The Day After Brexit

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Instead of arguing for or against British withdrawal from the European Union, we look at the likely outcomes if Brexit were to happen.

Picture the scene: The votes have come in showing that the British have not believed the strapline that “Britain is stronger in Europe” and the great debate about Brexit is over. Today is the first day of the next two years that will determine just how “Great” an independent Britain really is.

What will the UK’s relationship with Europe look like?
This is the key question that will create a great deal of uncertainty and could result in a great deal of damage. This uncertainty stems from the conflicting demands the UK has from a relationship with the EU and the cost the EU would charge in exchange.

The UK would favor an agreement that:

  • Maintains easy access to the EU markets for UK businesses
  • Has some control over the movement of people (addressing the current immigration concerns)
  • Allows deregulation
  • Has an ability to vote in EU decisions

However, this is a hefty wish list that has yet to be granted in any EU relationship and is unlikely to be without considerable concessions by the UK. UK politicians would have to manage a trade-off between what was in the best interest of the economy and how much political power they were willing to cede. Negotiations would be long and arduous, with enormous pressure to reach a swift agreement that all parties accept — a task few would envy.

In the meantime, let us turn to the financial and economic implications of Brexit over the next two years and beyond.

We believe that the British pound, which has already dropped 5-6% in the run-up to the Brexit vote, has room to drop up to 12% further.

A weaker pound could be helpful for the UK’s current account deficit, although a very large drop in currency would be required to cover the deficit and, in the long term, the pound is not expected to remain that weak.

The equity markets could also benefit from a weaker pound. Of the companies comprising the FTSE 100, some 70% of their earnings come from outside the UK, and with a weaker pound we expect an increase in earnings, which is positive for equities.

Interest rates
The Bank of England (BoE) would undoubtedly push out the prospect of rate hikes and might even go as far as to cut rates, as long as the pound was not in free fall. This easing would likely be mirrored by the EU in the face of uncertain market conditions and losing one the world’s financial epicenters, the city of London.

Inflation may follow a weaker pound due to higher import and oil prices. Given the long period of “low and slow” in the UK’s economy, inflation would normally be welcomed. However, the uncertain environment may force the BoE to keep interest rates low to support businesses.

The UK’s primary concern post-Brexit would be its high current account deficit and the foreign direct investment (FDI) needed to fund it. As seen in the following chart, Europe contributes a significant proportion of net FDI in the UK.

Net direct investment in the UK by foreign companies
Exhibit 1_Net direct investment in the UK by foreign companies
Source: Macrobond – April 2016

Any disruption in the flow of FDI would be problematic to the UK, although there is still a substantial proportion of FDI which originates from outside of the EU. One can only hope that this was not invested in the UK purely as a platform into the EU.

Trade with the EU (which accounts for roughly half of the UK’s total trade) would likely decrease post-Brexit. A study from the Centre for European Reform suggests that “the UK’s trade with the other EU members is 55% higher than one would expect, given the size of these countries’ economies.” This could imply that the UK is over-reliant on trade in the EU based on the ease of trade, which will almost certainly decrease with a departure from Europe.

On the employment front, the following chart shows that the UK has seen a steady increase in EU workers over time.

UK employment levels by nationality – EU & non-EU
Exhibit 2_Employment levels by nationality-EU and non-EU
Source: Macrobond – April 2016

Outside of the free movement of labor in the EU, we would see a shift in the composition of the UK workforce. While the number of jobs available to UK citizens would increase, the time needed to fill these roles would impact companies if EU employees were unable to remain working in the UK. Ultimately, this all would put pressure on wage rates and, in turn, the economic health of the UK in the short run.

Finally, we should expect a prolonged period of uncertainty, brought about by the extended renegotiations to dampen GDP growth generally, sapping confidence and undermining activity more broadly.

Within fixed-income markets, UK gilts (bonds issued by the British government and generally considered low risk) could be seen as less of a safe haven due to the possibility that companies may move their headquarters elsewhere on fears that the BoE could struggle to maintain its grip on policy. However, the majority of gilt holders are UK pension funds and central banks, which are unlikely to leave the UK markets because of the Brexit decision.

Within equity markets, different sectors would be impacted to varying degrees. Brexit is likely to have the biggest impact on banks, with retail, other financials, insurance and property hit to a lesser extent. Utilities and large international companies are unlikely to encounter big moves, assuming Scoxit does not immediately follow Brexit.

While the property market faces the potential loss of foreign buyers, a weaker pound could counteract this threat and attract more interest. Should the government decide to change the rules surrounding property investment by non-UK residents, we could see a decrease in investment. At least the sticky nature of the property market would prevent a quick withdrawal of investment by those already invested.

Following in the UK’s footsteps
Potentially, the most pertinent issue is the risk that other countries would follow in the footsteps of the UK’s decision to leave the EU. Scotland’s First Minister Nicola Sturgeon could rally the troops and have a “re-referendum” to untie Scotland from the UK and get back into Europe, though would the Europeans want to take on an economy so dependent upon oil when oil remains an unknown quantity?

Might we see Brexit alongside other populist parties gaining traction throughout Europe? Britain, some argue, could be seen as a safe haven amid a disintegrating Europe. This would encourage businesses to stay or indeed move across to the UK — Britain’s parting blow to the EU. Surely then, the wisest move for the EU would be to make the process of Britain’s exit as challenging as possible to deter others from following suit.

Bottom line
Overall, it is clear that a post-Brexit world would have its challenges. With no similar events to review in history, it is not possible to know what will happen on day one. However, one thing is certain: “All the world’s a stage and all the men and women merely players. They have their exits and their entrances; And one man in his time plays many parts.” How the world reacts to Brexit if in fact Britain decides to leave the EU, only time will tell.

© Columbia Threadneedle Investments

© Columbia Threadneedle Investments

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