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Brexit: don't panic

After 43 years within the European Union, the UK has decided to leave. The result of the referendum was clear: 52% of voters chose “Brexit”, and turnout was high. Looking beyond the result, the referendum has revealed a divided country:

  • A divide between urban and rural areas. In cities like London 75% of people voted to remain, while in rural areas 75% voted to leave;
  • A divide between generations;
  • A divide between regions: England and Wales voted to leave (53.5% and 52.5% respectively), while Scotland and Northern Ireland voted to remain (62% and 56%);
  • And a divide within the ranks of political parties, between supporters of the Bremain and supporters of the Brexit.

In other words, the result will have a lasting impact on British society. Indeed, following this referendum on the European Union, another referendum could be on the cards, as Scotland has already announced it wants to stay in Europe, and might call for another independence referendum.

What happens next?

  • First, we should expect a new British government. David Cameron has already announced he will step down in October, meaning that a new Prime Minister will be responsible for negotiations – probably a Brexit supporter…
  • We also need to watch the outcome of a meeting between the Union’s founding members, due to be held in Berlin on Saturday;
  • Expect the UK’s credit rating to be downgraded (by one or two notches);
  • And follow the exit negotiations. David Cameron announced that his successor will be in charge of triggering the Article 50 of the Lisbon Treaty. Boris Johnson, the likely next prime minister, indicated that there was no emergency to trigger the Article 50 and that he wants to hold talks with Britain’s UK partners before. The next European Council meeting is being held on 28- 29 June. It will be the most complex divorce in history. Once the Article 50 is triggered, negotiations will take up to two years - less time if there is agreement, and more if necessary and subject to a unanimous decision by all EU members (otherwise, the UK will be outside the EU, with no agreements on trade or free movement…).

There is no doubt that the consequences of this decision will have a lasting impact. It raises political challenges for the European Union (cohesion between countries, calls for an à-la-carte Europe, a new balance of power, etc.), and will have a negative impact on the UK economy. The extent of this impact will depend on the outcome of negotiations with the EU, which will determine the harm done to the UK’s exports. There are several possibilities:

  • Access to the single market and membership of the European Economic Area (EEA)… like Norway, which contributes to the European budget and benefits from the free movement of goods and persons, but does not have a free-trade agreement with the EU;
  • Membership of the European Free Trade Association (EFTA) like Norway, but with trade agreements negotiated with the EU, like Switzerland. Switzerland has certain restrictions like limited access to the EU for its banking industry (this is crucial to the UK);
  • No specific trade agreements, but no customs duties between the UK and the EU, as is the case for Canada, for example. However, part of the Brexit camp wants to impose customs duties on the EU.
  • The renegotiation of individual trade agreements with each EU country. Remember that the implementation of trade agreements involves between 4 and 10 years of negotiations.

There is a great deal of uncertainty, which explains why the markets have reacted so sharply. 

Bond yields fell dramatically in Germany, in the US, in the UK and in Japan. In particular, the German 10y. yield reached a new all-time low. Credit risk premia widened significantly (peripheral sovereign bonds and corporate bonds), to reach levels slightly above that of the Greek crisis of the summer 2015. On the forex market, the pound fell heavily to reach a 31 year low vs the USD. The euro fell vs the USD as well. The yen is sharply up, what may trigger a reaction from Japanese authorities. Equity markets fell heavily, more in peripheral countries than in core countries. The banking stocks suffered as well, while this is hard to discriminate between countries. Globally, the fall of the markets just erased the upward trend of the last few days, during which there has been a burst of optimism as several opinion polls gave the Remain ahead. This is too soon to know if the adjustment of the risk premia is over.

That being said, it is important not to panic. The BoE is ready to take the necessary measures to restore confidence on the markets and to support the UK economy. For euro assets, the ECB’s asset purchase programmes (in particular the CSPP and PSPP) and their possible adjustments will limit the risks of a too sharp widening of the spreads. Once again, central banks will rescue the markets.

 

 

 

2016-06-24-focus
ITHURBIDE Philippe , Global Head of Research
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Brexit: don't panic
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