However, legislation in some states and local communities provides for local referendums. The Belgian constitution has no provisions for referendums. In Italy, 500,000 signatures are needed to hold a referendum, but the process takes at least one year… and referendums on treaties are not currently possible and the constitutional court will probably not allow any. Same thing in Austria, where treaties are not subject to referendums. In France, a national referendum (Articles 11, 88-5 and 89 of the Constitution) mainly covers legislation, treaties and constitutional issues. Only the president can call a referendum and, for the moment, his mind is on the presidential elections (next April and May). It’s hard to see the Republican or Socialist parties taking this route after the presidential elections. Without the president’s consent, support must be obtained from at least 25% of members of Parliament (National Assembly and Senate) and at least 10% of the voters. In Finland, 50,000 signatures can force parliament to debate but it is not required to call a referendum. In Poland, 500,000 signatures are enough to trigger a referendum, which cannot call for rejection of the provisions of a European treaty. In Hungary, 100,000 signatures are enough to trigger a referendum, but there can be no referendums against an EU treaty or against the obligations flowing from an international treaty. So we are unlikely to see a series of referendums but are likely to see these issues debated extensively.
QUESTION # 12 Does Brexit make it more likely that accommodating monetary policies will continue?
If there is one good thing about Brexit, it’s that it reinforces the low-rate environment. Growth will weaken in the UK; the impact on trade is certain; and the fear of an impact on economies will encourage the major central banks to stick to their cautious stance.
Regarding the Fed, we have long known that no monetary normalisation or true tightening cycle is in the offing. The Fed is “behind the curve”, and it has thus far not managed to restore its leeway on interest rates. True, the dollar’s effective exchange rate has appreciated considerably (+13% since 2008), and acts as implicit monetary tightening. Fed models suggest that a 10% rise in the dollar’s effective exchange rate is equivalent to a 175bp rate hike! An additional appreciation in the greenback, driven by its safe haven status (and the safe haven status of US Treasuries) would therefore act as additional implicit monetary tightening. However, on the year to date, the dollar (in real effective terms) has actually fallen by 0.6%. Even so, in the current context, the Eurodollar curve is now pricing in the next Fed Funds rate hike for 2017.
We also know that the Bank of Japan is being forced to stick to an ultra-lowrate (now negative-rate) policy and QQE (Quantitative and Qualitative Easing) to restart economic growth and inflation and steer the yen downward. Brexit has triggered a significant appreciation in the yen, as a safe haven. So the BoJ is nowhere near ready to reverse its monetary policy. In fact, it must now use exchange rate policy (through market interventions) to keep the yen down, as that would otherwise be bad news for profits, share prices and growth.
The ECB will continue to ensure that rates remain low for some time to come. Brexit’s impact on euro zone growth is still not clear (everything will depend on UK-EU negotiations), but it will be visible.
The Bank of England probably has no choice but to ease its policy to head off the coming economic slowdown. At least, this is what can be gathered from the recent statements of the BoE governor, Mark Carney.
So much for those who were betting on rate hikes. They will probably lose that bet once again.
QUESTION # 13 Does Brexit reinforce the low-interest-rate environment and the quest for yield?
Is it possible to imagine
A second referendum
Negotiations with the EU
One thing European
All parties appear to have
Ireland, Malta, Cyprus and
Global growth will remain
European banks are being
The London financial market
We are unlikely to see
So much for those who
The ECB is keep rates